Every business model provides unique challenges when it comes to valuation.
The SaaS business model has been around for a while and is continually gaining popularity as bandwidth increases. From this explosion in popularity, those who specialize in business valuations have learned a great deal about SaaS as a business model and how to value a company that makes use of it, be it a startup, an SMB, or an enterprise.
In this post, we'll go over the key metrics you need to know about to create a valuation for a SaaS-based business accurately.
Valuation trends in the SaaS industry
There are several datasets we can use to examine how SaaS has grown in the past, and how it continues to grow as we move through 2021. Two important datasets come from Crunchbase's research at the end of 2018, and SaaS Capital's research as 2021 began. Using this data, we can see trend lines developing that will help give us a better idea of the current and near-future health of the SaaS market. What we see from that data looks excellent for those betting on the continued success of SaaS as a business model. Let's take a look now at two important factors in judging the health of an industry.
Median SaaS revenue multiples continue to increase
Although crude, revenue multiples are accurate enough to have become one of the most common SaaS metrics used to measure tech valuations. Calculating revenue multiples is as simple as dividing the company's enterprise value by its revenue. This is useful because you can easily get the company value of SaaS companies traded in the public market, allowing you to create an average revenue multiple for the SaaS industry as a whole. SaaS valuations can then be made for non-public software companies by multiplying their revenue by that amount.
As we can see from the SaaS Capital data, revenue multiples of publicly traded SaaS companies went from under 4x in 2008 to over 16x leading into 2021. Interestingly, as the Crunchbase data shows us, the rise in valuations happened despite having negative earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is one measure of profitability often used to measure a company's financial performance.
Median annual growth rate is strong
The negative $12 million EBITDA shown in the Crunchbase data for SaaS companies in 2018 didn't prevent growing revenue multiples because the industry had a positive cash flow of $36 million. Negative EBITDA is easier for investors to overlook when there is a strong pattern of growth in an industry. From the Crunchbase data, we know that the average median growth for a SaaS company in 2018 was a respectable 30%.
The SaaS Capital data gives us a more recent look at the growth rates of various SaaS companies. Even those with the lowest revenue multiples saw growth of at least 6%. On the other end of the spectrum, those companies with the highest revenue multiples, we see revenue growth at an average of 46%, when outlier Zoom is left out.
Four revenue metrics to look at when valuing a SaaS company
Let's assume that we aren't talking about companies that saw an unprecedented near quadrupling of their revenue as a result of COVID-19. For the more stable SaaS companies out there, how can we go about making an accurate prediction about the company's near-term finances in order to provide a valuation for them? For SaaS, there are four key metrics that drive most SaaS valuation calculations. Some of them we've already touched on, but let's now take a close look at what all four metrics are, and how they're used in the SaaS valuation process.
1. Seller's discretionary earnings
Seller's discretionary earnings (SDE) is a calculation typically used for small to medium-sized businesses. The problem with evaluating businesses based purely on profit is that the new owner may run the business differently. Everything from how much the owner is paid to discretionary spending likely changed under new ownership. By adding these values back into the profit calculation, the new owner gets a better idea of what they will be working with.
As a simple example of SDE, imagine a company that makes $800,000 in profit. This is after the owner pays themselves a salary of $200,000. A hypothetical new owner that wants to take a different salary needs to know that they have $1 million in profit to work with. Adding back in discretionary and owner-specific expenses gives new owners a more complete picture of what they are buying.
Similar to SDE is earnings before interest, taxes, depreciation, and amortization (EBITDA). Under this SaaS valuation method, the owner's salary is kept in the equation, but interest, taxes, depreciation, and amortization are all added back into (or subtracted from) the business income. This happens for much the same reason SDE adds expenses back in. The goal is to normalize the business's income such that the way it's financed and the tax choices it makes aren't a part of the equation. Again, this gives potential investors a more complete picture of what the business looks like financially.
3. Revenue multiples
We've already explained how revenue multiples work. By taking the valuation of a company where that data is known, and figuring out how its revenue relates to that value, investors can get a good estimate of what a company with unknown value is worth using only its revenue data.
There are ways of making this type of estimation more accurate. For example, during the pandemic, many SaaS companies have benefited greatly, whereas some have grown much more slowly. By breaking the larger category of SaaS into smaller categories and calculating the revenue multiples for the category that fits the target business the best, a more accurate SaaS assessment will be made of that company's value.
