How To Value A SaaS Startup
One of the biggest hurdles when it comes to building a SaaS startup is getting the necessary funding to fuel your growth.
Some SaaS founders bootstrap their businesses. Those who have money use it to fund their growth on their own. But for many, these options aren’t really preferable or even possible.
That’s where venture capitalists (VCs) come in.
Now, when VCs decide whether or not a SaaS startup is worth investing in, they use a number of different valuation methods.
The problem is, there’s no one-size-fits-all answer when it comes to how to value a SaaS startup.
It all depends on the individual business and its unique circumstances.
So, in this article, we’re going to take a look at everything you need to know when it comes to valuing your new SaaS company.
This will give you a better understanding of how they value startups like yours and how you can increase your chances of getting funding.
SaaS Valuation Multiples
Before we talk about the different SaaS company valuation methods themselves, we first need to understand valuation multiples.
A valuation multiple is simply a number that’s used to multiply with another number in order to arrive at a valuation.
This multiple is necessary to estimate the true long-term value of a SaaS company.
The multiple you’ll receive depends on a number of factors, including:
If your SaaS company is profitable, you’re more likely to receive a higher multiple.
This is because any investor will have more confidence in your ability to generate revenue and grow the business.
Assessing your profitability will require cold hard data. You will need to track and optimize the following SaaS metrics:
Annual recurring revenue (ARR): The most direct way to see a SaaS company’s profitability is by looking at its ARR.
This is the total amount of revenue that your company recurring on a yearly basis.
Obviously, a higher ARR will contribute towards a higher valuation multiple for your SaaS startup.
ARR growth rate: More than tracking your revenue, it’s important to see how much it’s growing over time.
This is because your SaaS company’s value is directly correlated with its growth potential.
The main SaaS metric you can use to track your revenue growth rate is the ARR growth rate. This is simply the percentage by which your ARR is increasing (or decreasing) over time.
Now, it’s common for SaaS startups to experience hyper-growth within their first few years. That’s why their average ARR growth rate falls around 144% every year.
Customer churn rate is the percentage of customers who cancel their subscription or don’t renew it at the end of the billing cycle.
A high churn rate will have a negative impact on your overall profitability. This, in turn, will lead to a lower valuation multiple for your SaaS startup.
Net revenue retention (NRR): This is a SaaS metric that reflects how much revenue you’re able to keep from your existing customers.
This considers the following factors to your monthly recurring revenue (MRR):
- Starting MRR: The MRR you had at the start of the month.
- Expansion MRR: The new recurring revenue you get from upselling.
- Churn MRR: The revenue you lose due to customer churn.
- Contraction MRR: The MRR you lose due to downgrades.
A positive NRR means that you’re able to increase your MRR even when taking into account the possible losses in your revenue.
This is a good sign for investors, as it indicates the long-term sustainability of your business.
Customer lifetime value (CLV): This is the total amount of revenue that a customer will generate for your company over the course of their relationship with you.
Now, for a SaaS startup, it may be a challenge to find your CLV since your business is still in its earlier stages.
However, you can estimate your customer lifetime by dividing 1 by your churn rate. Multiplying the resulting number with your average revenue per user (ARPU) will give you your CLV.
Customer acquisition cost (CAC): This is how much it costs you to acquire a new customer.
This includes all the marketing and sales expenses necessary to convince a lead to become a paying customer.
To calculate your CAC, simply divide your total sales and marketing expenses by the number of new customers you acquired in a certain period.
CLV/CAC ratio: This ratio gives you an idea of how much revenue you can generate for each dollar you spend on acquiring new customers.
For instance, if your CLV is $3000 and your CAC is $1000, then your CLV/CAC ratio would be 3:1.
This means that for every dollar spent on customer acquisition, you’re able to generate $3 in revenue.
A high CLV/CAC ratio is a good sign for investors since it indicates that your marketing and sales efforts are paying off.
Another important factor in how to value a SaaS startup is the company’s operational health.
This includes aspects of your business, such as:
Company age: A newer company will have more potential for growth than an older one. This is because investors will feel that there’s more room for the business to expand.
