Everything You Need To Know About SaaS Valuation
According to Growth Marketing Pro, total SaaS spending reached up to $152 billion in 2021. It’s bound to increase over the next few years too.
The SaaS business model has been growing in popularity because it’s a more efficient and lucrative way to do business. And many SaaS companies over the years have been able to scale their businesses quickly and reach a larger audience with ease.
And if you are running a SaaS company, one of the most important things you need to know is SaaS valuation.
What is SaaS Valuation?
In simple terms, SaaS valuation is the process of determining the worth of a SaaS company. This can be done by looking at revenue, growth, and other factors.
Why Is SaaS Valuation Important?
Knowing your company’s value in itself should be a given for any SaaS owner or founder. It helps you evaluate how much you have and how much you’ve grown.
But there are other reasons why it’s important, especially for a SaaS business.
Let’s talk about them one by one.
It Helps You Get Investors
If you’re looking to raise capital, SaaS valuation will be one of the first things investors will look at. They want to see if your company is worth investing in and if it has growth potential.
This is extremely important if you want to grow a SaaS startup and are looking to grow fast.
Funding your SaaS company yourself is still an option, of course. But it will be much slower than if you had outside investors.
What’s more, knowing how much your SaaS business is really worth can help you get the best deal possible from venture capitalists.
If you can prove that your company has a significantly high value, you can also get higher funding without giving up too much equity.
It Can Serve As A Benchmark For Progress
SaaS valuation can also serve as a benchmark for your company. You can use it to measure your progress and see how you’re doing compared to other SaaS companies in your space.
This is helpful because it allows you to set goals and track your progress over time. It’s also a good way to see if you’re on track to achieve your long-term goals.
It Helps You Plan Your Exit Strategy
Even if your SaaS business is in its earliest stages, you need to think ahead on how it will play out in the end. You need to think of your exit strategy.
What is your endgame? Are you going to sell your SaaS business? Are you going to merge with another company? Are you going to take it public?
Your SaaS valuation will have a lot to do with your exit strategy. It will determine how much money you can make from selling your business and what buyers are willing to pay.
This is why SaaS valuation is so important. It’s not just something that investors care about. It’s something that all SaaS entrepreneurs need to understand.
SaaS Valuation Multiples
To really know how SaaS valuation works, we first need to understand the role of valuation multiples and what affects it.
A valuation multiple is a number that’s used to determine the true long-term value of a SaaS company.
As its name suggests, you multiply it by a SaaS valuation metric to come up with the company’s valuation.
Your SaaS valuation multiple can range from 3-15x depending on a wide variety of factors:
This is probably the most important factor that affects your SaaS valuation multiple. The more profitable your SaaS company is, the higher your valuation multiple will be.
This is because investors are looking for companies that can generate a lot of profits in the long run. They’re not interested in SaaS companies that might make a lot of money now but will eventually fizzle out.
For a SaaS business model, though, it’s not enough to just look at your revenue or gross margin.
Long-term growth also means being able to keep your customers happy and retaining them for as long as possible.
This is why SaaS companies with a strong customer retention rate are often valued higher than those who don’t.
It’s also important to note that your SaaS company’s profitability will affect your valuation multiple in the future. So, if you’re not profitable now but have a solid plan to become profitable soon, your SaaS valuation multiple will be lower than it could be.
That’s why your SaaS valuation multiple will be heavily influenced by the following financial metrics:
- Annual recurring revenue (ARR)
- ARR growth rate
- Customer churn rate
- Revenue churn rate
- Net revenue retention
- Customer acquisition cost (CAC)
- Customer lifetime value (CLV)
- CLV/CAC ratio
- Gross margin
Investors are also interested in SaaS companies that have a lot of growth potential. They want to see that your company is growing quickly and that there’s a large market for your product or service.
The faster your company is growing, the higher your valuation multiple will be.
This is because investors are willing to pay more for companies with high growth potential. They’re betting that these companies will be worth more in the future.
To determine your SaaS company’s growth potential, you need to look at your:
- Total addressable market (TAM): The amount of potential revenue that your SaaS company can generate in your target market.
- Serviceable available market (SAM): The portion of the TAM that your SaaS company can realistically capture.
- Market share: The percentage of the SAM that your SaaS company currently has.
- Competition: The number of other SaaS companies competing for the same market.
The higher your TAM, SAM, and market share are, and the lower your competition is, the higher your SaaS company’s growth potential will be.
Your SaaS company’s health will also affect your SaaS valuation multiple. This is because investors want to see that your company is well-managed and has a solid foundation.
Some of the factors that affect company health don’t necessarily include measurable quantities. But you will need to look at the following characteristics:
- Company Maturity: SaaS companies that are newer are often valued higher than those that have been around for longer since they have more growth potential. On the other hand, older companies can also give investors a sense of confidence that the company has a solid foundation and can stand the test of time.