4. Net present value
Net present value (NPV) is a way to account for the passage of time on the value of money. Ten dollars now doesn't go nearly as far as it did 50 years ago. While investors probably aren't planning a half a century into the future, even a few years has an effect on the value of money. Net present value is a way of accounting for this so-called time value of money. It looks at all the money a project or business is expected to make over a given period of time, adjusts that into today's dollars, and subtracts the investment from it. A positive number indicates a good investment. The rate used to make the adjustment is called the discount rate. This older blog post gives you a detailed look at how to calculate a good discount rate.
The 7 key components of a SaaS valuation
The company valuation is just the first step. Investors are still going to want to know whether or not the business will provide them with a return on investment, and how big that return will be. To make that estimation, several metrics come into play.
1. Business age
Without any history, it's significantly harder to judge how a business will operate in the future and predict its scalability. By contrast, a business with several years of stable performance is much easier to make predictions about. Three or more years gives investors a decent idea of how the business will perform. Under two years, and you'll be dealing with a much smaller pool of potential buyers.
2. Business trends
The big benefit of having a history is that it lets investors see trends in the business. A business that has been losing money consistently will be much less attractive than one that is making steady gains every year.
3. Market trends
The overall SaaS market will also have trends that will let investors perform a SaaS valuation of a given business more accurately. If the whole market performs exceptionally well, or exceptionally poorly, it helps put into perspective the performance of an individual business.
4. Churn rate
Churn rate represents the percentage of customers that cancel their subscriptions on a monthly or annual basis. A high churn rate means the company must spend extra money replacing lost customers. Over a long period of time, a high churn rate is unsustainable and makes for a poor investment. A monthly churn rate of around 5% is decent, although for larger businesses with more stability it should be even lower. Anything over 10% is a big red flag.
5. MRR & ARR
Monthly recurring revenue and annual recurring revenue are two very important metrics for determining the health of a business. These must be weighed in relation to the expenses of a business, so there is no set in stone, good or bad, value for these metrics. Investors do prefer monthly recurring revenue over annual recurring revenue. This is because higher monthly revenue replenishes a business's cash reserves quicker.
The customer acquisition cost is the money a business must spend in marketing in order to get a new customer. It's always important to have this value as low as possible, though this is especially true when churn rates are higher. To evaluate whether a business's CAC is acceptable, we must also know the customer LTV.
7. Customer LTV
The amount a customer will spend with a company over their lifetime as a customer is called customer lifetime value (LTV). The metric is used in a ratio with CAC to judge the health of a business. Obviously, you want to get more out of a customer than you spend to get that customer. An ideal ratio in the SaaS world is generally thought to be around 3:1.
Use metrics you can trust
SaaS valuations are estimates to begin with, so getting an accurate result requires you to have accurate metrics. Adding imprecise data to an already imprecise calculation is going to result in a misleading figure. If you are selling your SaaS business, you want to ensure that you have the most accurate metrics available. You can get that with Paddle's ProfitWell Metrics subscription analytics.
Our free tools for SaaS businesses will keep track of all the important KPIs that matter to the valuation of your business. If you don't plan on selling anytime soon, ProfitWell Metrics can still help. The software is specially designed for the unique needs of the SaaS market. They'll give you all the numbers you need to make informed decisions about your business operations end ensure the YoY growth of your company.
SaaS valuations FAQs
How is SaaS valuation calculated?
To calculate SaaS valuation, investors take into consideration several metrics, including ARR, income, SDE-based valuation, EBITDA-based valuation, growth rate, NRR, gross margin, profit margins, revenue and revenue retention, etc.
Why are SaaS valuations so high?
There are several reasons why SaaS companies enjoy higher valuations, including:
- Recurring revenue they earn by charging monthly subscription/recurring fee
- More predictable earnings based on their defined pricing tiers
- Higher customer lifetime value from long-term contracts
- Attractive and unique intellectual property and proprietary tech
- Increased recent activity among SaaS companies compared to other industries
What is the rule of 40 SaaS?
When performing SaaS valuations, management teams stick to a general rule of thumb that says a company's growth rate should be 40% or higher when added to its free cash flow rate.ko