SaaS Valuation 101 - How to (Accurately) Value a Software Business

Introduction

Software as a Service (SaaS) business model has been around for a while, growing rapidly in the past years and becoming a go-to solution for many of high-growth tech startups. SaaS took over the digital world and it has become increasingly important for founders (and investors) to understand how to correctly value SaaS companies given their unique characteristics.

In this article, we will discuss the basics of SaaS valuation, the key metrics used in the valuation process, valuation methods, and factors that affect SaaS valuation. This article is made to be 101, an introductory piece. SaaS is an insanely huge topic to handle and we will only scratch the surface here, so stay tuned for future posts where we deep dive into SaaS a little more!

Let’s start with basics (and by basics, we really mean basics), by looking at what SaaS actually is and why these days it might just be the most important business model of all.

Defining SaaS

If you’re using an email provider, calendar apps, and office tools like Microsoft Office then you already know what SaaS is.

Simply put, SaaS is a cloud-based software delivery model enabling users to use applications over the Internet. With SaaS, the full software solution is hosted on remote servers maintained by a service provider and accessible through web browsers, mobile apps, or APIs. The beauty of SaaS lies in its convenience and cost-effectiveness. Users can swiftly start utilizing an application with negligible upfront costs, as they essentially “rent” the application from the provider.

Businesses don't have to worry about the costs of maintaining and upgrading the software either, as it is all taken care of by the service provider. Instead, companies can focus on their core operations and “outsource” the IT infrastructure to the SaaS providers.

Subscription-based approach is key to all SaaS businesses where customers pay a periodic fee, typically monthly, granting them on-demand access to the software. This provides a scalable, flexible, and accessible solution for businesses and individual users, positioning SaaS as an undisputed leader vs. traditional software delivery models.

Benefits of SaaS for Businesses

Many companies turn to cloud-based software solutions due to the cost-effectiveness and high product efficiency. SaaS provides businesses with many benefits, including:

1. Lower upfront costs: With SaaS, you don't have to worry about the costs of purchasing and installing new software. Instead, simply subscribe to the service and start using it right away.
2. Scalability: SaaS solutions are designed to be easily scalable, which means that as your business expands, you just adapt it according to the increasing number of users, data volume, and other features.
3. Flexibility: SaaS solutions are typically accessed through a web browser or a dedicated software client, which makes them easy to use and accessible from anywhere with an Internet connection.
4. Greater collaboration: SaaS solutions are often designed with collaboration in mind, which means that they can help businesses work more effectively as a team.
5. More efficient use of IT resources: With SaaS, businesses don't have to worry about maintaining and upgrading their software, as it is all taken care of by the service provider. This means that you can focus on core operations and leave the IT infrastructure to the experts.
6. Highest level of security: All users enjoy the highest security standard that vastly minimizes risk of downtimes and cyber attacks.

Key SaaS Metrics and Their Valuation Impact

While every software startup is unique and there isn't a universal methodology that promises to deliver an accurate valuation, SaaS companies operate (and can be analyzed) on fairly standardized metrics.

Company Age and Growth Profile

While businesses with years of track record tend to command higher credibility and investor conviction, this doesn’t always mean a higher valuation multiple. Growth profile is the crucial piece of a puzzle and the very reason while a two year old unprofitable startup growing top-line 400% year-on-year might be worth more (on paper!) than its ten years old competitor, steadily cash-flowing — but not growing at all. Different types of investors value different metrics, and while VCs might look at revenue growth only, more traditional buyers will appreciate cash generation ability and healthy growth profile.

Monthly Recurring Revenue (MRR)

MRR is the total revenue generated by the company's subscription-based products on a monthly basis. It includes all recurring revenue but excludes one-time fees. It is a #1 key metric for SaaS companies as it provides a clear view of the company's recurring revenue stream and its growth potential.

For example, if a SaaS company grows their MRR at 10% every month, they can predict doubling revenue every seven months. With this information, companies can make informed product decisions, and investors can more accurately forecast business potential when it comes to valuation.

Customer Acquisition Cost (CAC)

CAC is the total cost of acquiring a new customer and it includes all the money spent on marketing and sales to acquire new users. In principle companies should aim to keep CAC as low as possible, though that’s not always the case. Venture-backed companies might be ‘okay’ to splurge and keep their CACs high in order to grab the market share as quickly as possible, though high CACs will always alert a potential stakeholder whether the company's growth is sustainable, and whether it can acquire new customers at a reasonable cost.

To accurately evaluate if a company CAC is acceptable, we must also know the customer lifetime value (LTV).

Customer Lifetime Value (LTV or CLV)

LTV is an amount a customer will spend with a company over their lifetime relationship with the product. For example, if a SaaS company has an average revenue per customer of $50 per month and the average length of a customer's subscription is 12 months, its LTV would be $600.

As a business, you obviously want to get more from your customers than you spent on acquiring them, so LTV metric is commonly used in a ratio with CAC. As a rule of thumb, a great LTV:CAC ratio is thought to be around 3:1 (you get three times more out of your customer than you spent on acquisition).

Churn Rate

Churn rate is the percentage of customers who cancel their subscriptions within a given time period. It is a crucial metric as it reflects the company's ability to retain its customers and generate predictable revenue.

A high churn rate immediately alerts investors that the company might be a poor performer and ultimately needs to spend extra money to acquire additional users. High churn rates impact valuation very negatively, low churn rates give much-needed confidence and drive premium valuation outcomes.

Understanding SaaS Valuation

In essence, the worth of any business is equal to the net present value of its future profits. SaaS companies however tend to characterize with strong, steady growth profile (they have the potential to multiply their current revenue many times) and have low-risk unit economics (can easily turn to profitability with scale).

