How SaaS Company Valuation Works:
Methods & Multiple Factors
How much do you think your SaaS company is worth?
If you’re not sure, you’re not alone. Many entrepreneurs have trouble putting a value on their business. But having an objective SaaS company valuation is very important.
It’s not just useful for companies who are considering selling their company or taking it public on the stock market.
Being able to prove your SaaS company’s worth with a concrete number can also attract investors who can give you the resources that you need in order to grow.
So, how do you go about valuing a SaaS business?
In this article, we will talk about some SaaS company valuation methods and the factors that affect that value.
3 Types of SaaS Company Valuation
There are three main types of SaaS company valuation: SDE, EBITDA, and Revenue. Each valuation method has its own pros, cons, and best use cases.
Let’s talk about them one by one.
The first and simplest type of SaaS company valuation is the revenue-based method.
In this method, the valuation is based on a multiple of the company’s annual recurring revenue (ARR). The most common multiples are 2x to 5x.
So, if a company has $1 million in annual recurring revenue (ARR), and the multiple is 3x, then the company would be valued at $3 million.
Now, you may be wondering how to find the right valuation multiple for your SaaS business. Don’t worry, we’ll talk about it in more detail later on.
The revenue-based valuation method is best used for small businesses (under $5 million ARR) or SaaS startups with high growth potential.
It’s also best used when there isn’t a lot of historical financial data to go off of because it’s based on future projections.
The biggest disadvantage of this valuation method is that it doesn’t take into account the company’s profitability.
So, a company with low margins could be valued the same as a company with high margins even though one is much more profitable than the other.
The higher a company’s ARR, the higher its valuation will be because it indicates that the company has a lot of potential for growth.
This is why young companies with high ARR but little to no profits tend to be valued higher than more established companies with lower ARR that have fewer resources to reinvest in growth.
Seller Discretionary Earnings (SDE) Valuation
The second type of SaaS company valuation is Seller Discretionary Earnings (SDE).
SDE is basically all the remaining money you have after you (the business owner) have paid all the expenses to keep your company going.
It is calculated by taking into account all the revenue that a company generates and then subtracting all the expenses. These include the cost of goods sold (COGS), operating expenses, and taxes.
Now, let me clarify something when it comes to SaaS COGS. It’s easy to imagine what the COGS are for traditional businesses, like manufacturing or retail. The COGS is simply the costs for the raw materials and every expense needed to turn them into the finished product.
However, for a software company, the COGS is a bit different. After all, you don’t have a physical product that needs raw materials.
In SaaS, the COGS can be things like the cost of hosting your software on the cloud, employee salaries, fees for software licenses, and more.
To calculate your SDE, take your total revenue and subtract your COGS and operating expenses. Then add the owner compensation to display your SaaS company’s overall earning power.
The SDE valuation method is often used by investors because it gives them a clear picture of the company’s cash flow and profitability. It also takes into account one-time items such as bonus or commission payments, which can distort the true picture of a company’s earnings.
This valuation method is best used for small businesses (under $5 million ARR) with sole owners.
Last but not least, the third type of SaaS company valuation is the EBITDA.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It’s basically your company’s gross income before deducting these expenses.
EBIDTA is a measure of profitability that doesn’t count historical or circumstantial deductions from the following factors:
Interest: EBITDA doesn’t include interests because they can vary for every business.
Taxes: EBITDA also doesn’t include taxes because tax laws can change over time. What might be considered taxable income today could be non-taxable tomorrow.
What’s more, taxes may also vary for each location. So, a business in one country may have to pay more taxes than a SaaS company in another country.
Depreciation and Amortization: Depreciation is the expression of the deteriorating value of physical assets over time.
For example, imagine that you just bought a server for $3,000. You don’t record the full three grand as a cost for the year. You record it as an asset.
Then let’s say that the value of the server depreciates by $300 every year. That’s the figure that appears as an annual expense, which you deduct from your assets.
Amortization, on the other hand, is the expense of paying off intangible assets.
