SaaS Valuation: Navigating the Landscape of Valuing a SaaS Company
SaaS Valuation is the process of determining the total worth of SaaS Company. This valuation is not only important for founders but essential for angel investors and VC as well. Because founder wants to raise investments based on the valuation, similarly Investors also willing to find the true valuation of the SaaS startup, therefore investor get fair equity against investment. Hence create a win-win situation.
The $100 questions is, how will all stakeholders finds the valuation of SaaS Startups,
Answer is Financial Modeling. A financial model is a forecasting tool for future earning potential based on the various factors that play a vital roles in the valuation. Moreover, it is also essential to understand, that every industry has different revenue model, growth opportunities, earning multiples, investment required and cost to execute the business, therefore valuation approach is also different for every industry. We have heard DCF valuation approach, Comparable Analysis and Asset based Valuation, which is widely use in the valuation. But there are 2 most important factors, one is Startup and another is SaaS Company.
SaaS Startup is more challenging than any other company, because unlike traditional business model, It has asset investment, inventory, which will be selling to specific area or markets etc, whereas SaaS business model has recurring revenue, software infrastructure, Intellectual property, value proposition, R&D team to Pivot based on market demand, headcounts, and the entire World is the market, and it has a potential to quick scaling to the globe.
Therefore, In SaaS Financial Model, there are many things which will be different in Valuation of SaaS Company. By understanding SaaS valuation drivers and attributes, you can make sure that you’re not making a bad deal or underestimating your company’s worth.
Types of SaaS Valuation Methods
Depending on the profitability and maturity of your SaaS business, selecting a valuation method can be strategic, aiming to optimize the multiplier applied to your earnings. Three primary methods exist for valuing a (software-as-a-service) SaaS company based on its earnings:
- SDE (Seller Discretionary Earnings) Based Valuation
- EBITDA Based Valuation
- Revenue or ARR based Valuation
When assessing SaaS business valuations, smaller companies often prioritize SDE, while larger ones lean towards EBITDA. However, for SaaS companies, neither of these approaches may suffice. Let’s delve deeper into this matter.
Revenue based Valuation
The initial method for valuing a software business involves Annual Recurring Revenue (ARR). ARR-based buyers are inclined to pay multiples of ARR due to the perceived value of recurring revenue, a trend increasingly favored by private equity firms.
While some view this as a secondary valuation approach, we argue that a revenue-based valuation is optimal, particularly if your SaaS Startup has recently attained product-market fit (PMF), is driving T2D3 growth, or has achieved a revenue range of $1 to $100 million ARR.
At Excel Business Resource, we refer to these stages of SaaS growth as ‘Start’ and ‘Scale.’ With SaaS business models relying on subscription-based revenue, they can swiftly reach PMF and generate ARR or MRR (Monthly Recurring Revenue).
To qualify for a valuation based on revenue multiples, your ARR should exceed $2 million, accompanied by year-over-year growth rates exceeding 50%.
If your SaaS company is undergoing hyper-growth or intends to do so, opting for a revenue-based valuation over an EBITDA-based one is advisable, as your revenue is poised to surge, even if profitability may not be immediate.
SDE based Valuation
For small businesses valued at under $5,000,000 or $5 million, the typical approach involves using a multiple of seller discretionary earnings (SDE), also known as seller discretionary cash flow. This method is especially common for businesses with slower growth rates and lacking a formal management team.
SDE (Seller Discretionary Earnings) represents the profit retained by the business owner after subtracting all costs of goods sold and essential (non-discretionary) operating expenses from the gross income. Notably, any owner salary or dividends can be added back to the profit figure.
In simpler terms, SDE can be described as:
SDE: Revenue- Cost of Services – Operating Expenses + Owner’s Compensation
SDE serves as a crucial metric in valuing small businesses, as it reveals the genuine earning potential at their core. Given that many small businesses are operated by their owners and depend to some extent on their involvement, there are associated owner salaries and expenses. Owners often compensate themselves with a salary that might not align with market rates and may also utilize the business for tax-efficient personal expenditures. These adjustments, known as addbacks, are legitimate inclusions to accurately reflect the business’s true earning capacity.
EBITDA based Valuation
Let’s imagine your software company has achieved the rule of 40, indicating a healthy balance between growth and profitability, or you boast a notably low customer acquisition cost (CAC).
In larger corporations, where the organizational structure involves numerous employees and management personnel, ownership tends to become more fragmented, with multiple shareholders often playing less active roles. They might hire a general manager or CEO to oversee day-to-day operations. In such scenarios, any owner compensation or discretionary expenses should be accounted for within the business to accurately depict its true earning potential.
