I am so happy to introduce our next speaker today. I've been reaching out and talking to Alex for over a year, and he graciously accepted the opportunity to be one of our featured speakers at SaaS Metrics Palooza. He's the general partner at Meritech Capital, one of my go-to resources when it comes to public SaaS and cloud companies' clumps and benchmarks. Alex, welcome to SaaS Metrics Palooza.
Awesome. Well, thank you again, Ray and the SaaS Metrics Palooza team. I really appreciate it. Today, I'm going to walk you through a variety of public market valuation metrics for the software market. At Meritech, we've been an investor in software companies for almost 25 years. We were one of the first growth investors in Salesforce, the first pure SaaS IPO. And over the past few years, we've built a lot of infrastructure around how to track and monitor the public markets. We host a lot of that stuff on our website as well, meritechcapital.com benchmarking. We have what we believe is the largest free and easy-to-use application to sort and filter and understand the valuation and makeup of the public SaaS market, which today is almost a $2 trillion industry.
And so this presentation today, we'll walk you through four different pieces around valuation multiples, operating metrics and KPIs, what growth and profitability means in today's market, as well as some company rankings. The purpose of this is for any mid to late stage software CEO or executive team to understand what value their company could achieve in the public markets. We've obviously had a very dramatic change with interest rates over the past couple of years in the public markets. And we'll dive into all of that here.
So with that, I'll get started with a chart. I'm sure many of you have all seen before, but NTM revenue multiples by multiple percentile. And the reason we do it this way is because we wanted to show the 25th, 50th, 75th and 90th percentile NTM revenue multiples. As you can see, things have come down a lot. Every chart around public software multiples looks kind of like this. Back in 2015, things were around 10 times forward revenue. They rose up dramatically and then have come back down. And if you look a little bit deeply, take a look at the purple line, which is the 90th percentile company. This is essentially the top 10 public software companies, and those multiples are down 80% from their peak of over 52 times. So if you go back to the peak in 2021, your forward revenue estimate, you were worth 50 times that number, which was unprecedented in public software history. That is down to 12.2x today, and the current median for everything is about 6.5x. And to take another perspective on this, these are the public software companies, which in theory are the best companies in the world, or best SaaS companies in the world, because if you can go public, generally companies decide to. So this is the cohort of the best companies in the world. It represents almost $2 trillion of market cap, and this is where they're trading today. You can see in the box here that down from the peak, we looked at the COVID boom periods and everything is down. Multiples are down 50, 60, 70% on a median basis, and the best companies today in the top 10% can expect to trade about 12x their forward revenue estimates.
Here's the revenue multiples for the top 10 companies. As you can see, this is quite a bit different than the chart before, and we took on any given day, what are the top 10 trading multiples. You can see that these numbers also rose dramatically during the COVID period, and on the same token, also came down dramatically post. The top 10 company median was almost 70x forward revenue. To put that in perspective, if a company is doing $100 million of forward revenue, they'd be worth $7 billion. That's a period of time where we had businesses like Zoom and Snowflake and Shopify worth over $100 billion a piece. As you can see, that's down about 80% from a 2021 high of 70x. The top 10 companies today are trading about 14x their next 12 months revenue. What if you take a look at implied ARR multiples, which is total revenue times four. This is the proxy that we use to benchmark ARR. ARR, annual recurring revenue, is used commonly in the private markets as a valuation metric. While many public companies don't report it, we've implied it, and it ends up being quite close.
This chart looks at the public SaaS ARR multiples for the past eight years, and for the entire market, these companies traded a median about a little bit over seven times. That's actually below the pre-COVID median of 8.8x, but down 70% from the high of 21.4x. Now we're going to dive into some operating metrics and KPIs. On the first one, we're going to look at medium NTM revenue growth and free capital margins for all software companies. As you can see, it's been one thing is certain. In the past two years, companies, to put it simply, are trading growth for profitability. The green line is the median NTM revenue growth rate of all public software companies. As you can see, it rose in the 2020 period and then has been declining in a relatively aggressive way ever since. The median is about 15%. On the bottom, the dark blue line, is the median free cash flow margin. So as growth has come down, free cash flow margins have come up. And we're going to get into the composition of what that means in a minute and what that means for valuation. But again, companies, due to the market conditions, have to get free cash flow positive. And investors are demanding more margins. And that is not unlike what is happening in the private markets as well.
