Business
11
minutes read

Explaining SaaS valuation & how to value a SaaS company

Written by
Michał Domański
Published on
January 28, 2023
TL;DR

SaaS valuation is an essential concept for investors, buyers, and owners. However, determining the value of a SaaS business might be difficult, as it requires an understanding of many different metrics. This article will explain the different metrics you'll need to know how to value a SaaS company.

Author
Michał Domański
Sales Operations Manager
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SaaS valuation is crucial for buyers, investors, and owners. However, valuing a SaaS company is difficult and necessitates mastery of numerous variables.

The market for Software as a Service has skyrocketed recently. Even still, it isn't probable that industrial development will slow down any time soon despite some economic uncertainty.

According to the Fortune Business Insight, the SaaS market is expected to reach $716.52 billion by 2028, growing from a valuation of $113.82 billion in 2020 to $130.69 billion in 2021.

Furthermore, numerous approaches must be used to gauge a company's final value rather than just one single approach. You may avoid making a bad transaction or undervaluing your company's worth by understanding the SaaS valuation factors and features.

What is SaaS Valuation?

SaaS valuation is the process of determining the value of your SaaS company. It can be complex, but it is essential to know your worth before selling your business or receiving an investment. So the first thing to do is look at what the market says about similar companies in your industry.

As a benchmark, you can use SaaS valuation multiples, such as Price-to-Earnings (P/E) ratio and Price-to-Sales (P/S) ratio. Still, these SaaS company valuation multiples can be adjusted based on factors such as growth rate, profitability, and industry trends.

However, it's important to note that SaaS valuation multiples should be used as a benchmark and not as an exact value for your company.

Related read: SaaS gross margin and net profit business metrics explained

You should also take into account factors such as:

  • How much money has been raised by your competitors?
  • How quickly did they raise it?
  • What's their revenue per customer?
  • How many customers do they have?
  • What is your revenue per customer?
  • How much money do you make from each customer?
  • What is your churn rate?
  • How many customers do you have?
  • What percentage of customers leave each month?
  • What is your LTV/CAC ratio (lifetime value divided by customer acquisition cost)?

Three Types of SaaS Company Valuations

When it comes to valuing SaaS companies, there are three main approaches:

Revenue-based Valuation (ARR Multiples)

The most popular way to value a SaaS company is by multiples of annual recurring revenue (ARR). For example, if a company makes $100M in ARR, its actual value would be around $100M.

This is the most popular method for valuing SaaS companies because it allows for direct comparison between companies with similar ARR levels. The downside is that it needs to account for operating expenses or other costs associated with running the business.

EBITDA-based Valuation

VCs and private equity firms mainly use this SaaS valuation calculator metric. It measures a company's cash flow after paying all its expenses and taxes but before accounting for debt repayment or equity dilution (i.e., stock options).

EBITDA (earnings before interest, taxes, depreciation, and amortization) is advantageous for businesses with significant earnings.

You can use the following equation to get your SaaS company's EBITDA:

Net Income + Interest + Taxes + Depreciation + Amortization

For more established, developed businesses, this approach takes a variety of things into account. As a result, EBITDA valuation is frequently employed for businesses with earnings power greater than $5 million ARR.

You may also like: Unlocking SaaS Renewal Success: Strategies, Metrics, Best Practices

SDE-based valuation

This metric is based on the sales efficiency of a company. It measures how efficiently a company generates revenue per employee (sometimes called "top-line sales per employee"). The more efficiently a company generates revenue. Therefore, its SDE should be higher.

Here is how to determine SaaS SDE:

Revenue - Operating Expenses - Cost of Goods Sold + Owner Compensation

SDE valuation makes the most sense for enterprises with a single owner or annual revenue under $5 million.

How to Value a SaaS Company?

If you're looking to sell a SaaS company or are considering starting one, you must understand how to value a SaaS company.

Based on sales, you can use the following four metrics to gauge a SaaS company's value:

  • ARR (Business size) (Business size)
  • Growth rate (Momentum)
  • Net revenue retention (Product/Service Quality)
  • Growth margin (Profitability)

With a fundamental baseline multiple of 10, businessman David Cummings concentrated on ARR, growth rate, and net revenue retention:

Valuation = Market Sentiment x ARR x Growth Rate x NRR x Gross Margin

Further consideration led Cummings to develop the SaaS Rule of 40, which balances growth, profitability, and cash burn.

Valuation = 10 x ARR x Growth Rate x NRR

The multiple was reformulated in the following iteration as "market sentiment," calculated by dividing enterprise market value by firm revenue. Profitability was also taken into account by Cummings as a growing margin:

SaaS Rule of 40 Total = Growth rate % + Profit %

Cummings' approach now provides an even more precise notion of the valuation after growth and profit are considered.

Valuation = ARR x Rule of 40 Total x Market Sentiment

The multiple is determined by market mood, and ARR considers firm size. The Rule of 40 makes valuations more realistic by considering both profitability and the cash burn rate.

