SaaS valuation is an essential concept for owners, investors, and buyers. However, determining the value of a SaaS business is complex and requires understanding many different metrics.
This article will show you the different metrics you need to perform a SaaS company valuation.
What Goes Into a SaaS Valuation?
SaaS business valuation is a hotly contested subject. Several factors effect the price, such as the SaaS business model, sector, intellectual property, value proposition, and more.
Because there is so much data to consider, the most popular valuation methods for SaaS involve using a variety of metrics and calculations based on the company's earnings.
We’ll explain these below.
Which SaaS Metrics Matter Most?
There are lots of metrics that investors and owners use to value SaaS companies. Some of them are complex, while others are fairly straightforward.
Let's take a look at the metrics that really matter.
Churn is an essential metric for investors. The typical SaaS business model relies on monthly subscriptions. The churn metric calculates how many of these subscribers cancel the service, either monthly or annually.
You can work out the churn rate with this simple formula:
(Canceled customers / total customers at the start of the year) X 100
For example, you start the year with 1000 customers. Over the year, 50 customers have canceled their subscriptions.
Therefore: (50 ÷ 1000) x 100 = 5.
Your churn rate is 5%.
Churn is vital because acquiring customers is expensive. You're leaking money if you're just mashing new customers into a business with high churn.
A low churn rate implies customer satisfaction and loyalty.
CAC & LTV
Customer acquisition costs (CAC) and lifetime value (LTV) are two metrics that can tell you a lot about the profitability of a SaaS business.
CAC refers to how much it costs you in sales and marketing to acquire a new customer. For example, you spend $500k on marketing, which results in the acquisition of 1000 new customers.
To find CAC, you take $500,000 ÷ 1000 = $500. So, each new customer costs your business $500.
LTV is a metric that expresses the average amount of revenue you can expect from a customer.
The ratio between CAC and LTV is quite instructive. For example, if your CAC is $500 and your LTV is $1000, then your business has good growth potential.
However, if your CAC is $500 and your LTV is $250, then the metric is -$250. That number implies your business is not currently profitable.
So a SaaS company's numbers (LTV - CAC) should be positive.
MRR vs. ARR
Monthly recurring revenue (MRR) calculates the revenue of a SaaS business over a particular month on a “recurring” basis.
Annual recurring revenue (ARR) looks at the same revenue over a year.
Some investors are more interested in MRR than ARR. This is because MRR can be a better predictor of future income. Market conditions, competition, and regulations are constantly changing, and a lot can change in a year.
However, other investors believe that ARR offers a "big picture" view of revenues and therefore provides a better, fuller picture of the health of the SaaS. ARR is perfect for companies with complex or seasonal subscription models.
Other Metrics Driving SaaS Company Valuations
Churn, CAC & LTV, and MRR vs. ARR are the most critical metrics for SaaS company valuation. However, many other factors play a part in working out a fair price for a company.
Some other factors to consider are:
Competition: What similar businesses are in the space? What advantages do you have over them to ensure they don't take the bulk of future market share?
Technical knowledge: How dependent is the company on the technical expertise of the founder? If they exit, is that knowledge transferable?
Customer acquisition channels: How established are customer acquisition channels. Are they already delivering value (and customers)?
Saturation: Market saturation can heavily reduce growth potential. SaaS valuation is based on future growth, so if a market is already tapped out, this can impact exit prices significantly.
YoY growth rate: Year over year (YoY) growth rate measures changes in annual revenue. This metric is expressed in a percentage and is an excellent way to track velocity in subscriptions or capital efficiency.
Scalability: Scalability is a specific type of growth where revenue increases faster than you add resources. For investors looking to turn a profit, a business that can scale is extremely attractive.
TAM, SAM, and SOM: TAM, SAM, and SOM are three different metrics that look at the market your business operates within.
TAM stands for the total addressable market and measures the size of the overall market a business is targeting.
SAM is short for the serviceable addressable market. This metric measures the percentage of the SAM that you can actually access due to location, type of service, or other factors.
SOM (or, serviceable obtainable market) looks at how much of the market you can feasibly capture. This metric examines what share of the market your competitors have and how many users you can realistically target with your product or service.
Of course, countless other SaaS valuation metrics are helpful depending on different factors. These are just a sample of the most critical measures of a company's value.
The Valuation Formula: How is SaaS valuation calculated?
As you can see, calculating the value of your SaaS isn't an exact science. There are too many contributing factors and complexity at play.
However, there is a straightforward formula that only uses four metrics to estimate the value of software companies.
The metrics involved are:
● ARR (business size)
● Growth rate (momentum)
● Net revenue retention (product quality)
● Gross margin (profitability)
The formula is:
Valuation = ARR x Growth Rate x NRR x 10.