Median net dollar retention. This is a really important metric. Essentially what this means, a dollar today equals what a year from now. For SaaS companies, due to their characteristics of subscription models, where they can grow with their customers over time or sell their customers more end products. This is a very important metric to track. As you can see, this metric is also coming down just like growth rate. Upsells have been harder. They've decreased. Churn and contraction have increased. And that net dollar retention, which is on any given cohort, how much revenue gain you have above 100%, is coming down even for the best companies. We've seen it come down dramatically. We don't know where this will necessarily bottom out. But best in class used to be 120-125%. Now it's more like 110-115%. Hopefully this number somewhat stabilizes. As you can see, there was a huge drop off from Q3-22 to Q4-22 and a more slight drop off from Q1-23. So our hope is that this is starting to trough out, but we'll have to wait and see.
Here's another interesting metric that looks at efficiency. And if you look at this over time, you can garner some interesting insights. This is the implied ARR for FTE, which is full-time employee. So we track, obviously, top-line statistics as well as total employees, and we look at that ratio. And if you remember the chart before, free capital margins are coming up. Well, most of the cost of a software company on operating expenses comes from people. And that is, put simply, payroll. And so as there have been many layoffs, many reductions in force, many hiring pauses, the median ARR per FTE has come up pretty dramatically over the past few quarters. In the 2021 period, companies were hiring very aggressively. Growth was all that mattered. You needed people to grow. And while software companies don't grow literally with headcount, there is some correlation there. Times could not be more different now. Companies have decided to pause, in many cases, pause hiring or reduce their headcount sizes. Therefore, this number is continuing to go up and to the right.
We also look at payback periods. And, you know, we looked at this a bunch of different ways. And this is payback period in months on a gross margin adjusted basis. And as you can see, the median for public software was around 20 months. And these are all months. In Q2 to Q4 21, we dipped below 20. We're at 17, 18 months payback. As you can see, it's been a steady march up and to the right. No surprise. As we showed you, net dollar retention is coming down, meaning that upsell is less than people expected. Sales cycles are taking longer. Churning contracts are increasing. So the net new business that a company has to add in a given quarter is becoming harder to come by and costing more. Therefore, the months to pay back are increasing. Hopefully, this doesn't go really too far above 30 months, but we'll see where it troughs out. Now we're going to look at growth and profitability and regressions. And this is really important because everyone talks about growth rate being a dominant force in valuation and that it was free cash flow margin being a dominant force in your valuation multiple.
The reality is very nuanced and there's a mix. And we decided to dive into that. This first chart looks at growth rate and profitability buckets for all software companies. And I know there are a lot of numbers on this table, but we essentially segmented meeting revenue multiples by the forward or next 12 months growth rate of a company over time. We picked 2017 as being a proxy for the pre-COVID times and 2021 as a proxy for the post-COVID boom period. As you can see on the right, there's some red there. Multiples have come down pretty much across the board. And it's actually interesting. There is not a single public SaaS company that Wall Street expects to grow faster than 40% over the next 12 months, even while burning cash. So, this grid can be used for mature private companies to understand hypothetical trading multiples based on the market conditions today. And just to dive into a couple columns, there's some red boxes around the NTM revenue multiple, today's median, as well as market cap. As you can see, companies that grow faster traded higher revenue multiples, and they're also larger. And note that the reason that on today's median there's dashes in the 40% revenue growth bucket is, like I said, the street doesn't expect a single company out of almost 100 public SaaS companies to grow faster than 40%. Hopefully, that changes.
We've seen some positivity over the past few weeks in some public software earnings, but we are still nowhere close to where we were in 2021. As you can see, companies in 2021 that the street expected to grow faster than 40%, even if they were burning cash, were worth over 40 times forward revenue. And there's not a single company in that bucket today. Now, instead of looking at growth rate, we look at rule of 40, which is the composition of your year over year growth rate, as well as your free cash flow margin. It's very similar to the prior chart, but it's segmented based on that rule of 40 composition. So, taking a look at it in the same way, there is a lot of red on the decrease in multiple. As you can see on the first column, 61, 57, 58, 66, multiples are down dramatically across the board, and market cap is down, but maybe not as much for some companies. With that said, if you look at the difference between 2017 and today, on a multiple basis, we're still somewhere down, somewhere up, but on a market cap basis, the best companies have continued to grow. So, even as their multiple has come down, their market cap has grown. And I want to point again to the two red boxes here.