Might be interesting: Effective SaaS User Management: Tips and Tricks

SaaS Metrics that Impact Valuation

Here are some key metrics that impact valuation:

  • Owner Involvement: The business owner is the company's primary decision-maker and leader. This person is vested in the business's long-term success and will work to ensure that value is maximized from every transaction.
  • Business Age: It's about how long your company has been operating. If it's less than 3 years old, you may need help proving your company's viability to investors. If you're older than 3 years but still relatively new to SaaS, you may need more time before you're ready for venture capital funding.
  • Growth Trends: Good growth trends are essential for any successful SaaS business model. A growing customer base indicates that customers find value in your product or service and want to continue using it over time. Growth trends can show investors that there's room for expansion into new markets and geographic areas, which increases the potential return on their investment in your company.
  • Funding State: The stage of funding a company indirectly impacts its valuation. If a company is already in the growth stage, it will be valued higher than in the early stages.
  • Churn Rate: It is the percentage of customers who have stopped using your product or service within a month or year after subscribing. You need to map the customer journey. A high churn rate can mean that users are unhappy with your product or service or find it challenging to use. Either way, it's bad news for investors who want to know that their investment will grow over time and not shrink.

Most Common Mistakes in SaaS Business Valuation

This is the sad truth we have seen in my career as a business valuation expert. Many must be aware they are overvalued and pay too much for their funding rounds or acquisitions.

How would you know if your business is overvalued? Here're some of the most common mistakes:

Comparing Yourself with Competitors

Most companies compare themselves with others in their industry, but this is a big mistake. There are no other companies like yours in the world! You have a unique value proposition based on your strengths and weaknesses. When you compare yourself with other companies, you will copy their strategy instead of creating one that works for you.

Valuing According to the General Market

Another common mistake is valuing your company based on the general market, which makes no sense! The public market doesn't care about your company or its valuation; it's just an average price that doesn't reflect any specific company's value. If you want to know what's going on in your industry, talk to investors or advisors who specialize in your field — not just anyone who happens to be listening!

Worth checking: How to calculate SaaS Magic Number? A Step-by-Step Guide

Using a One-Size-Fits-All Valuation Service

Many online valuation services purport they can give you an accurate valuation of your company within minutes but be aware of them. Unfortunately, they use general formulas and averages that only consider some key factors, such as your company's stage in the life cycle, growth rate, and profitability. The truth is there is no one size fits all method to determine the value of your SaaS startup.

What Can You Do to Increase the Value of Your SaaS Business Before a Sale?

Here are a few tips for increasing the value of your SaaS business before a sale:

Reduce Churn

It's important to reduce churn as much as possible before going into the market. Churn, or customer turnover rate, is one of the key components in calculating your company's valuation. So to increase your chances of success when selling your SaaS business, you must lower churn rates before entering the market.

In the world of software companies, retaining customers not only generates steady revenue but also validates the relevance and efficacy of your SaaS product in the marketplace. Reducing churn enhances your recurring revenue, thus directly improving your cash flow, an important element that potential buyers would evaluate. To increase your chances of success when selling your SaaS business, you must employ effective customer retention strategies to lower churn rates before entering the market.

Secure Intellectual Property (IP)

An excellent way to increase the value of your SaaS business before a sale is to secure your intellectual property (IP). This includes trademarks, copyrights, patents, and trade secrets but also proprietary algorithms, unique workflows, or distinct interfaces your software might have. Intellectual properties can act as competitive barriers and can significantly influence the valuation multiple during a sale.

Avoid Discounting

Another way that software companies often lose money when they sell their SaaS businesses is by discounting too heavily during sales cycles. While discounting might seem like an easy method to boost short-term revenue, it may compromise the integrity of your pricing strategy, and thus, reduce profit margins.

Consistently low pricing could also skew the valuation multiple negatively as it makes it harder for future investors or acquirers to see how profitable your company will be. Maintaining a balanced pricing strategy is vital for sustaining a healthy cash flow and ensuring an attractive valuation.

Document Source Code

Another way to boost the value of your SaaS business is by documenting the source code and making sure that it is available for inspection by potential buyers. A well-documented, clean, and maintainable codebase speaks volumes about the quality of the product and the professionalism of your software development practices.

This allows potential buyers to conduct thorough due diligence and ascertain if any hidden defects or vulnerabilities in the application could cause future problems.

Enhance Financial Management

Buyers consider companies with strong financial management practices as lower risk, thereby increasing their willingness to pay a premium. Having clear financial statements, predictable cash flow, and well-managed expenses can improve your valuation multiple. Demonstrate strong cost management, well-planned investments, and consistent profitability to heighten your SaaS business's value.

Market Positioning

Potential buyers are interested in companies that can demonstrate a strong market position with significant growth potential. If you have a unique product, a large addressable market, and a strong competitive position, you are likely to attract higher offers. Strategies that enhance your market positioning, such as targeted marketing campaigns, strategic partnerships, or expansion into new markets, can significantly increase your SaaS business's value before a sale.

So How to Value a SaaS Company? Final Words

SaaS Valuation is tricky because it's not about revenues. The reason? It's about profits! – Instead of historical revenues, valuing a SaaS business looks at a software company's standard 15% net profit margin, the net income line on the income statement.

At Apptension, we understand the complexities of SaaS valuation and specialize in designing, building, and launching digital products. In addition, we know that valuing a SaaS business is not just about revenues but rather profits. Learn more on our SaaS consulting services page!