However, an older company will usually have a longer track record. This can give investors more confidence in the company’s ability to generate revenue and be profitable.
Assets: A company with more assets will usually be valued higher than one with fewer assets. This is because the former will have more to offer investors in terms of long-term stability and growth potential.
In terms of SaaS companies, common assets include a strong team, valuable intellectual property (IP), and solid customer relationships.
Owner involvement: Now, this can be a matter of perspective for your potential investors.
For one investor, high owner involvement might be a good thing. They may feel that the business will be better managed and have a clearer vision.
However, other investors might see high owner involvement in a negative light. They may feel that the company is too dependent on the founders and doesn’t have a strong enough team to sustain itself.
What’s more, a business that is too dependent on its owner may be harder to sell in the future.
The important thing here is to gauge how your potential investors feel about this issue. The best workaround is to be highly involved while simultaneously training your team to function on their own.
When valuing a SaaS startup, it’s also important to consider the size and growth potential of the target market.
A large and growing market will usually be more attractive to investors than a small or stagnant one. This is because there’s more potential for the company to generate revenue and achieve profitability.
To get an idea of your target market’s size, you can use industry reports or consult with experts in the field.
You may need exact numbers for the following pieces of data:
Total addressable market (TAM): This is the total revenue that your SaaS product can potentially generate in a given market.
Serviceable available market (SAM): This is the portion of the TAM that your company can realistically target.
Market share: This is the percentage of your target market that you currently serve.
For example, if you’re generating $100 million in revenue in a $1 billion TAM, this means that your market share is around 10%.
It’s important to note that the TAM, SAM, will change over time. And so will your market share. So, make sure to keep track of them and update your data accordingly.
Market saturation: Another huge factor in SaaS valuation is its competition. If your market is already too saturated with a multitude of competing products, there will be less demand for it.
This will present a challenge for you to generate new revenue. And it will also make it harder to justify a high valuation for your company.
SaaS Valuation Methods
Now that we’ve discussed some of the key factors in how to value a SaaS startup, let’s take a look at some common valuation methods.
The following are three popular methods used to value early-stage SaaS companies:
The revenue-based method is one of the most direct and therefore most commonly used methods to value SaaS startups.
Under this method, your company’s valuation will be based on a multiple of its current ARR.
So, if your SaaS startup has an ARR of $1 million and a revenue multiple of 10x, your company would be valued at $10 million.
The SDE valuation method is similar to the revenue-based method in that it’s also based on your current profitability.
However, under this method, your company’s valuation will be based on a multiple of its seller discretionary earnings (SDE).
SDE is a measure of how much profit a company makes after accounting for all its operational expenses.
To calculate your SDE, you take your total revenue, subtract your cost of goods sold (COGS), and add the owner’s compensation.
Basically, it’s your gross margin plus the owner’s compensation.
The usual COGS for a SaaS company includes the following:
- Hosting fees
- Cost for software licenses
- Office utility fees
- Employee salaries and benefits
Investors use SDE as a valuation method because it provides a more accurate picture of your cash flow and earning potential.
This SaaS valuation method is best for SaaS startups with sole owners and an ARR below $5 million.
If your SaaS startup has multiple owners or is generating more than $5 million in ARR, then the EBITDA valuation method may be more appropriate.
Under this method, your company’s valuation will be based on a multiple of its earnings before interest, taxes, depreciation, and amortization (EBITDA).
To calculate your company’s EBITDA, you take its net revenue and add your interests, taxes, depreciation costs, and amortization.
VCs use the EBITDA valuation method because it doesn’t count circumstantial deductions, such as interests, taxes, depreciation, and amortization.
This makes it a more accurate measure of your company’s true profitability.
Final Thoughts On How To Value A SaaS Startup
Being aware of your own SaaS startup’s value is crucial for two main reasons:
- It will help you raise money from investors.
- It will help you sell your company if you ever decide to do so.
Whether it’s your series A, B, or C funding round, or you’re looking for an exit strategy, SaaS valuation is an essential skill for you to have.
Knowing how much your company is worth will help you get the best funding (or selling price) without giving up too much equity (or selling your company for too low).
Looking for more guides to help you grow your SaaS startup? Check out our blog here.