Take a look at the NTM revenue multiple. For companies that have a 60% score on the rule of 40, they traded almost 11 times. For companies that are below 20% on the rule of 40, 3.8x. So, there is a dramatic spread in valuation multiple for companies that have a high rule of 40 score, as well as those that have a lower one. Moreover, on the median market capitalization, taking a look at today's median, companies with a 60% plus rule of 40 are worth almost $40 billion. Companies with a sub-20% rule of 40 score are worth about $2 billion. So, again, there is a huge spread of companies based on their rule of 40. Although, rule of 40 doesn't tell the whole story. And so, this gets a little bit more nuanced, but bear with me and I'll explain. This is the rule of 40 composition. So, as we know, rule of 40 score is important to look at, but it's also important to look at the makeup of the rule of 40 because there's both a revenue growth rate, as well as a pre-cash flow margin. And again, it's quite nuanced. And so, we decided to break down growth and cash flow margins by showing the median multiple and the median rule of 40 of each bucket. You can look at simple regressions that compare multiples against growth or rule of 40, which are very valuable, but this shows the actual composition of the rule of 40. And this is very important for private companies.
Sometimes, we meet businesses where, yeah, we're growing 100% a year, but our pre-cash flow margins are negative 100%. And so, our rule of 40 score is zero. And there's a lot of nuance on scale, where you're investing, but for most soon-to-be public companies, they not only need to focus on the high growth rate, but also the pre-cash flow margin. And if you look at the red boxes on the bottom left chart, you can see that there's a 5.4, 6.7, 9.6, and a 9. It follows a general line up into the right. And what does that mean? It essentially means that companies that have a similar rule of 40 but are growing faster can trade a significant premium to companies with lower growth rates and higher pre-cash flow margins. Why is that? Investors still pay today the highest prices for companies that are growing quickly but have some pre-cash flow. Why is that? We believe it implies that a company has a great market structure. If you're growing at, say, 30% a year and you have 10% pre-cash flow margins, the street can expect that you have a very good market structure. That in maturity, if you were to grow at, say, 10% to 15%, you could have dramatically higher pre-cash flow margins and you'd be worth even more. And so, that's the reason today investors are still paying more for a unit of growth than they are for a unit of pre-cash flow. And we'll talk more about that in a moment. The chart on the right looks at those same group of companies that are applied in those red boxes, and the rule of 40 score is kind of similar. I'm going to note a couple different ones. If you look at the first chart on the bottom left that says 5.4X, and then you look on the right, the 41% rule of 40 score. That's for a business that's growing less than 10% on revenue but has 30% plus pre-cash flow margins. On the top right, on the left chart, you have 9.0X. That's a company that's growing greater than 30% but has 10% pre-cash flow margins and a lower rule of 40 score, and it trades at almost double the multiple. And again, investors are still paying more for a unit of growth than for a free cash flow, even in this market.
And here, take a look at this. This is another chart that plots those red boxes to visualize this inverse correlation between rule of 40 and multiple for this very reason. You could not pick this up from looking at a simple regression. Investors still pay the highest prices for companies that are growing quickly but have some pre-cash flow margin. And again, this implies that companies have great margin structures. As you can see, the green bars in this slide represent the NTM revenue multiple and the blue bars represent the median rule of 40. So, companies on the right that are growing the quickest but even have a lower rule of 40 score are still worth almost twice as much as a company with the same rule of 40 score with a very low revenue growth rate and a high free cash flow margin. This is why. We went and looked and did a two-factor regression on the relative importance of revenue growth versus free cash flow margin. So, what does this mean?
We looked at that ratio every single month over the past many years, and we plotted it here on the chart. As you can see, during the boom times of the COVID period where everything was about growth, growth, growth, revenue growth was over 11 times more important than free cash flow margin. Today, it's still 3x more important than free cash flow margin. And so, said another way, a 1% increase in growth rate would have the same impact on multiple as a 3% increase in free cash flow margin. And we'll see where this settles over time, but there's been a whole backlash against growth. But if you really dig in and do these two-factor regressions, growth still rules the day, but you also have to have free cash flow margins. In the prior market regime, all you needed was growth and growth at all costs was where you were valued the most. Now, you need free cash flow margin. So, what do we do with that ratio? We decided to create something called the Meritech Rule of 40. And we take this as a regression analysis based on enterprise value over implied error or multiple versus the Meritech Rule of 40. And so, what do we do? We weight growth by the relative importance. And in this case, it's about 3x to free cash flow margins.
