SaaS Company Valuation – Learn to Value your Company the Right Way!
February 8, 2022 Edwin Kooistra
With the growing need for software, its market diversified, and buying complete software became an obsolete practice. Businesses shifted to the SaaS model where, instead of buying, they pay software vendors a monthly fee to avail their software services on web-based applications through cloud computing.
This resulted in a massive growth of businesses as customers got easy access to company services. However, what remains a topic of debate is ‘how to value SaaS companies.
Companies carry out a business valuation to determine the sale value or the merger value of their company. It is also necessary for tax reporting and establishing new partnerships. Owners and investors hire business valuation accountants to oversee this process. There are several approaches to determine the value of SaaS companies.
However, it is important to understand SaaS valuation multipliers and metrics to ensure accurate measurement of your company’s value.
- Why are SaaS companies valuable?
- Types of SaaS evaluation
- What is a SaaS valuation multiplier?
- Secondary valuation multiples
- How to increase your SaaS valuation multiplier?
Why are SaaS companies valuable?
It cannot be denied that SaaS companies have added benefits that give them an edge over companies that use manual or outdated methods to reach their customers. There are multiple uses for companies utilizing SaaS. Firstly.
There are low upfront costs and high gross margins as service costs go down over time. Since SaaS applications do not offer a single purchase, there are recurring revenues with payments made every month by the companies availing of SaaS services. This eliminates the costs of installation and worrying about the software’s obsoleteness.
Moreover, there is also no issue of business growth and scalability as the software’s easy and flexible interface allows customers to expand their use of company services and access them from anywhere in the world. Moreover, there is more room for data to be stored in large quantities while maintaining user privacy. SaaS offers a very low risk of data loss.
Software integration is also effortless as data is integrated into all systems. One of the major benefits that SaaS offers is the constant updates of software so the company evolves with the ever-growing technological environment. Companies that avail of SaaS application services can use the software on their terms by customizing it according to their needs. SaaS companies provide software to create a better experience for their customers which makes them valuable.
Giants like Microsoft, Google, Shopify are all examples of SaaS companies. However, other small-scale vendors also provide SaaS services.
Types of SaaS Evaluation
SaaS can be evaluated in three ways by a company’s earnings. It is not complicated if you understand the multipliers thoroughly.
SDE or Seller Discretionary Earnings
SDE is used for companies that are valued at under $5 million. It is the amount left after the owner pays all expenses and adds that amount to the salary.
The formula for calculating SDE is:
SDE = Revenue – Cost of goods sold – Operating expenses + Owner compensation
Let’s understand these terms one by one:
Revenue: it is the income generated by sales made by the company
COGS: it is the cost that the business incurred while producing goods sold
Operating expenses: these include expenditures such as rent and utilities paid by the company
Owner compensation: the wage paid to the owner
SDE is used for valuation businesses that do not incur a lot of costs and have a slow growth rate.
The salaries of such companies are not market competitive and the workers rely on their owners. SDE is the best way to determine the earning power of a small or medium enterprise
EBITDA is the earning of the company before paying interest, tax, and amortization. It shows the profitability of the business. However, to understand how well your business is performing, you must know the revenue as well.
The EBITDA margin is calculated by:
EBITDA Margin=EBITDA/Total Revenue
To figure out your standing in the industry, you need to compare the EBITDA margin to the average of the industry. If your company has less revenue but more EBITDA margin, the investor will most likely value your company high.
ARR or Revenue Based Valuation
This method of SaaS business valuation is becoming popular among investors and owners. The costs incurred by the company during investment are considered expenses. Therefore, they have to invest a huge amount to gain revenue. Investors are valuing business through Annual Recurring Revenue Valuation.
With the help of revenue, they can forecast future income and profits and understand the worth of business. Investors buy ARR multiples if they have good recurring revenue.
What is a SaaS Valuation Multiplier?
SaaS valuation multipliers help companies compare themselves with other companies of the industry and help determine the valuation method which they can use. The bigger the company is, the bigger the multiplier it has. There are several multipliers but not all can be used for every company.
ARR or MRR
Annual recurring revenue or monthly recurring revenue shows how profitable a business is. Investors are more interested in seeing high MRR as they make accurate forecasts. A company that wants to succeed should focus on increasing its revenue, more importantly, recurring revenue.
Investors are keen to buy companies that have $5 million as their ARR because its multiple is $1 million, unlike large companies which have ARR above $10 million. A company earns approximately $10 million ARR when it is in the growth stage and $100 Million ARR in the profit stage.
The percentage of NRR (Net Retention Rate) gives the changes in customer retention rate, both positive and negative. NRR is determined by subscription cancellations, increase in the number of subscriptions, and subscription downgrades
Churn and Renewal Rates
The churn rate is the number of customers lost in a month or a year. There is no definitive churn rate for every company as scalability is different for each business. However, an acceptable churn rate is between 5%-7%.
