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Determining the value of a software-as-a-service (SaaS) business is arguably the most important step in the sales process. This holds true whether you’re buying or selling. In the case of the former, you need to be sure you aren’t overpaying for your investment, and in the case of the latter, you want to be sure you aren’t under-selling your business.
The Core Metrics of SaaS Valuation
Let’s start with a general overview of a business’s valuation process. SaaS companies tend to be unique in that no two businesses are entirely alike, even within the same industry. This makes establishing a valuation framework that can be applied across multiple organizations something of a challenge.
For the purposes of this piece, we’ll use a valuation model proposed by Atlanta-based tech entrepreneur David Cummings. It comprises four key metrics, all focused on the connection between subscribers and revenue. These are size (Annual Recurring Revenue), outlook (Growth Rate), stability (Net Renewal Rate), and efficiency (Gross Margin).
The core metric you’ll use to represent a business’s size is Annual Recurring Revenue. However, I’d caution against measuring this in a vacuum. There are numerous other factors that come into play when determining a business’s size.
- The number of subscribers.
- The number of staff.
- Business partners and vendors.
- Marketing capabilities.
- The number of unique products and variations.
- The needed capabilities or proprietary/coding knowledge.
The speed at which your business is projected to expand is represented by Growth Rate. In the case of SaaS businesses, this refers to year-over-year revenues, though the two generally go hand-in-hand. As with your business’s size, however, there are other factors at play here as well.
- Subscriber churn. For a given period of time, how many subscribers do you lose, on average?
- Subscriber growth rate. Is it higher than your churn?
- Market outlook. Are there impending or predicted industry changes that could adversely affect your business’s growth rate?
- Recent changes to your product portfolio. A new application or acquisition will likely improve your growth rate, for instance.
If a business’s Growth Rate fell to zero, what would that do its Annual Recurring Revenue? This is measured by Net Revenue Retention. As you might expect, subscriber retention is absolutely key for this metric, as are upsell capabilities amongst existing subscribers.
Let’s say, for instance, a SaaS business sells an enterprise collaboration app with several ‘tiers’ of membership. The base application doesn’t cost much to use but is relatively limited both in terms of functionality and in how large of a team it can support. Some ways to generate additional sales amongst existing users could include:
- Premium features and feature-sets.
- Discounts for subscribers looking to upgrade to a higher tier.
- If applicable, discounts on other products in the SaaS business’s portfolio, or bundled deals.
Last but not least, a business’s Gross Margin refers to how much money a business has left after all other expenses have been paid. These include employee salaries, server maintenance fees, marketing budget, and any other incidental costs a business might accrue. The thing that makes SaaS companies particularly valuable for investors is that they usually tend to have an extremely high Gross Margin, retaining anywhere from 60 percent to 90 percent of their total revenue.
Obviously, the higher a SaaS business’s Gross Margin, the better. As a general rule, if you’re selling a SaaS business, you’ll want to cut costs wherever you can without impacting the end-user experience. The following are activities you will want to complete 6-12 months before you list so you can document their impact on the bottom line and you don’t miss out on capturing that value.
- Shifting from a physical office to a distributed workforce.
- Leveraging licensed contractors rather than internal staff for functions such as marketing and accounting.
- If applicable, finding ways to automate the maintenance of your SaaS offerings where possible.
- Eliminate unnecessary items from your business’s inventor.
- Increase your subscription fee. This can be extremely risky, and if done carelessly, could end up having a significant negative effect on your subscriber numbers.
The Most Important Metric of All
As you’ve surmised, each of the metrics described above is important in its own way. But which of them is most critical? Which is the most accurate indicator of not only a SaaS business’s current value but also its future prospects?
The answer is that all four metrics are important. Together, they ultimately determine which metric ultimately forms the core of your business’s valuation. There are three options available to us here.
- Seller’s Discretionary Earnings (SDE). Generally applied to small businesses and those that are reliant on their owner, it measures the total cash available to the owner after all expenses have been paid. It is applicable if a business has a low growth rate and revenue under seven figures. The calculation for SDE can be found here, courtesy of Investopedia.
- Earnings Before Interest, Taxes, Deprecation, and Amortization (EBITDA). Defined by Investopedia as more of a raw measure of profitability, EBITDA may be a good metric for larger SaaS businesses, but only if there is not the potential for rapid growth in the near future.
- Current and projected revenue. Last but not least, if a SaaS business is large and has good growth prospects, then simply focusing on current and projected revenue may be the best factor in valuation. This is because EBIDTA doesn’t necessarily measure long-term cash flow or growth.
It’s important to note that the above metrics should not be measured in a vacuum. There are other factors that can impact a business’s valuation as well, such as competitors and age. At the end of the day, the most important thing to keep in mind is that no two SaaS businesses are the same. The larger the business grows, the tighter the books have to be. Private equity doesn’t mess around.
A valuation framework that works for one may not necessarily work for another.