We believe this is the most accurate way to reflect the current valuation environment shown in the prior slide and results in a very, very high correlation. So, what does that mean? This means that you take your revenue growth rate and you multiply it by 3. And you also take your free cash flow margin as is. That is the Rule of 40 score that you use against your multiple. And it goes to show you that if we wanted to plot a company's valuation using this methodology, there is a 0.62R2, meaning that greater than half the time, this score represents an accurate view of the valuation that is shown. So, we believe this is a very strong metric. We've cut this in many different ways. And we'll continue to use this to help value companies most effectively both in the private markets as well as in the public markets. And we looked at this over time. We said, well, our Meritech Rule of 40 is highly accurate. But if we can't tell what it looked like over time, it may be great today. But what about in the past?
And so, we plotted this Rule of 40 correlation over time against standard growth rate and Rule of 40 correlations. Following the market sell-off and multiple compression early 2022, growth in Rule of 40 multiple correlations converged. As you can see, the blue line is based on Rule of 40. The dark blue line is based on revenue growth. And the dotted green line is the Meritech Rule of 40. And we've smoothed this out over three-month periods to make the chart more easier to read. And so, that's why they don't exactly match the current R-squared on the slide before. As you can see, the Meritech Rule of 40 shows a consistently higher correlation than just growth. But the two lines move in unison given the disproportionate weighting of the revenue growth rate. So, we feel confident after looking at this trended correlation analysis over time that our value, our regression methodology is the one that will yield the highest results closest to what companies are truly valued at.
Lastly, we look at some company rankings. And this was an interesting exercise because we often get asked, what does best-in-class mean for a company? And so, we just looked at the top 10 public SaaS companies that had the highest implied error multiples. What do they look like? Well, they're pretty big. They're $1.9 billion of error. They're growing almost 35% year-over-year, have 125% net dollar retention, have implied ACVs or annual contract values of about $75K. They have gross margins of almost 80%. They're profitable on a non-gap basis, and they have free cash flow margins of around 12%. And their Rule of 40 score is about 40. So, these businesses are large, and they are growing very fast. As you can see on the implied error, there is no company in the top 10 that is less than $500 million of error. So, what does that tell you? The market cares that you're big, that you're growing quickly, and that you have great unit economics. Here's a different cut of that looking at the top 10 market capitalization companies. And there's some crossover with the prior slide, but not much. And this obviously has a relation to scale, given your multiple is based on the size of your revenue base. But again, these companies are very impressive and growing very quickly. You can see the implied error of these businesses is $5.3 billion. They're growing on a larger base, so they're growing a bit slower at about 20%. Net dollar retention is 120%. They have very strong payback periods of 22 months. Gross margins are 80%. And LTM free cash flow margins are 25%, and almost a Rule of 50, Rule of 40 score. And the median market cap of these businesses is $61 billion. So, this is what businesses should be aspiring to. The best-in-class companies will get here. It takes a very long time. Adobe, which is the largest business, has been around, I think, since the 70s or early 80s. So, it's taken them a very long time to get to this valuation. But these are what the largest companies look like in trade in the public SaaS market today.
We also looked at quartiles. We wanted to shed some light on, okay, you showed me the top companies. You showed me the top 10, the top 10 by market cap, but what about quartiles? So, what does it mean to be a top quartile public SaaS company? It means that you're worth about $24 billion. You traded about 14 times implied error, and you're about $1.7 billion of error, growing over 30% a year. You have a free cash flow margin of 16% and a rule of 40, a score of right at 40. As you can see, the multiples come down pretty dramatically as you move to the right. And let's take a look at the bottom quartile. So, what is a bottom quartile public SaaS company? They're about $500 million of error. They're not growing very quickly at about 10% year-over-year, and they have 1% LTM free cash flow margins. They are not really making any money. So, the street is saying, back to that point on rule of 40 composition, the street wants you to grow quickly and have some free cash flow in today's market. Growth still rules the day. These companies are not growing quickly, and they do not have great margins. Therefore, they are trading at very low revenue multiples.
Lastly, people always ask, well, what does it look like to be in the bottom 10 of implied error companies? And this isn't a list you necessarily want to be on, but because they exist, we wanted to show them. So, you can see that the bottom 10 implied error multiple companies are trading around 1 to 3x implied error, which is not very high. Let's take a look at their metrics on the median where the red box is on the right. Implied error of a little bit under 400 million. There again, they are not growing quickly. They're growing about 10% year over year. Net dollar retention is below the median at 109%. The gross margins are 75%. LTM operating margins are about zero. LTM free cash flow margins are negative. So, if you're a $400-500 million revenue company, and you're not growing quickly, and you're not generating a lot of cash, you will not trade well in today's market environment. And this is unfortunately where these companies are today. So, that just goes to show where if things don't work out as planned and companies do not achieve either the growth rate or the free cash flow margin the market is hoping for, they will not trade well in the public markets. And here's our appendix with just some footnotes. And with that, I will send it back to Ray. And thank you so much for letting me walk through all that.