For potential buyers evaluating an EBITDA Valuation in the SaaS realm, the focus lies on the company’s capacity to generate robust cash flows. Private Equity firms, for instance, might seek these strong cash flows to facilitate borrowing.
Moreover, the EBITDA model emphasizes profitability, enabling SaaS companies below the $5 million revenue mark to still command high multipliers. In such cases, opting for an EBITDA-based valuation might yield the most favorable multiplier for your SaaS business.
EBITDA, representing Earnings before Interest, Taxes, Depreciation, and Amortization, proves advantageous for companies with substantial profits.
To calculate your SaaS Company’s EBITDA, utilize the following formula:
Net Income + Interest + Taxes + Depreciation + Amortization
This method considers various factors pertinent to mature, established businesses, making EBITDA valuation a preferred choice for companies boasting earning power exceeding $5 million ARR.
Now that we’ve discussed valuation methodologies, let’s delve into the main reason you’re here: identifying the SaaS valuation multiplier.
Valuation Multiples
Valuation multiples are key in setting fair prices for SaaS businesses and staying up-to-date with market trends. While the idea is straightforward multiplying average net profits by a specific factor it’s essential to grasp the intricacies and metrics influencing these multiples.
For instance, B2B software companies can be worth anywhere from 3x to 15x their yearly revenue. This depends on various factors, including who’s doing the valuation and what other similar companies are valued at in the industry.
In a business valuation for software companies, the listing price is:
Average net profit for the last year x multiple
As a general rule of thumb, the B2B SaaS valuation spectrum looks something like this:
But how do you figure out your SaaS multiple? While some factors that influence it might be beyond your control, here are some key valuation attributes to concentrate on:
Choice of Multiple
Choosing the Right Metric: EV/Revenue is the top choice for valuing SaaS companies. This makes sense because, as many SaaS firms prioritize growth over profits, traditional profit-based multiples may not accurately reflect their value. For instance, if a company trades at 5.0x Revenue and forecasts a 30% EBITDA margin, it hints at a future 16.7x EV/EBITDA multiple.
Revenue Multiple:
From our years of experience, we’ve found that basing the revenue multiple on annualized current run-rate revenue gives the most accurate picture of a business’s scale. We steer clear of using trailing or projected revenue. However, it’s important to mention that our analysis excludes B2C SaaS companies and B2B companies with annual revenue per customer under $500 due to their unique customer acquisition and retention strategies.
Public vs. Private Multiples:
Typically, we start the valuation process by looking at the median revenue multiple of public SaaS companies. From there, we adjust to calculate the private multiple based on ARR (annualized run-rate revenue). As a rule of thumb, we subtract 1.3 to account for the risks associated with smaller, private companies and the lack of liquidity in their stock. Over time, this discount of 1.3 times revenue has remained relatively stable.
Growth Premium:
How fast your company is growing compared to others can significantly impact its valuation. Smaller companies often find it easier to achieve rapid growth. As a rough guideline, if your business is growing at double the average rate, its valuation multiple could increase by 50%. So, the quicker your company grows compared to similar-sized SaaS firms, the higher its valuation multiple may be.
Other Important Metrics:
Several key metrics can impact the value of a SaaS company:
Addressable Market Size: Larger markets tend to result in higher multiples.
Retention Rate: Strong customer retention rates can greatly enhance valuation.
Gross Margins: Higher margins typically lead to better valuations.
Capital Efficiency: Using capital efficiently can result in higher multiples.
CLTV vs CAC Analysis: This customer lifetime value vs customer acquisition cost ratio comparison is an essential metrics to value a SaaS startup. A higher ratio means a SaaS startup is earning more revenue from each customer than its customer acquisition.
What is the rule of 40 in SaaS?
The Rule of 40 in SaaS valuation is a guideline used to evaluate the overall health and attractiveness of a software-as-a-service (SaaS) company. It suggests that a SaaS company’s combined annual growth rate (typically measured as revenue growth) and profit margin (typically measured as EBITDA margin) should sum up to at least 40%.
For example, let’s say a SaaS company has a revenue growth rate of 30% and an EBITDA margin of 15%. To calculate the Rule of 40 number:
30% (revenue growth) + 15% (EBITDA margin) = 45%
Since 45% is greater than the Rule of 40 threshold of 40%, this SaaS Company meets the criteria and is considered an attractive investment opportunity according to the Rule of 40.