Once you have this number, you adjust it based on the gross margin.
Let's use an example to make it easy to understand.
A SaaS business has an ARR of $7m. Their growth rate is a steady 55%, with an excellent NRR of 115%. Plugging that into the valuation formula gets us:
Valuation = (7 x 55 x 115 x 10). This implies a valuation of $44m or x6.3.
But remember, we need to adjust for gross margin. We can calculate gross margin as (Revenue minus Cost of Goods Sold) / Revenue.
So, if revenues were $7m and costs were $1, we have (7 - 1) / 7 = A gross margin of 86%.
This figure is above the average SaaS growth margin of 75%, which means we can increase our valuation multiplier.
Of course, we should remember this formula is very straightforward. More reliable SaaS valuations will need to account for several other metrics.
Types of SaaS valuations
There are three main ways to value a SaaS company by using its earnings. These are:
● Revenue multiples
Let's explore each below.
EBITDA: EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Essentially, it measures a company's overall financial performance.
You can calculate EBITDA with a simple formula that adds together:
● Net Income
The combined total is the EBITDA. This metric is often used for more established SaaS with $5m ARR or above.
SDE: SDE, or Seller Discretionary Earnings, is a metric that works out how much financial benefit a single owner would get from a business annually.
To calculate this SaaS valuation, you take:
Total Revenue and minus (Operating expenses + Costs of Goods Sold) and then add Owner Compensation.
SDE is a good metric for SaaS companies with a single owner or a value under $5m ARR.
ARR multiples are the ratio between Annual Recurring Revenue (ARR) and company valuation. The Multiple can be found by dividing the Valuation by ARR. i.e., Multiple = Valuation / ARR.
This metric is considered a great way of calculating the value of private SaaS companies.
Most Common Mistakes in SaaS Business Valuation
Working out SaaS valuations is full of potential pitfalls. Here are three mistakes that you should avoid.
#1. Valuing according to the general market
Median public SaaS companies were trading at multiples of x13 by late 2021. Some valuation companies treat SaaS businesses like every other online or software development business, despite their different models.
This can result in low or inaccurate valuations.
#2. Comparing with competitors
If one of your competitors sells, you might think that benchmark will suggest your company is worth a similar amount. However, it's not always the case.
Without forensic details of both your competitor and the deal, you could be over or undervaluing your business.
#3. Comparing your business with the public SaaS companies
Public SaaS companies have higher valuations. However, these companies are huge. They've got access to capital, a well-established customer base, significant market shares, the best talent, etc.
Having SaaS valuation data is essential for business owners, potential buyers, and your management team. No matter what side of the negotiation table you’re on, you need to understand the true value of the company. Without this knowledge, you risk making bad investments or selling at a price way below what you’re truly worth.
For small businesses looking for an exit or investment, understanding how investors value your business means you can evaluate ahead of time whether it's worth seeking capital or holding out for a little longer.
What is the difference between a SaaS valuation and its corresponding exit valuation?
Early-stage SaaS startups can be challenging to value. Many of the usual SaaS company valuation techniques don't apply because these businesses are too young to sell and have limited financial data.
However, you can work out the SaaS company valuation by forecasting the exit value. In short, for investors, that means:
a) establishing their entry point of investment
b) establishing the future exit value
Exit valuation — frequently referred to as terminal valuation — can be calculated by using:
Enterprise Value (EV) / EBITDA
From here, you can get a multiple for your SaaS company valuation.
What is the difference between enterprise and consumer SaaS valuation?
You can use the same metrics for enterprise and consumer SaaS company valuations.
However, enterprise SaaS companies often have more considerable profitability potential due to:
a) more stability of subscriptions
b) value of subscriptions
As a result, the multiples may be adjusted.
What are SaaS valuation multiples?
SaaS valuation multiples are a popular way to determine fair asking prices and keep an eye on market trends.
Basically, you take the average net profits from the last twelve months and multiply it by a number, like x10 or x20, to get the sale price.
For example, a SaaS company sells for $20m. Their average net profits over the last 12 months were $2m. Therefore, their valuation multiple was x10, i.e. $2m x 10 = $20m.
Of course, the number you multiply by varies considerably based on many of the factors we discussed above, such as:
● Does the owner want to stay involved?
● Is the business established?
● Customer acquisition costs (CAC)
● Churn rates
● Customer LTV
● MRR vs. ARR
What is the rule of 40 in SaaS?
The rule of 40 is a popular metric in the VC and growth capital space. It's a deceptively simple formula that suggests:
SaaS companies need to have a combined percentage growth rate and percentage profit margin of over 40% to be considered a sound investment.
For example, if your revenue growth is 25% and your profit margin is 20%, then the rule of 40 number is 45%. Because 45% > 40%, your SaaS company is considered an attractive proposition for investors.