The global SaaS market value is expected to reach $344.3 billion by 2028. Over that same period, tech CFOs need to stay up-to-date on SaaS valuations to better understand and improve their business's financial health. For this article, I’ve explored and written about the essential metrics and strategies that help make informed decisions and attract investors in the dynamic SaaS world.
Understanding SaaS Valuation: An Overview
Valuing a SaaS company depends on its growth, both current and expected, with investors' perspectives on growth evolving as the company matures. In the initial stages, things like the founder's fit in the market and growth potential are vital. However, as the company moves to later funding rounds, key indicators like net revenue retention and market share become more significant. Regardless of the stage, consistent growth momentum is always the central value driver.
When determining your SaaS company's valuation internally, it's important to understand what you want to get out of in your next funding stage; whether you're looking for a pre-revenue Seed Round, gearing up for a Series C, or approaching an IPO. Consider these guiding questions:
- How much do we aim to raise?
- What will this funding enable us to achieve?
- How much equity are we comfortable parting with?
- Are we profitable yet, or do we expect to become profitable through these funds?
- How much runway will this funding give us?
- How much is required to reach our revenue target?
- How can we minimize equity dilution?
- How will this round influence future ones?
Over a decade ago, investor Marc Andreessen remarked, "Software is eating the world" in a Wall Street Journal essay and that statement still rings true. SaaS funding has seen a sevenfold increase in the past ten years, growing six times faster than overall venture capital. This surge in investor attention is largely due to SaaS's expanding utility and its penetration into new sectors.
In 2022, the worldwide SaaS market stood at $257.47 billion. It's projected to soar to $1.3 trillion by 2030, with a Compound Annual Growth Rate (CAGR) of 19.7% from 2023 to 2030.
SaaS platforms empower companies with a strategic edge. They give insights from large data and have a flexible cloud system. The demand for leading SaaS companies is strong, and we expect this trend to last the decade. After all, if the demand wasn’t there, why would you be here?
Key Metrics That Drive SaaS Company Valuations
If an investor wants to invest in or buy a SaaS company, they'll check its strengths using certain metrics. Some are complicated, and some are simple. Let's dive into the metrics that truly count.
Churn is a key metric that investors keep an eye on. In the typical SaaS world, businesses earn through monthly subscriptions. Churn measures how many subscribers stop using/unsubscribe from the service, be it monthly or yearly.
Here's a simple way to calculate the churn rate:
(Canceled customers / total customers at the start of the year) X 100
For example, imagine you started the year with 2000 customers, and over the year, 100 of them opted out.
Using the formula above, we can see that your churn rate is 5%: (100 ÷ 2000) x 100 = 5.
Understanding churn is essential because it’s almost always cheaper to keep existing customers than get new ones. If too many customers are leaving, it's like pouring water into a sieve; try and try but it’ll never fill up.
A low churn rate indicates happy, loyal customers and is important to investors regardless of the business stage you’re in - if you’re struggling to retain the ones you have, I’ve covered some strategies for reducing customer churn in another article.
Customer Acquisition Costs (CAC) and Lifetime Value (LTV)
Understanding the profitability of a SaaS business is easier when you look at two key metrics: Customer Acquisition Costs (CAC) and Lifetime Value (LTV).
CAC gives you an idea of what you spend on sales and marketing to get a new customer. For instance, let’s say you invest $300k in marketing and it results in 600 new customers. By dividing $300,000 by 600, you get $500. This means it costs you $500 to attract each new customer.
Now, LTV represents the average revenue you can expect from a customer throughout their relationship with your business. Bring them together and you have the LTV/CAC Ratio - your at-a-glance metric to show if your business is sustainable.
The balance between CAC and LTV can tell you a lot, especially about customer retention and profitability. Let's say your CAC is $500 and your LTV is $1500. This hints that your business is in a good spot, as a 3:1 ratio is ideal for SaaS businesses.
On the other hand, if your LTV were to be $300 and your CAC is still $500, you'd be at a deficit of $200 for every customer. In other words, you’d be losing $200 for each new customer that uses your product… not very sustainable. Ideally, you'd always want the difference (LTV - CAC) to be positive but, if you’re in a crowded market and/or taking a well-funded run at first place, this can be fine.
