SaaS Valuations: How to Value a SaaS Company

Software as a Service (SaaS) is a way of using software where you pay for it on a subscription basis instead of buying it outright. The software is hosted on a central server (in the cloud) and you access it through the internet. It’s sometimes called on-demand software or web-based software because you can use it whenever you need it, without having to install it on your own computer. It’s a convenient and flexible way to use software without the hassle of managing and updating it yourself—and as you can imagine, most businesses are run on many different types of SaaS platforms for a variety of operational needs. 

Most companies, for example, need to store and track their customer and prospect data, and they use a customer relationship management system (CRM) to do this. CRMs are a good example of SaaS platforms, as are enterprise resource planning (ERP) tools and content management systems (CMS). Businesses have become reliant on such technologies to help streamline their business processes, so it’s no surprise that this market has untapped potential and is extremely attractive to investors.

How SaaS companies get valued

The SaaS valuation process has long-been developed and redeveloped by entrepreneurs, investors, and business advisors. It’s an amorphous model that continues to change, but for the most part, the underlying valuation principles remain the same. 

Investors consider various factors and methodologies to assess the company’s potential for generating revenue, growth prospects, and overall value in the market. Key steps in the SaaS valuation process may include:

Financial Analysis: Analyzing the company’s financial statements, including revenue, expenses, profitability, and cash flow, to understand its financial performance and stability.

Market Analysis: Assessing the target market size, growth potential, competition, and industry trends to gauge the company’s positioning and market opportunity.

Revenue Evaluation: Examining the revenue model, pricing strategy, customer acquisition, and retention rates to estimate future revenue projections and assess the company’s ability to generate sustainable income.

Comparable Analysis: Comparing the SaaS company with similar companies in the market, both publicly traded and privately held, to identify valuation benchmarks and understand market norms.

Mainly, there is no singular way to determine or calculate a company’s worth or potential value, but investors have pinned some important metrics to consider.

SaaS metrics that matter the most

Similar to the appraisal process for say an antique car or a painting, there are many considerations and attributes to consider when appraising a private SaaS company that could impact its overall and long-term value. First, let’s consider some of these attributes and metrics for their respective impact on the valuation process. 

Churn, CAC (Customer Acquisition Cost) and LTV (Customer Lifetime Value), and MRR (Monthly Recurring Revenue) vs. ARR (Annual Recurring Revenue) are important metrics in SaaS valuations for investors.

• Churn refers to the rate at which customers cancel their subscriptions or stop using a SaaS product. High churn can negatively impact a company’s revenue and growth potential. Investors closely monitor churn rates to assess the stability and long-term viability of a SaaS business.
• CAC represents the cost incurred to acquire a new customer, including marketing, sales, and onboarding expenses. LTV, on the other hand, estimates the total revenue a customer is expected to generate during their lifetime with the company. A healthy SaaS business typically has a higher LTV than CAC, indicating that the customer lifetime value outweighs the cost of acquisition. Investors evaluate these metrics to gauge the efficiency and sustainability of a SaaS company’s customer acquisition strategies.
• MRR refers to the recurring revenue generated by a SaaS company on a monthly basis, while ARR represents the annualized version of that recurring revenue. MRR is a valuable metric for assessing the company’s current revenue stream and growth trajectory. ARR, on the other hand, provides a more comprehensive picture of the company’s revenue over a full year. Investors analyze MRR and ARR to evaluate a SaaS company’s financial performance, growth rate, and revenue stability.

In SaaS valuations, investors consider these metrics in combination with other factors such as market size, competition, product differentiation, and overall market trends. The goal is to assess the company’s revenue potential, profitability, and scalability, which ultimately influence the valuation and investment decisions.

The SaaS valuation formula

Is it a surprise that there is no tried and true SaaS valuation formula based on metrics? Nothing in the world of finance is ever that straightforward, however the desired outcome is the same: a high multiple. What is a SaaS valuation multiple? 

