SaaS Valuation 101 - Here's How to Value a SaaS Company
Determining the economic value of a SaaS company is beneficial for understanding its growth potential and profitability, whether you’re looking to sell to expand to a new market or aiming to scale.
However, valuation is never straightforward, nor are its determining metrics an exact science.
In fact, valuation multiples are mere ballpark estimates, not exact measures of how much a company is worth.
In this article, we will help you navigate the complex concept of SaaS valuation–from explaining valuation metrics to understanding the role of external advisors in attaining an accurate evaluation.
How to Value a SaaS Company
There are three main ways to perform a SaaS company valuation: revenue or ARR-based, EBITDA-based, and SDE-based.
Let’s dig deeper.
Revenue-Based Valuation Approach
Revenue-based or Annual Recurring Revenue (ARR) valuation focuses on potential growth. The other two, on the other hand, look mainly at profits and earnings.
Most private SaaS companies prefer this approach because they make significant upfront expenses while investing in growth. Hence, current numbers may not support an objective forecast of profitability.
So they focus instead on determining their growth outlook, assuming that the higher the growth potential, the higher the company’s value.
What is a Multiplier in Business?
Multipliers, also known as the price-to-earnings (P/E) ratio or earnings multipliers, are used in valuations to determine the actual value of a company.
Smaller businesses typically have multipliers of one to three, while larger and more established ones can have four or higher.
Factors that affect multipliers include the following:
Business size and organization
To determine your current multiplier:
Take your market capital or enterprise value
Divide the value by either your earnings or revenue
$4,000,000 (enterprise value) ÷ $2,000,000 (earnings)
= 2 (current multiplier)
To calculate projected business value:
Take your earnings before interest and taxes (EBIT)
Multiply the value by the average industry multiplier (the multiplier may vary depending on the factors listed above)
$4,000,000 (EBIT) ✕ 2 (average industry multiplier)
= $8,000,000 (business value)
What is NTM Revenue?
NTM revenue (also called “forward revenue”) is a company’s forecasted revenue over the next twelve months.
Businesses valued for their growth potential, such as SaaS companies and startups, are often valued based on their NTM because much of their real value is yet to be seen.
EBITDA-Based Valuation Approach
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization”.
This valuation model is used mainly for larger enterprises with a complex management structure or those with an earning power of $5 million or higher.
It determines a company’s economic value based on its financial stability by looking at cash flow minus operational obligations and taxes.
Businesses are generally valued anywhere from three to six times a company’s EBITDA. Several factors influence valuation in this case, such as:
Return on investment (ROI)
Businesses with a high growth potential or that operate in a fast-growing market may benefit from conducting EBITDA-based valuations, as the end figures are typically much higher than their net income.
The main reason is that EBITDA factors back into a business’s actual value its non-cash and recurring expenses, depreciation, and amortization.
However, because EBITDA can present an inflated picture of a company’s worth, most buyers will negotiate for a lower value when striking a deal.
SDE-Based Valuation Approach
The SDE or Seller Discretionary Earnings valuation method works best for smaller businesses with an ARR of less than $5 million that operate with and rely heavily on a single owner.
Compared with EBITDA valuation, which looks at overall financial performance, SDE valuation measures revenue generation efficiency per employee.
With this approach, the amount that owners pay themselves as a salary is considered to determine a company’s earning capacity accurately.
Unsure how to calculate your company’s value? Try using Exitwise’s Business Valuation Calculator to understand your company’s mergers and acquisitions (M&A) transaction value in real-time.
What is the Rule of Thumb for Valuing a Business?
The general rule of thumb when appraising a business is to weigh in on industry-specific multiples such as EBITDA, revenue, and discretionary earnings to arrive at an estimated value of a company.
It’s important to note that while these are helpful for business owners to gain a high-level overview of their company’s value, there is no one-size-fits-all approach.
Every enterprise is unique. Many factors outside of revenue and earnings affect the actual value of a company, such as the business model, its unique value proposition, and intellectual property.
A combination of several valuation approaches may be necessary to gain a clearer, more accurate picture.
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SaaS Valuation Multiples Explained
SaaS valuation multiples are factors by which revenue is multiplied to arrive at a ballpark estimate of a company’s value.
Using the multiples approach in SaaS business valuation, we can compare similar businesses by evaluating them using standard financial metrics.
Types of Valuation Multiples
There are two types of valuation multiples:
Enterprise: Commonly used in SaaS M&A transactions and includes enterprise value-to-sales and enterprise value-to-EBITDA ratios. This type of valuation multiple is most beneficial where debt may affect business value, as it eliminates the impact of debt financing from the equation.
Equity: Evaluates specific aspects of a company’s financial performance, such as dividend yield and price-to-earnings ratio. This type of SaaS multiple is used when investors want to own a small share in a company.
Since equity value is impacted by changes in capital structure, enterprise multiples are often regarded as more accurate tools for determining market value.
Equity multiples, on the other hand, are easier valuation models because they rely on readily available financial data.
Methods for Using Multiples in Valuation
There are two ways to use valuation multiples when determining a company’s market value:
Comparable Company Analysis: Makes an assessment of companies with similar characteristics (such as size and industry) and works under the assumption that similar companies have identical multiples.
Precedent Transactions Analysis: Look at past M&A transactions of companies in the same industry to arrive at a benchmark for a valued company.
How Do Early-Stage SaaS Valuation Multiples Differ?