Monthly Recurring Revenue (MRR) vs. Annual Recurring Revenue (ARR)
Monthly Recurring Revenue (MRR) measures a SaaS business's steady revenue in a month. On the other hand, Annual Recurring Revenue (ARR) gauges the same but for an entire year.
Some investors lean more towards MRR as it can better forecast future earnings for young, punchy tech businesses experiencing rapid growth. With the ever-changing landscape of market conditions, competitors, and regulations, a lot can happen in 12 months.
Yet, some investors prefer annual revenue (ARR) for its comprehensive insight into a year's worth of growth and the company’s value. It's especially great for SaaS companies that have intricate or season-based subscription models.
Valuing a SaaS business can spark quite a debate. Many elements come into play, including the business model, industry, intellectual property, and value proposition, among others. Given the vast amount of data to sift through, the metrics mentioned above are among the most commonly referred to.
Other Financial Indicators
You can assess the value of a SaaS company based on its earnings in three main ways: SDE, EBITDA, and Revenue. Depending on your business's profitability and stage of development, you may choose one valuation method over the others to achieve a more acceptable result.
Using EBITDA for Valuation
EBITDA, which stands for Earnings before interest, taxes, depreciation, and amortization, is particularly useful for companies with strong profits.
Let's say your software company has hit the rule of 40 or has a generally low customer acquisition cost (CAC). When SaaS buyers are looking at an EBITDA Valuation, they're interested in the company's ability to generate solid cash flow. This can be especially important for Private Equity firms that might need to secure cash flow through borrowing. Additionally, this metric is becoming a crowd favorite in a recession-fearing investing environment; the proof is right in front of investors, rather than down the road.
Moreover, the EBITDA approach focuses on profitability, so even SaaS companies with less than $5 million in revenue can potentially get a high multiple. In such cases, opting for an EBITDA-based valuation could result in the highest possible multiple for your SaaS business, as long as you have money left at the end of the day.
To work out your SaaS company's EBITDA, here's a simple formula:
Net Income + Interest + Taxes + Depreciation + Amortization
At the end of the day, though, most start-ups looking for funding aren’t going to be anywhere close to profitability, making EBITDA valuation a common choice for companies with annual recurring revenue (ARR) exceeding $5 million.
Using SDE for Valuation
Seller Discretionary Earnings (SDE) shows what's left after the owner has covered all costs, including payroll, overheads, and tools. It also includes the owner's salary to highlight the business's earning potential.
Calculating SaaS SDE is straightforward:
Revenue - (Cost of Goods Sold) - (Operating Expenses + Owner Compensation)
If your business has a single owner or generates less than $5 million in annual recurring revenue (ARR), using SDE is often the most suitable valuation method.
Using Revenue for Valuation
Often, the simplest way to value a software business is through Annual Recurring Revenue (ARR). ARR buyers are willing to pay multiples of this metric because they appreciate the value of recurring income. Private equity firms are increasingly favoring this valuation approach.
While some may see revenue-based valuation as a last resort, it's an excellent choice if your SaaS company has recently achieved product-market fit (PMF) or has an annual recurring revenue ranging from $5 to $100 million.
To pursue a valuation based on revenue multiples, your ARR should exceed $2 million, and your year-over-year growth rates should be over 50%. If your SaaS company is in a hyper-growth phase (or plans to be), a revenue-based valuation is preferable over an EBITDA-based one because your revenue will be able to take the lead, even if profitability isn't sky-high.
Strategic Factors Impacting SaaS Valuation
Beyond the SaaS metrics I’ve just mentioned, there are several other strategic factors to consider during the valuation process.
Secure Intellectual Property (IP)
You'd think it's a no-brainer, but many business owners overlook securing their intellectual property before a financing round or sale. As you probably guessed, this oversight can complicate the deal down the line. For SaaS businesses, safeguarding IP is crucial; this is especially true for deals over $500K, where the funds involved become substantial. While it's best to address this during the early stages of your business, it's never too late. You can still apply for a trademark before selling.
Buyers and investors are keen to see a company's leadership team with a track record of effectively executing its business plan and possessing the necessary skills to drive the business forward. Here are some questions for SaaS founders to consider when assessing their leadership teams:
- Does our team have a demonstrated history of accomplishments?