The churn rate for small businesses is usually high unlike that of a big business. The renewal rate determines how many new customers subscribed to the service or returned to it. However, when we compare it with churn rate, churn rate is a better multiplier to determine the success of the business correctly.
Secondary Valuation Multiples
Gross margin is the amount a company retains or saves on the cost of goods sold. It is simply the savings that the company has after incurring costs on the production and selling of its products and services
A business can identify growth opportunities and expand in areas of interest. Given the resources, how rapidly can a company grow, acquire and be ready for an IPO.
Year-over-year Growth Rate
This multiplier measures the changes that occurred in the company in the last 1 year. Companies should make sure that their financial situation does not vary largely. 10%-20% is acceptable but if it goes above 50%, investors are likely to run away from it
SaaS businesses must expand in multiple sectors to survive. Some SaaS companies restrict their growth to a few sectors. Investors are interested in an expanded set of business therefore it is advised to broaden your market horizon.
Involvement of the Owner
Investors find companies without owners more attractive to buy. If you are planning to leave the ownership of your business, make sure that the people working under you are experienced and tech-savvy. If investors find a loophole, they will immediately back off.
Age of Company
Older companies have a higher multiple and do not attract investors. However, companies that have been in the market for 1-2 years are appealing to the investors.
Diversity of Customers
A company has several segments of customers. They should make sure that one segment does not generate more than 20% revenue. This makes a company vulnerable. Revenue generation should be divided equally among multiple segments of customers
Companies which communicate their business values with customers and investors are more likely to attract them. It is important to make a loyal customer base to increase the value of your business.
The methods a company uses for reaching out to its customers play a major role in identifying the multiple the investors will use to value the business. This helps businesses must secure the investor to identify which markets they can acquire. Tech product marketing methods include SEO, Account-based marketing, referrals, Google Ads, and others.
The assets of a company are its human resource and equipment. If your company has a strong set of these, you will most likely attract investors and equity firms.
It is important to keep the market value in mind before selling your business. If the market rate of valuation is high, keep your rates high as well and vice versa.
How to Increase your SaaS Valuation Multiplier?
Protect your Brand Identity
Businesses must secure their identity. Patents, IP, trademarks, and copyrights must be protected from competitors because if they use your identification, it will be a major drawback for investors’ interest in your business.
Be Careful with your Pricing
You must consider your customers’ opinion when you plan to increase yearly prices. Take them in confidence as to why you need to increase your prices and how they feel about it. This will enable you to gain trust and expand your goodwill which in turn will attract investors to your business.
Strengthen your Marketing Infrastructure
The key to any successful business is constant marketing. No matter how established you are in the industry, marketing is imperative and must be done frequently. Make sure to establish strong marketing campaigns for your service
Improve your Customer Experience
Having an active customer feedback portal and a low churn rate will improve your customer experience. You must reach out to customers to listen to their grievances regarding your services and what advice they have to offer to make them better. At the end of the day remember, the customer is your product.
Standardize and Record all Processes
This may not seem like an important factor when you start your business but without properly documenting your business records, you cannot exit the business. Every transaction, employee records, and dealings must be documented to keep your business clean and attractive for investors
Use Marketing-as-a-Service to Increase your Valuation Worth
Marketers are running out of tactics to showcase their content. SaaS companies’ marketing strategy requires some important steps to keep under consideration.
You must know how to identify your brand purpose and target customers. Then identify the keywords that your target market uses while searching the service so that your company gets its desired ranking on google.
You must position yourself in a way that you gain the trust of customers by showcasing them new and unique solutions. Your marketing team must be an expert in writing the correct messages for the type of markets you want to approach on social media.
How do you value a SaaS company?
There are 3 main methods to value a SaaS company. One is by ARR (Annual Recurring Revenue), the second is by EBITDA and the third is by SDE. SDE methods are used by companies with less than $5million in revenue whereas ARR is the most popular one because of its accurate predictability and forecasts.
What are the valuation multiples for SaaS companies?
The valuation multiples for SaaS companies are Annually or Monthly Recurring Revenue, Net Revenue Retention, and Churn & Renewal rates.
How are SaaS startups valued?
SaaS startups are valued by the secondary valuation multipliers as they are not established enough to be valued by primary valuation methods.
What is the rule of 40%?
The rule of 40 is used by investors who are interested to invest in companies that have a profit and growth margin of 40% or above.
Why are SaaS companies so valuable?
SaaS companies are valuable because of recurring revenue and fast growth. The SaaS market is expanding and is sustainable which makes it an attraction for investors. There is more room for data storage and a larger market can be accessed through it. Customers feel more satisfied using SaaS services
What is a good gross margin for a SaaS company?
70%-80% is considered a good margin for SaaS companies to enable them to operate professionally.
What is the profit margin for SaaS?
For a SaaS company, 80%-90% is considered a good profit margin
What are SaaS metrics?
There are several metrics out of which Churn and Renewal rate, Customer lifetime value, and ARR are the most popular.