I know that was a ton of data. Wow, Alex, so much data. And that's one of the benefits of recording these sessions, because for the people like me who really want to dive, I can go back and watch it three or four times. But a couple things jumped out at me. So, most of the audience here are going to be private SaaS company executives, CEOs, CFOs, and some go-to-market leaders. And I get asked this question all the time. So, if I'm a little bit later stage, thinking about maybe going public over the next 12, 24 months, what's that sweet spot of growth and profitability as measured by free cash flow? And what I saw in one of your charts was kind of 20% to 40% growth plus at least 10% to 20% free cash flow as a margin. That's really where you're getting the highest multiples today is that balance growth, correct?
That is correct. And like I was saying, growth still rules the day. And so, public market investors care about growth because they want the metric. Because if you have a high growth rate, you'll have the metrics to show that we can do this for a long period of time. So, what I ask the question of a lot of late stage private companies is, what does it take for us to grow at many hundreds of millions of revenue at 30% a year with 10% free cash flow margins? Can we back into that market structure? Does that exist for us?
That's a question that in today's market, many companies are asking themselves and many companies are doing just that. We had Klaviyo that just filed their S1 a couple of weeks ago and that's a business that's almost 700 million of ARR growing over 50% with 25% free cash flow margins. That is the type of business that investors want to be a part of. You're big, you're growing quickly and you have great margins and you're a market leader. I'm going to ask you to bring out your crystal ball. You saw that 3X growth is more important than profitability for multiple reasons and that's come down from 11, 12, 15 months ago. Do you think that's going to continue to increase as we come out of this recessionary period for the SaaS industry? We're going to see that back to 4 and 5?
I can't predict the future, unfortunately, but I think it all depends on where interest rates fall. I think the entire market underestimated the dramatic impact that interest rates would have on public software valuations and we saw that over the past year and a half. Do I believe that if rates were to fall, that we'll see that number go back 4, 5, 6X? I think that's very possible. What I will say and what I'm pretty sure about is the monetary policy, the market structure for monetary policy to go back to it being worth 10, 11, 12X, that is not going to exist in the short to medium term. Maybe in the long term, maybe in 7, 8, 10 years, but I think it's pretty safe as a founder. You can assume that that number, even if rates come down a bit, could go up to 4 or 5X, but we are not going to be back into the 10, 11, 12X. And then my last question. You analyzed the best of the best, the public SaaS and cloud companies. Cap payback period, you showed where that's kind of went up to 21, 22 months, right? That's improved a little bit over the last two couple months. Everyone used to say, oh, it's 12 months. That should be your kind of threshold of where you want to be at. Your data shows you that 12 months isn't statistically accurate. Why do you think it's closer to 20 for these public companies?
Yeah. A couple things, and this is a very nuanced question. And the reason we do it this way is because we want to be able to benchmark across many different companies, and I'll say it's directionally correct. We also apply gross margin to the net new business. And so there's a lot of different ways to calculate sales efficiency, and it's very nuanced. And so while this is a great proxy, it is not the exact way to do it. But with that said, we apply the company's non-gap gross margin to that figure. And so I think a lot of people talk about 12 months paybacks. That is based on a net new ACDV versus a net new gross margin. At the end of the day, people care about your gross margin and gross profit dollars. And so we decided to apply that to account for various market structures in the payback period because companies have different gross margins.
You know, Alex, we didn't even prep that, but it was a perfect softball because Dave Kellogg and I have this podcast called SaaS Talk, and we were talking about the importance of applying gross margin or gross profit-based CAC payback period. So important for the audience. We would strongly recommend if you're not doing CAC payback period on a gross margin-adjusted basis, you're not getting a full picture of your efficiency. Would you agree with that?
Yeah, couldn't agree more. We suggest that. And I think on a per-company basis, like I said, it's good to look at these things across benchmarks, but if you're a private company, you have all your own data. There are many ways to triangulate around sales efficiency that go much deeper than just looking at the months to pay back. Well, Alex, thank you so much for being a speaker here at SaaS Metrics Palooza 23. And I know people will go back and look at your charts, but my go-to online site is at meritechcapital.com/benchmarking and the regression analysis, one of the best things I've seen in the industry.
So thank you and Meritech Capital for putting that out there to the industry. Awesome. Thank you, Ray. Appreciate it.