SaaS Minority Investment: DCF vs Market Multiples
A growth-equity fund is valuing a private B2B software company for a $30 million minority investment. Trailing revenue is $48 million; management reports ARR of $52 million growing 28%, gross margin 78%, and net revenue retention 112%. EBITDA is negative $3 million and free cash flow is negative $6 million after capitalised software but before stock-based compensation of $5 million. The company has $18 million of debt and $9 million of cash. Public comparables trade at 6.5x EV/ARR for 25%+ growers and 4.0x for 15% growers; the median has fallen 20% in six months. A DCF using a 12% WACC, 3% terminal growth, and 25% steady-state FCF margin yields an equity value of $310 million. The deal team’s comparable-company analysis yields $260 million. The fund needs a 3.0x gross multiple on a 5-year hold. It asks whether $30 million for 10% is attractive.
1. Reconcile the DCF and comparable-company values and identify the assumptions that drive the gap.
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The $30 million for 10% implies a $300 million post-money equity value, between the DCF’s $310 million and the comparables’ $260 million. That proximity is misleading because the DCF is not clean. Free cash flow is stated before $5 million of stock-based compensation; treating SBC as a real economic cost reduces value by roughly $5 million divided by the 9% spread between 12% WACC and 3% growth, or about $56 million. On that adjustment, DCF equity value falls to roughly $254 million, below the deal price. The 25% steady-state FCF margin is also aggressive for a company still burning cash; it requires large sales-and-marketing leverage. The comparables tell a different story: 6.5x ARR gives $338 million EV, or about $329 million equity after $9 million net debt; 4.0x gives about $199 million equity; the $260 million median implies about 5.2x ARR. The market has repriced growth software, and the DCF may be capitalizing a terminal margin the company has not demonstrated. The gap is therefore explained by SBC, terminal margin, and multiple compression, not by a superior DCF.
2. Assess whether the investment meets the 3.0x gross multiple requirement; show the exit math and the assumptions that must hold.
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A 3.0x gross return on $30 million requires $90 million of proceeds after five years. At 10% ownership, that requires $900 million of exit equity value. If ARR grows 28% for three years and 15% for two years, exit ARR is about $144 million ($52m × 1.28^3 × 1.15^2). At 6.5x EV/ARR, exit EV is about $938 million; with net debt near zero, 10% is about $94 million, or 3.1x. At 5.0x, exit EV is about $721 million and the stake is about $72 million, or 2.4x. At 4.0x, it is only about 1.9x. So the 3.0x case requires both high growth and multiple persistence. It also ignores dilution: if future rounds reduce the fund to 8%, the required exit equity value rises to $1.125 billion. The deal should not be approved on the base case without pro-rata rights, a ratchet, or a lower entry price; sensitivity to exit multiple is the dominant risk.
3. What diligence would you require on the DCF’s 25% steady-state FCF margin before relying on it?
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The 25% margin is a terminal assumption, so diligence should test whether the business model can reach it. Ask for cohort-level gross margin, customer acquisition cost and payback, sales-and-marketing spend as a percentage of new ARR, net revenue retention by cohort, churn, and pricing power. Check whether capitalised software is being used to flatter cash flow and whether R&D and SBC are properly expensed. Compare the assumed margin with mature software peers and with the company’s own path from negative FCF. Model a downside case with 15% FCF margin and 14% WACC; the value should fall materially. Also test terminal growth of 2% rather than 3% and examine the terminal value share of total DCF value. If terminal value exceeds roughly 75% of the total, the investment case depends mostly on assumptions that cannot be diligence-verified, and the fund should demand a lower price or structural protection.