In the case of SaaS businesses, amortization is generally accounted for the research and development (R&D) that goes into creating the SaaS product itself.
These two aren’t counted because they are generally one-time investments that have smaller financial repercussions every year.
To calculate your company’s EBITDA, simply take your net revenue and add your interest, taxes, depreciation costs, and amortization costs.
This valuation method is often used by buyers and investors because it gives them a better picture of the company’s true earnings. It also doesn’t include one-time items that can distort the company’s financials.
This valuation method is best used for more mature SaaS companies with an ARR of more than $5 million.
The SaaS Valuation Multiple
Earlier, we mentioned something about a valuation multiple.
SaaS valuation today involves a revenue multiple or valuation multiple.
This helps you come up with a figure that reflects the true long-term value of a SaaS company, not just in terms of one year or two.
These valuation multiples typically range from 3x to 15x, depending on different factors about your business’ sustainability, scalability, and transferability.
So what are those factors? Let’s discuss them below.
Obviously, a SaaS company’s financial status plays a huge role in its long-term value. So you’ll need to look out for different key financial factors.
These include the following:
Revenue (SaaS ARR and MRR): A SaaS company with a higher ARR or monthly recurring revenue (MRR) is generally valued at a higher multiple. That’s because it has a steadier and more predictable stream of revenue coming in.
Churn and Renewals: Churn is the percentage of customers that cancel their subscription to your SaaS product in a given period of time.
To calculate it, simply take the number of customers that you lost in a month or year and divide it by the total number of customers that you had at the beginning of that period.
For example, let’s say that you started the year with 100 customers and ended it with 80. With 20 out of 100 gone, that means you had a 20% churn rate.
Generally speaking, a lower churn rate is better because it indicates that your customers are satisfied with your product and are less likely to cancel their subscriptions.
On the other hand, renewals refer to the percentage of customers that extend their subscriptions after their initial contract expires.
To calculate it, take the number of customers that renewed their subscription and divide it by the total number of customers that had expired contracts.
For example, let’s say that out of 100 customers with expired contracts, 80 of them renewed. That would give you a renewal rate of 80%.
A higher renewal rate is usually better because it indicates that your customers are happy with your product and are more likely to continue using it.
Net Revenue Retention (NRR): NRR is a metric that measures the percentage of revenue that a SaaS company retains from month to month or year to year.
For example, imagine that a SaaS company has an NRR of 100%. That means that it’s able to retain all of its customers and doesn’t experience any customer churn.
Now, imagine another SaaS business with an NRR of 90%. That means that it loses 10% of its customers every month or year.
Generally speaking, higher net revenue retention leads to a higher valuation multiple because it indicates that the company has loyal and satisfied customers.
Gross Margin: You can calculate your gross margin by taking the difference between your total revenue and your COGS. Then divide the resulting number by your revenue.
For example, let’s say that your SaaS company’s overall revenue is $1 million and your COGS is $200,000. That gives you a gross margin of 80%.
A higher gross margin often means that a company is more profitable. And as we mentioned before, profitability is one of the main factors that determine valuation.
Year-On-Year Growth Rate: This factor can be measured in terms of SaaS ARR growth rate. To compute it, get the difference between this year’s and last year’s ARR. Then divide it by the previous ARR.
For example, let’s say last year your SaaS company made $1 million in ARR then $1.5 million this year. That’s an ARR growth rate of 50%.
A SaaS company with a high growth rate is also generally valued at a higher multiple. That’s because it has more potential for future growth and expansion.
Apart from financial factors, there are also operational factors that affect valuation. These include the following:
Company Age: In most cases, the older a SaaS company is, the higher its valuation multiple will be.
That’s because an older company is more likely to have established itself in the market and to have a steadier stream of revenue.
What’s more, being able to generate steady revenue for years can help prove that your company is sustainable. It can also help you forecast your future cash flow.
Owner Involvement: The level of involvement of a company’s owner can also affect valuation. If the owner is heavily involved in the day-to-day operations of the company, it’s generally less transferable and therefore valued at a lower multiple.