Important Metrics To Consider While Valuing A SaaS Company
When valuing SaaS companies, it’s crucial to consider a variety of essential metrics. These metrics provide valuable insights into the company’s performance, potential, and overall value. Let’s delve into each of these metrics in detail:
Gross Margins (GM):
This metric represents the difference between a company’s net sales revenue and its cost of goods sold. A higher gross margin indicates better efficiency in generating profits from sales revenue. Ideally, SaaS companies should aim for gross margins of 80% or more.
Scalability:
Scalability refers to a company’s ability to handle growth efficiently. The Ansoff Matrix is a useful tool for assessing growth opportunities and considering factors such as market size, growth potential, and the cost of expansion. Companies with higher revenue can pursue larger acquisitions or even prepare for an IPO.
Year-over-Year (YOY) Growth Rates:
YOY growth rates measure the percentage change in a company’s performance over the past 12 months. SaaS buyers typically prefer growth rates between 10% and 20%, avoiding rates exceeding 40%, which may indicate potential risks or unsustainable growth.
Total Addressable Market (TAM):
TAM represents the total revenue opportunity available for a specific product or service within a defined market. SaaS companies should target markets with ample growth opportunities, typically with TAMs closer to $1 billion rather than $100 million.
Competitive Landscape and Customer Acquisition Cost (CAC):
The competitive landscape can impact various aspects of a SaaS company, including customer acquisition costs, SEO growth, and intellectual property rights. Understanding your positioning and value proposition is crucial, especially in highly competitive markets.
Owner Involvement:
Owners looking to exit their SaaS company must reduce their operational involvement and ensure the presence of strong technical knowledge within the company. Lack of expertise can hinder operations and diminish attractiveness to investors.
Company Age:
The age of a company can influence its perceived value. Typically, businesses that are at least two years old are preferred by investors, with older companies often commanding premium multiples.
Diversity and Customer Concentration:
Diversification across customer segments and channels is essential to mitigate risk. Relying heavily on a single client or channel can deter investors, as it poses a higher level of risk to the business.
Value Proposition:
A compelling value proposition that addresses significant pain points in the industry is crucial for attracting and retaining customers. Well-defined messaging and positioning validated by the ideal customer profile (ICP) and product-market fit (PMF) are key to driving customer engagement and loyalty.
Customer Acquisition Channels:
The effectiveness of customer acquisition channels, such as inbound and outbound marketing strategies, significantly influences a company’s valuation. Diverse marketing channels allow for expansion opportunities while optimizing existing channels.
Company Assets:
Proprietary technology, data assets, and an experienced management team are valuable assets that contribute to a company’s overall value. These qualities are often overlooked but can significantly impact valuation.
Public Market Valuations:
Public market valuations of SaaS companies can influence private company valuations. It’s essential to consider market trends and valuations of comparable companies when determining a SaaS company’s worth.
By analyzing these metrics in detail, stakeholders can gain a comprehensive understanding of a SaaS company’s value and make informed decisions regarding investments, acquisitions, or exits.
Navigating SaaS Metrics: A Journey through Company Lifecycle
As SaaS companies evolve, understanding various key metrics becomes crucial for assessing organizational health and optimizing business strategies. The importance and relevance of these metrics shift throughout the company lifecycle. Let’s explore the different growth stages and the key metrics associated with each.
Super Early Stage:
In the nascent phase, companies focus on product-market fit with less emphasis on detailed financials. As they progress to Series A funding, key metrics include Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR), No. of Subscriptions, No. Of traffic, Customer Acquisition Cost (CAC), and marketing and sales expenditures.
Early Stage:
As traction builds and the company moves through Series C and D rounds, attention shifts to expansion and efficiency. Key metrics now include Customer Lifetime Value (CLTV) to revenue ratio, gross margin, churn rates, and ARR.
Growth Stage and Beyond:
For companies reaching IPO and beyond, new metrics take precedence as management aims for future visibility. Priorities include overall expenses, deferred revenues, EBITDA, and customer growth over time.
Bottom Line
Having access to SaaS valuation data is vital for business owners, potential buyers, and management teams alike. Regardless of your position in negotiations, grasping the genuine value of the company is crucial. Without this understanding, there’s a risk of making misguided investments or settling for a sale price significantly below your actual worth.
For small businesses seeking an exit or investment, comprehending how investors value your business empowers you to assess in advance whether pursuing capital is worthwhile or if holding out for a bit longer is a better strategy.
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