- Team: SaaS companies with a strong and experienced team are often valued higher than those without one. This is because investors feel like these companies are more likely to succeed.
- Existing Company Assets: SaaS companies with valuable assets, such as patents or a large customer base, are often valued higher than those without them. This is because these assets can give the company a competitive advantage and make it more likely to rise above its competitors.
- Owner Involvement: A high level of owner involvement can be good or bad depending on the case. If you’re considering selling your company one day, then it’s usually better to have less owner involvement so that it’s easily transferable. If you intend to stick with it till the end, then a high level of owner involvement can inspire confidence in investors.
SaaS Valuation Methods
Now, let’s move on to how you can actually compute your SaaS company valuation.
In most cases, it involves a SaaS valuation metric multiplied by—you guessed it—your valuation multiple.
So let’s talk about the most common ways to value a SaaS business.
The most straightforward SaaS valuation method is revenue-based valuation.
With this method, you simply multiply your SaaS company’s annual recurring revenue (ARR) by your valuation multiple.
For example, let’s say you have an ARR of $100,000 and you’re using a multiple of 10. This would give you a SaaS valuation of $1,000,000.
The main advantage of revenue-based valuation is that it’s easy to do and doesn’t require a lot of guesswork. However, it does have its limitations.
One such limitation is that it doesn’t take into account future growth potential. So if your SaaS company is growing rapidly, this method might not give you an accurate valuation.
Another limitation is that it’s only applicable to SaaS companies that are already generating revenue. So if your company is still in its pre-revenue stages, this method won’t work for you.
Another basis for SaaS valuation could also be your seller’s discretionary earnings (SDE).
This valuation metric looks at all your profit margin (including the owner’s compensation) after taking out the total cost of keeping your operational cost.
The operational cost comes in the form of the cost of goods sold (COGS). For a SaaS business, COGS include the following expenses:
- Hosting fees
- Licenses for software used in business operations
- Office rental and utility fees
- Employee compensation
To calculate SDE, take your total revenue and subtract your COGS. Then add the owner’s compensation.
The SDE is a useful SaaS valuation metric because it shows how much profit the business is actually making.
This is also a suitable approach if you’re valuing a small, private, sole-owner SaaS company with less than $5 million ARR.
Since you’re the only owner or seller, you can use your compensation at your discretion. You may choose to keep it or reinvest it in the business.
For larger SaaS companies, another SaaS valuation metric that’s often used is EBITDA.
This stands for earnings before interest, taxes, depreciation, and amortization.
This is an effective valuation metric because it doesn’t count circumstantial costs or losses brought by the following:
- Interests: Some SaaS businesses, at some point, may have resorted to getting a loan for their funding. The amount they pay in interest can significantly reduce their profit margins. However, this reduction is circumstantial and may not be indicative of the SaaS company’s real earning potential.
- Taxes: SaaS companies have to pay taxes, which can also reduce their profit margins. But then again, it’s a circumstantial cost that can vary from time to time or from one place to another.
- Depreciation: SaaS companies often have to invest in new equipment or software. The value of these assets will gradually depreciate over time and that depreciation will appear in their financial statements. But it’s not really relevant to the value of a SaaS business.
- Amortization: SaaS businesses may also choose to amortize the cost of certain intangible assets, such as patents and research and development (R&D) costs. Like depreciation, this is not really indicative of the SaaS company’s true value.
To calculate EBITDA, take your net revenue and add back all your costs from interests, taxes, depreciation, and amortization.
The EBITDA is an excellent valuation metric because it only counts the recurring operational costs, which are included in your COGS.
However, you may encounter some non-recurring expenses that do not necessarily fall under the “ITDA”, such as severance checks or lawsuit settlements.
In those cases, you may choose to add back those costs to your EBITDA. But make sure your investor or buyer agrees to do so.
Now, EBITDA valuation is best for larger SaaS businesses with over $5 million ARR.
This is because net revenues for large businesses can be significantly affected by one-time or circumstantial expenses mentioned above. And they may not necessarily be that relevant to your SaaS company valuation.
The Rule Of 40
The Rule of 40 is a SaaS valuation metric that’s becoming more popular these days.
As a growing SaaS company, profitability isn’t your only measure of success. You also need to consider your growth.
For example, let’s say that you’re reinvesting most of your profits into funding your customer acquisition efforts.
In that case, your SaaS business may not be very profitable yet. But it could still be valuable because of its high growth potential.
That’s where the Rule of 40 comes in.
The Rule of 40 states that the sum of your SaaS company’s growth rate and profitability should be equal to or greater than 40%.
If it’s lower than 40%, It may be an indication that your SaaS business isn’t very healthy.