Valuing an early-stage company is unique because most valuation models don’t apply. During the initial stages of business, companies are yet to see profits and are instead actively investing in growth.
Financial performance indicators, such as historical data, are also insufficient and can’t provide a clear picture of a company’s status.
Therefore, qualitative elements, like management experience, play a significant role in the valuation process. A company’s scalability, business model, and market are other factors that affect valuation.
The most common early-stage SaaS valuation multiples include enterprise value-to-EBITDA and enterprise value-to-revenue.
Factors Influencing SaaS Valuations
SaaS valuations are complex processes affected by a myriad of factors. The following are some of the most common metrics that affect a company’s market value:
Size of the total addressable market (TAM): The size of the overall market that the company operates within–not to be confused with Serviceable Addressable Market (SAM) and Serviceable Obtainable Market (SOM).
SAM is the chunk of the market a company can access, while SOM is the market portion it can reasonably capture.
Long-term growth potential: Refers to a company’s potential to increase its customer base, expand to new markets, and improve its investment returns.
Company age and stability: Pertains to the length of time that a company has stayed in business. SaaS startups three years old or younger have yet to prove their stability.
Moreover, according to a SaaS Capital report, it takes five years for a SaaS company to reach $1 million in ARR.
Market competition and positioning: A company’s ability to influence the behavior of its target market, which depends on its unique value proposition and the quality of its products and services.
Intellectual property and brand protection: Securing intellectual property in the form of trademarks, patents, and copyrights protects trade secrets and unique algorithms, which increases a company’s market value.
Customer diversity and concentration: The number of customers on which revenue and profits are anchored. The more diversified your customer base, the more stable your business is.
Essential SaaS Valuation Metrics
Whichever valuation model you use, the following financial metrics are key indicators of your company’s value:
The number of customers that leave your business within a specific period.
(Canceled customers ÷ total number of customers) × 100 = Churn Rate
(50 canceled customers ÷ 100 total customers) × 100 = 50% Churn Rate
Customer Acquisition Cost (CAC)
The amount it costs for a company to acquire a new customer.
Total marketing budget ÷ total new customers = CAC
$100,000 marketing budget ÷ 1,000 new customers = $100 CAC
Monthly Recurring Revenue (MRR)
A company’s revenue that recurs every month.
Total number of customers × average billed amount per customer = MRR
100 total customers × $100 billed amount = $10,000 MRR
Annual Recurring Revenue (ARR)
The revenue of a SaaS company year after year.
(Annual revenue ÷ initial investment) × 100 = ARR
($100,000 annual revenue ÷ $300,000 initial investment) × 100 = 33% ARR
Total revenue after subtracting the initial costs.
((Total revenue - cost of goods sold) ÷ total revenue) × 100 = Gross Margin
($100,000 total revenue - $50,000 cost of goods sold) ÷ $100,000 total revenue) × 100 = 50% Gross Margin
A company’s actual profit after subtracting all expenses from revenue.
Total revenue - total expenses = Net Profit
$1,000,000 total revenue - $700,000 total expenses = $300,000 Net Profit
The Role of External Advisors in SaaS Valuation
Whether you’re looking to buy or sell (or even if you’re simply trying to gauge the health of your business), knowing how to value a SaaS company is crucial for understanding a business’s overall financial condition.
Engaging Experts and Industry Professionals
You can conduct a surface-level valuation yourself, but you need experts to get a more accurate picture of what your business is worth.
Valuations are a complex, multi-disciplinary process that requires the aptitude and knowledge of industry professionals.
You’ll need M&A advisors, corporate lawyers, and investment bankers to create a successful exit strategy. These experts take care of each stage of M&A transactions–from preparation and planning to conducting due diligence and documentation.
Benefits of Utilizing Valuation Services
Every step of the M&A process is time-consuming and meticulous work that requires acute knowledge of the playing field and understanding how to market a business to the right prospects.
The right M&A team will not only help you increase your chances of receiving better offers but also protect the confidentiality of your data and ensure a smooth sales process.
Frequently Asked Questions (FAQs)
We’ve addressed some of the most commonly asked questions about valuations for SaaS companies below:
What is the rule of 40 SaaS valuation?
Entrepreneur and venture capitalist Brad Feld popularized the Rule of 40 in SaaS valuations.
It states that for a SaaS company to be successful, it should have a combined growth rate and profit margin of 40% or more.
For example, if your company is growing at a rate of 30%, your profit margin should at least be 10%.
According to this rule, businesses growing at a rate of 40% can have a 0% profit margin and still be viable. Those growing at an even higher rate (say, 50%) can afford to lose a percentage of their revenue.
Slowing down growth may result in higher profit margins. However, it may take businesses longer to scale.
How do early-stage SaaS valuation multiples differ?
Valuation multiples for early-stage SaaS companies differ from those for more established enterprises because very little historical data can form a solid basis for their financial performance.
Therefore, valuations for pre-revenue outfits often look at their growth potential and exit value using multiples like EV/Revenue and ARR.
Qualitative indicators, like management experience and customer base, are also considered to form a more rounded picture of a company's status.
Understanding a SaaS company's value and growth potential is complicated work.
It requires a thorough analysis of various aspects of business–from figuring out which valuation models work best to applying the right multiples.
You need industry professionals' expertise to maximize your business's sale and ensure a win-win valuation process.
Jumpstart your exit strategy today. Get in touch with Exitwise advisors to set up your dream team of M&A experts!