A SaaS valuation multiple, also known as a revenue multiple or revenue valuation multiple, is a ratio used in the valuation process of Software as a Service (SaaS) companies. It is calculated by dividing the enterprise value (EV) of a SaaS company by its annual recurring revenue (ARR). The SaaS valuation multiple provides a way to assess the value of a SaaS company based on its revenue generation capabilities. 

The multiple takes into account factors such as growth rate, profitability, customer retention, and market dynamics. A higher SaaS multiple indicates a higher valuation, implying that the company is expected to generate significant revenue and growth in the future. Naturally, there are a few different ways to arrive at the revenue total used to complete this equation. 

• SDE (Seller’s Discretionary Earnings) is a financial metric commonly used in business valuation and investment analysis. It represents the total earnings generated by a business, including the owner’s salary, benefits, and other discretionary expenses. SDE provides a holistic view of a company’s financial performance, taking into account the income available to the owner-operator. Investors often consider SDE as a measure of the cash flow potential and profitability of a business.
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial indicator that shows a company’s operating profitability before accounting for non-operational expenses and financial factors. It provides a clearer picture of a company’s operational performance by excluding expenses such as interest payments, taxes, depreciation, and amortization. EBITDA allows investors to assess a company’s core profitability and compare it to other businesses in the same industry.
• Revenue refers to the total amount of money generated by a company from its primary business activities, such as sales of products or services. It represents the top line of a company’s income statement and is a fundamental indicator of a company’s financial performance. Revenue growth is often an important consideration for investors, as it indicates the company’s ability to attract customers, expand its market share, and increase its overall profitability. Strong and consistent revenue growth is typically seen as a positive signal by investors, suggesting that the company is in a healthy financial position.

Investors and acquirers use the SaaS valuation multiple as a benchmark to evaluate the company’s financial worth and compare it to industry standards and similar companies in the market. 

In 2021, the median late-stage valuation for SaaS deals reviewed by IVP was a staggering 114.3x ARR, according to a presentation the firm shared with PitchBook. That multiple expanded more than seven times from the 15.5x ARR fetched by SaaS companies in 2017 and has since returned to 2017 numbers. However, it’s important to note that the SaaS valuation multiple is just one of several value indicators used in the SaaS industry. 

The Rule of 40

In the growth equity space, investors conceived of a guiding rule in determining a metric used to evaluate the financial performance of software companies. The Rule of 40 is achieved if growth rate percentage plus profitability margin equals 40% or greater.

The formula states that the sum of a company’s growth rate (in percentage) and its profitability (measured as EBITDA margin) should be at least 40%. For example, if a company has a growth rate of 30% and an EBITDA margin of 20%, their Rule of 40 score would be 50% (30% + 20% = 50%). A higher Rule of 40 score indicates a healthier balance between growth and profitability.

Investors generally look for companies that achieve or exceed a Rule of 40 score of 40% or higher, because the company is demonstrating both strong growth and a reasonable level of profitability. The sweet spot for investors lies in finding companies that can achieve significant growth while still maintaining a level of profitability that ensures sustainability and potential returns on investment.

Conclusion

SaaS valuation is important in growth equity because it helps investors assess the financial worth and potential of a SaaS company. It provides a basis for determining the value of the company’s business and understanding its growth prospects. By valuing a SaaS company, investors can make informed decisions regarding equity investments, funding rounds, and potential exits.

Additionally, SaaS valuations enable investors to compare different investment opportunities, benchmark the company against industry standards, and negotiate favorable terms. In fact, this is a standard practice at Volition Capital. Valuations provide a framework for evaluating the risk-return profile of the investment, identifying potential value drivers, and estimating potential returns on investment.

In the growth equity space, where investors seek companies with high growth potential, SaaS valuations play a crucial role. They provide insights into the company’s revenue-generating capabilities, market positioning, and scalability, helping investors make strategic investment decisions to maximize returns and support the company’s growth trajectory.