- How does our leadership team's turnover rate look?
- Is the current team aligned on our direction and the path to get there?
- Have we established a clear succession plan?
A united team with expertise in the field will pique more interest from potential buyers. A fractured team looking to sell and get out is less interesting to any buyer.
Customer Acquisition Channels
For SaaS businesses targeting small- and medium-sized enterprises (SMEs), maintaining a low churn rate is critical. If they're losing a significant portion of customers yearly, they need to consistently attract new ones.
Investors focus on how your business acquires customers. They check for a mix of channels like organic search, email marketing, affiliates, and paid ads. The more diverse and effective these channels, the better. For example, good organic search rankings indicate a strong position but can change, so this isn’t the be-all and end-all. On the other hand, constantly competing on constant outflow channels (like paid search or pay-per-click) can be a weakness.
In short, top SaaS businesses have varied, strong customer acquisition methods with good conversion rates and customer lifetime value.
Valuation Methods And Their Relevance
To calculate the Valuation Multiple, use the formula below:
Valuation Multiple = -3.2 + (0.32 SCI) + (8.26 ARR Growth Rate) + (2.62 * NRR Rate)
Remember, the first part of the formula starts with a negative (-3.2), so be sure to get that right! Those specific numbers, like -3.2 or 2.62, are determined from in-depth research and statistical methods. It's best not to read too much into them individually; they make sense as part of the entire formula.
For example, consider a private SaaS company with these figures:
- An ARR of $6.0 million
- An ARR growth rate of 30%
- A net revenue retention rate of 110%
Now, let's try to determine its valuation for June 2023, when the SaaS Capital Index (SCI) is 8.5x. Applying the formula, we get:
-3.2 + (0.32 * 8.5) + (8.26 * 0.30) + (2.62 * 1.10) = -3.2 + 2.72 + 2.478 + 2.882 = 4.88
With these computations, the baseline Valuation Multiple comes out to be 4.88x, which indicates a company valuation close to $29.28 (4.88 x 6 from $6M ARR) million.
At the end of the day, remember that this number is great to give you a starting point to approach the market but you can’t accept this valuation as law. Your company is worth what others are willing to pay for it, this is simply one informed way to create your price tag.
Preparing Your Company For Investors And Venture Capitalists
There are several strategies you can use to position your SaaS business for higher valuations. Below are the most effective strategies:
Investors are on the lookout for SaaS companies that promise both rapid growth and long-term revenue. To boost your valuation, aim for quick growth while keeping sustainability front and center. Here's how you can do it:
- Introduce a complementary product with proven market demand.
- Optimize high-ROI customer acquisition.
- Ensure great service and user experience.
- Explore new markets and diversify offerings.
Refine Your Pricing
Pricing crucially affects SaaS valuation since it influences revenue and profit. To align with growth goals, SaaS businesses should revisit their pricing strategy often. Some tips to enhance pricing include:
- Research to determine the optimal price.
- Offer tiered pricing for a diverse customer base.
- Use promotions to attract or retain clients.
- Raise prices gradually as you grow.
Keep Your Finances Spot-On
Precise financial reporting is pivotal for SaaS valuation, as investors use these to gauge company health. Maintain spotless finances by:
- Hiring an expert accountant.
- Implementing robust financial safeguards.
- Consistently reviewing financial data.
- Recording all financial activities precisely.
Strengthen Your Leadership
A robust leadership team boosts a SaaS company's success and valuation. Enhance your team by:
- Hiring experienced leaders.
- Creating a positive work environment.
- Providing ongoing training.
- Emphasizing diversity and inclusion.
Consider Mergers or Collaborations
Merging or otherwise partnering up with others can help SaaS firms grow their audience, tap into new sectors, and diversify revenue. This can up the valuation. Here's how to approach it:
- Research potential collaborations.
- Secure win-win deals with functional experts.
- Integrate new entities thoughtfully.
- Leverage new strengths for growth.
Navigating The SaaS Valuation Landscape In 2023
Regardless of whether you're an established SaaS provider or a startup navigating product-market fit, valuing your business is a crucial aspect of your strategy. Keep in mind that investors and buyers aren't seeking another costly venture; they're seeking a sustainable growth engine with a profitable outlook.
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