In calculating a SaaS company’s Rule of 40 value, the profit margin and growth rate come in the form of the EBITDA margin and the ARR growth rate.
The EBITDA margin is simply your EBITDA divided by your total revenue. And the ARR growth rate is the year-over-year growth of your SaaS company’s ARR.
To calculate your Rule of 40 value, simply add your EBITDA margin and ARR growth rate.
For example, let’s say you have an EBITDA margin of 10% and an ARR growth rate of 30%. In that case, your Rule of 40 value would be 40%.
The Rule of 40 is a good SaaS valuation metric to use if you’re a high-growth SaaS company. This is because it takes into account both your profitability and your growth potential.
Weighted Rule Of 40
One possible disadvantage of the Rule of 40 as a SaaS valuation method is that it puts profitability and growth on equal footing.
While there’s absolutely nothing wrong with that, most venture capitalists favor growth over profit, especially for early-stage SaaS businesses. So, the Rule of 40 may not be the best SaaS valuation metric for everyone.
That’s where the Weighted Rule of 40 comes in.
The Weighted Rule of 40 is simply the Rule of 40 with weights assigned to profitability and growth.
The revenue growth rate usually has a value of 1.33 while the profit margin often has 0.67.
So let’s take our earlier example where you have an EBITDA margin of 10% and an ARR growth rate of 30%.
This would give you a Weighted Rule of 40 value of 46.6%, which is slightly higher than your rating in the non-weighted method.
SaaS Valuation Metrics by Stage of SaaS Business
As we mentioned earlier, SaaS valuation is essential for getting investors on board and getting some SaaS capital.
But it’s also important to understand that funding is different throughout various stages of a SaaS company’s maturity.
Because of this, venture capitalists generally value SaaS companies differently depending on which stage they’re in.
Here’s a brief overview of the four main stages of a SaaS business and the valuation metric for each one:
Seed Round: Based On The Founder
The seed round is the first stage of funding for a SaaS company.
At this point, the SaaS business is usually just an idea. There’s no product yet, and there are no customers. The SaaS company is valued based on the founder’s experience and track record.
At this stage, the valuation method we’ve talked about so far won’t really apply yet, since there are no real metrics to base it on.
Instead, investors will likely estimate your future company’s potential value based on how much funding you’re asking for and how much equity you’re willing to give up.
For example, imagine that you are asking for a seed fund of $2 million but are willing to give up only 5% of the company.
They will likely extrapolate that—if 5% of your company is worth $2 million to you—the whole company (or 100% of it) would be worth $40 million.
This is a very basic SaaS valuation method, but it’s common for seed-stage SaaS companies.
Series A Round: Based on SDE & Founding Team
The Series A round is the second stage of funding for a SaaS company. At this point, the SaaS business usually has a product and some customers.
The funding raised in this round is often used for things like product development, marketing, and hiring.
At this stage, your new SaaS startup’s value would depend on your cash flow and founding team. More specifically, it would be based on your SDE and the experience of your founding team.
Series B Round: Based On Revenue Growth
The Series B round is the third stage of funding for a SaaS company. By this point, the SaaS business usually has a lot of customers and is growing quickly.
In fact, the T2D3 framework follows that a new SaaS business should triple its ARR every year in its first two years and then double per year in the next three.
Yes, that’s a tall order. But that’s what it takes to stay competitive in the SaaS industry.
For this reason, SaaS companies in their Series B round are often valued based on their revenue growth. Specifically, your ARR growth rate.
Following the T2D3 framework, you should achieve at least a 300% ARR growth rate for the first two years and 200% in the following three.
Series C Round: Revenue & Exit Strategy
The Series C round is the fourth stage of funding for a SaaS company. At this point, the SaaS business usually has a lot of customers and is growing quickly. They may also have reached profitability and nearing your exit strategy.
In the SaaS world, it’s common for companies to achieve an exit through an acquisition by a larger company or finally listing your company on the stock market.
This is where your more traditional valuation methods and multiples will be most useful.
What’s more, investors tend to favor mature SaaS companies with strong net revenue retention.
Steady net revenue retention indicates that you’re successfully keeping churn on the down low and maximizing your CLV.
Both of these SaaS metrics are essential for a strong SaaS business, so it’s no wonder that they would be favored by investors in a Series C round.
Final Thoughts About SaaS Valuation
SaaS valuation is a complex topic with no easy answers. However, we hope that this guide has given you a better understanding of the different methods and stages involved in SaaS valuation.
Keep in mind that there is no one-size-fits-all answer when it comes to valuing your SaaS business. The method you choose will depend on your stage of funding, your SaaS metrics, and your goals as a business.
What’s most important is that you choose a SaaS valuation method that makes sense for your business and will help you achieve your long-term goals. And of course, make sure you’re on the same page with your potential investors.
Want more guides to help you grow your SaaS business? Check out our blog here.