For a younger, healthy SaaS company, there is a big upside in future profits as it can be way more valuable to focus on top-line growth while staying “in red” vs. trying to turn profit too quickly (which could hinder further growth). These young, high-growth companies are usually being valued with a multiple of their annual recurring revenue (ARR) or monthly recurring revenue (MRR).

On the other side of the table we have a different type of SaaS businesses. While not triple-digit-crazy-growing anymore, they managed to find their niche, turn healthy profit and generate steady cashflow for their shareholders. These firms can be valued using discounted cash flow (DCF) method, where we estimate the present value of the company's future cash flow and ability to generate cash over time, or using an EBITDA multiple.

Ultimately, regardless of a growth profile and situation, finding the right valuation benchmark is tricky. It depends not only on the company’s performance, but also market conditions, competitive dynamics or, in case of an M&A situation, the number of buyers bidding for a business.

To accurately value a SaaS business, we always recommend taking a holistic approach and combining all relevant methods to come up with a median number that accurately portrays given scenario.

Discounted Cash Flow

DCF analysis is a very popular method used to value SaaS companies, albeit those mature ones. It estimates the present value of the company's future cash flows, taking into account the company's ability to generate cash over the long term. It is based on the premise that the value of a company is equal to the present value of its future cash flows. DCF analysis is a complex method that involves forecasting future cash flows, calculating the discount rate, and estimating the terminal value. This method is widely used in the professional finance industry (investment banks, private equity funds) and applies well to companies that generate (or project to generate) meaningful profits.

DCF analysis is a powerful tool that can provide valuable insights into the company's financial health. It does, however, have its limitations. It is highly dependent on the accuracy of the assumptions made about the future cash flows, so if the assumptions are incorrect, the valuation can be significantly off.

Revenue Multiples

The revenue multiple method is very (if not the most) popular method used to value SaaS companies. This method values the company by multiplying the company's past (usually last twelve months) or projected (usually next twelve months) revenue by a multiple based on the industry average. The multiple is usually based off the similar companies within the specific vertical.

The revenue multiple is a simple and easy-to-understand method, widely used in the venture capital and finance industry to value SaaS companies. It is highly sensitive to revenue projections though, and does not take into account cash flow or profitability levels, what in many cases can be misleading.

EBITDA Multiples

For larger SaaS organizations that turn profit, EBITDA multiple might be the most accurate representation of company value. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a widely popular metric that measures a company's overall financial performance. Similar to revenue multiple, this method values the business by multiplying past or forecasted EBITDA by a multiple based on the sector average. The multiple is based off the similar (profitable) companies operating in the space.

Seller Discretionary Earnings (SDE)

This method is most commonly used for a small, private software businesses. SDE equals profit company generates after deducting from revenue operating expenses and cost of goods sold, but after adding back owner compensation.

Many privately run SaaS businesses are bootstrapped and run very lean, where owners live comfortably by taking a significant part of profits as compensation (as they should!). Adding owner compensation back into SDE gives therefore a more accurate measure of company’s earnings potential.

Comparables Analysis

Comparables analysis is a method that compares the valued company to other similar companies in the industry. This method derives the valuation multiple from either a basket of publicly traded comps in a similar niche, or a precedent transactions that involved a target operating in a similar space.

The analysis is based on the premise that similar companies, even though different size and region, should have similar valuations.

Comps analysis provides a quick and easy way to value a company, yet it’s highly dependent on the market data. As an example, while Salesforce can be somewhat comparable to our small CRM software provider, we should remember that it’s not exactly apples-to-apples comparison and further analysis is needed to derive more accurate value.

So How to Value a SaaS Startup?

Let’s summarize. To correctly estimate the value of your SaaS business, we need the following in order:

Know Your Metrics

Regardless if you’re running a booking portal for hairdressers or an accounting software platform, SaaS companies are characterized by a standardized set of metrics that we described above (MRR, ARR, CAC, LTV and churn level). Those are the numbers SaaS companies are being valued with, so knowing these metrics ‘cold’ is crucial if you’re looking to accurately assign valuation to a SaaS business.

Choose Your Valuation Method(s)

To get most accurate benchmark, you should use several methods to value a SaaS business. As a small business owner of a bootstrapped company, SDE will likely be the most appropriate metric, but if your business is larger, consider using EBITDA. If you’re projecting high top-line growth, use revenue-based multiples to capture the upside potential.

Determine and Apply the Multiple(s)

We’re wrapping up with the tricky part - finding the right valuation multiple. It’s more of an art than science and getting the right number requires operational understanding of a sector as well as getting the ‘feel’ of a market environment. Though not always straightforward, you should aim to establish a range of multiples for similar businesses to your own, using publicly traded comparables or private M&A transactions. You should also take into account your success metrics (churn, LTV:CAC ratio, growth level, etc.) alongside company age, product demand, technology excellence and more.

Hiring a Right Valuation Advisor

Despite universal KPI development, valuing a SaaS company can be challenging given unique business model characteristics, strong need for market understanding and often lack of proprietary data access. However, by understanding the basic key metrics, valuation methods, and factors that affect SaaS valuation, founders and investors can make much more informed decisions and try come up with “good enough” ballpark number by themselves.

If you're looking to professionally value the software business, you might want to consider hiring an expert that will understand details quickly, identify key opportunities and challenges, and deliver actionable recommendation.

Due to highly technical nature of SaaS, we recommend choosing a specialized valuation firm over a generalist advisor. Devil is always in details, and to uncover the hidden value of a private SaaS company (especially small to mid-size scale) you need much more than off-the-shelf valuation model. Assessing customer behavior, segment maturity, licenses or tech excellence — this is all vital part of the value proposition, and should be reflected in the valuation.

To learn more about Flow Partners valuation service, click here.