On the other hand, if the owner is more hands-off and lets others handle the day-to-day operations, the company is often valued at a higher multiple.
That’s because it indicates that the company can run without the owner’s constant input and supervision.
Assets: A SaaS company with valuable assets (such as patents or proprietary technology) is often valued at a higher multiple. That’s because these assets can provide the company with a competitive advantage and help it generate more revenue in the future.
In addition to financial and operational factors, there are also market-related factors that can affect your company’s valuation.
TAM, SAM, and SOM: The size of the total addressable market (TAM), serviceable addressable market (SAM), and share of the market (SOM) can all affect company value.
For example, a company with a large TAM is generally valued at a higher multiple because it indicates that there’s more potential for growth.
Market Saturation: The level of market saturation can also affect valuation. A company operating in a saturated market is often valued at a lower multiple because more competition can likely mean slower growth.
Conversely, a company operating in an unsaturated market is often valued at a higher multiple because there’s more potential for faster growth.
Value Proposition: A company with a strong value proposition is often valued at a higher multiple because it’s more likely to succeed.
To state the obvious, a company with a weak value proposition is often valued at a lower multiple because it has a greater risk of failure.
Customer Acquisition Channels: The channels that a company uses to acquire customers can also affect valuation.
For example, a company that relies heavily on paid advertising is often valued at a lower multiple because it’s more expensive to acquire customers.
On the other hand, a company that relies mainly on organic channels is often valued at a higher multiple because it’s less expensive to acquire customers.
Public Market Value (for public SaaS companies): Publicly-traded SaaS companies can be valued using their market capitalization. You can get this number by multiplying the current stock price with the total number of shares outstanding.
For example, let’s say that a publicly-traded SaaS company has a stock price of $10 and 20 million shares outstanding. That gives it a market capitalization of $200 million.
However, if you want to value a privately-held software company using this metric, you’ll need to come up with an estimated stock price. You can do this by looking at the market capitalization of similar companies that are publicly traded.
SaaS Key Performance Indicators (KPIs)
We have already talked about the ARR, revenue growth rate, NRR, gross margin, and churn rate. Let’s look at some other SaaS KPIs that can affect your SaaS company valuation.
Customer Acquisition Cost (CAC): The cost of acquiring a new customer can have a big impact on valuation. However, on its own, the CAC doesn’t explain much. It has to be compared to other metrics in order to provide useful insights.
That brings us to the other metric.
Customer Lifetime Value (CLV): The customer lifetime value (CLV) is the total amount of revenue that a customer will generate over the course of their relationship with a company.
When you compare the CAC to the CLV, you get what’s known as the CLV:CAC ratio. You can find it by dividing your CLV by your CAC.
For example, let’s say you have a CLV of $6000 and a CAC of $2000. That’s a CLV:CAC ratio of 3:1, which is the standard for SaaS businesses. That means you’re earning $3 for every dollar you spend on customer acquisition.
A high CLV:CAC ratio indicates that a company is generating more revenue from its customers than it’s spending to acquire them. This is generally a good sign, and companies with high CLV:CAC ratios are often valued at higher multiples.
Conversely, a low CLV:CAC ratio indicates that a company is spending more to acquire customers than it’s generating in revenue from them. This is generally a bad sign, and companies with low CLV:CAC ratios are often valued at lower multiples.
Final Thoughts About SaaS Company Valuation
As you can see, there are many factors that can affect the valuation of a SaaS company.
The most important thing to remember is that valuation is not an exact science. There’s no one right answer, and different people will value a company differently.
The best way to think about it is as a range.
For example, let’s say you’ve been told that your company is worth $10 million. That doesn’t mean you should expect to sell your company for exactly $10 million. It’s more likely that you’ll sell it for somewhere between $8 million and $12 million.
The best way to ensure that you get the highest possible valuation is to prepare in advance. Work with an experienced mergers and acquisitions (M&A) advisor to understand the market and make sure you’re putting your best foot forward.
If you do that, you’ll be in a good position to get the highest possible valuation for your SaaS company.
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