SaaS Companies Valuation: How to Value and Sell a SaaS Business?
SaaS Business – the State of the SaaS Market
The global SaaS market has been bullish for some time now. Even though the CoViD-19 pandemic has resulted in a dip in the markets, it has been completely opposite in the case of SaaS. The pandemic has reinforced the importance of SaaS for businesses, the results of which can be seen in the past two years. From the year 2021 to 2022, the global SaaS has grown by around 19%. The latest value of the SaaS market, by the end of 2022, was $257 Billion and is expected to grow to $1298 Billion by the end of 2030. The average CAGR is 19.7% for the years 2022 – 2030.
In the United States, especially, the investment in SaaS startups climbed to $90 Billion in 2021. This is equal to the investments of the past three years combined, and a 150% growth in investments year-on-year. Various factors such as the huge migration to the cloud, enhanced cybersecurity investments, remote work, etc. drive the growth in investment for SaaS.
According to the report by BetterCloud, every organization will become powered by SaaS at some point, even though most companies are still in the early stages of adoption. This accompanied by the pressure to innovate, has also improved M&A activity in the last two years which was low in 2020 due to the Pandemic. Larger corporations are wanting to acquire early-stage SaaS startups that bring innovation to the table and have a competitive edge over their competitors.
At Sett & Lucas, we believe that the interest in SaaS businesses is going to consistently increase as new innovation, availability of funds, and interest in the latest technologies rise. We’re projecting a demand for high-quality SaaS businesses and we believe the demand will stay high through the decade.
When is the Right Time to Sell Your SaaS Company?
You have successfully built and grown a SaaS company. You have spent a lot of time and money to build a product that the market seems to like with moderate growth. So, what is the right next step? The right step is the one that feels right to you and it can be driven by anything from personal changes to business considerations. One such step/decision is to sell your SaaS business. The greatest dilemma that every SaaS founder faces is the dilemma of when and why to sell their SaaS business. Following are some factors to consider to decide if it is the right time to sell your company.
Growth Opportunities
This is one of the most important and common factors to consider when selling your SaaS business. Your business might be successful and early growth trends might have been sharp. But, there is a tipping point for growth and after some time it might slack.
Scaling your business to reach more markets or create more products require capital. The capital is for new hires, for marketing, and for improving the product. Most of the SaaS startups might just not have the revenue to do that. This might be due to your SaaS business model, which is usually low-cost, high-volume subscription/ sales. Some companies may thrive on fewer enterprise-level sales. Both models have their own defects, the biggest of which is revenue shortage to feed growth.
Large corporations have the funds and resources to scale your business. At this point, the most sensible option is to sell your SaaS business or to invite external funds for a share in the company. This can provide the means for your business to grow and reduces risk.
Market Consolidation
Say A and B are your competitors in the market. They offer similar products and have been consistently growing alongside. If one or both of your competitors attract a sale offer from large corporations and gets acquired, the chances are you might get an offer soon. Market consolidation is when companies from the same industry acquire each other to make bigger corporations to facilitate growth and innovation.
When you see trends of market consolidation, it might be the right time to prepare for a sale. There are two reasons to do that. Better funds from acquirers and investors mean growth. Another is that, if your competitors are already funded then it is high time you catch up or you might be left behind.
Changing Market Condition
Market conditions can change almost instantly. With that, the entire ecosystem of SaaS startups can change for good. Change in market conditions can happen due to anything ranging from a new regulation or a new innovation or worse a global pandemic. The rapid changes or rapid acceleration of the market, also known as the hot market, can create better funding/ sale opportunities for your business. And it is best if you utilize the same to scale and grow.
One such example is the CoViD-19 pandemic which accelerated the demand for cloud-based solutions for remote work and e-learning. Zoom skyrocketed its revenue by 300% during this pandemic and it is simply to change market conditions.
You’ve Reached Sale Value
Sale value is the average value that a business should reach in Annual Recurring Revenue (ARR) in order to attract investors and acquirers. For a software company, an ARR of $5 Million to $10 Million in revenue, brings many offers to the table.
Selling your business at the sale point gives you the opportunity to liquidate and scale your market and product. It also means that you have a product that has a good customer base and a target market. This gives you an advantage over your competitors and also gives a perspective for your business for the next few years.
Your Product is Not Whole Offering
Having a good product and customer base doesn’t necessarily translate to having a whole business model. Your SaaS product can be very niche and can solve a particular business problem in a particular industry. This might mean that your product is a good offering as a feature addition to an existing product set/ solutions rather than a product on its own.
In this case, the chances of your product being acquired by the existing product companies are more. Also, your product will be more valuable when provided as a whole business suite rather than a single offering. Hence, the best decision might be to sell your SaaS business in this case.
You’re Interested in Technical Aspect
As a SaaS founder, you might be into product development and the technical aspects of your business rather than the business aspect of your business. However, someone has to do the heavy lifting of running day-to-day operations and scaling the business.
If this is the case with you, you can hire more people. For a temporary cash flow, you can sell some percentage of your company or get a loan. However, this might not be sustainable for everyone. There is the option of selling the business to someone who can run the show while you focus on improving the product and making it world-class.
Factors Involved in SaaS Company Valuation
Business Age, Trends, & Market Trends
The business age, business trends, and market trends determine the value of SaaS companies and also the number of potential buyers interested in their business. A business that has relatively less history (less than 2 years) would have a small number of potential buyers. This is because the business performance in the future and its scalability cannot be determined with such short history. The higher the age of business, the more the business trends that can be seen. For example, a business with a trend for increasing revenue every year would appeal more to buyers/investors.
Similarly, market trends play an important role in the value of your business. If the SaaS industry as a whole is performing exceptionally well (which it is), the number of buyers and value of your business would be higher too.
Churn Rate
Churn rate is an important metric to consider while valuing your SaaS business. It represents the percentage of users who have unsubscribed or stopped using your services monthly or yearly. Acquiring customers is expensive and if your churn rate is high, then it means that you’re losing money if you’re just losing customers while spending to add new.
A lower churn usually means that your product is reliable and your customers are loyal to your brand. A churn rate of 5 to 7% is ideal and anything more than 10% is bad.
Below is the formula to calculate your churn rate,
Churn Rate = (Total No. of unsubscribed customers/ Customers at the start of the month) * 100.
For example, if you have 1000 customers at the start of the month and 50 have unsubscribed by the end of the month, then your churn rate is,
Churn rate = (50/1000) * 100 = 5%
Monthly Recurring Revenue(MRR) & Annual Recurring Revenue(ARR)
MRR and ARR determine the monthly and yearly revenue of a company for valuation. However, they cannot be both good metrics to measure a company’s performance. In short, MRR is the revenue that a company generates every month and it can be a good indicator of performance for SaaS companies that sell products/services on a monthly subscription basis. And ARR is the revenue of a company yearly and it can assess the performance of B2B SaaS companies that offer subscription services for a period of time such as quarterly, yearly, or multi-year contracts, etc.
Generally, buyers/investors are more interested in MRR than ARR since it replenishes company’s cash flow every month.
The formula for calculating Monthly Recurring Revenue is below,
MRR = (Price of Unit 1 x No. of Subscribers) + (Price of Unit 2 x No. of Subscribers) +…
Let’s say you have 5 customers who pay $10, and 10 customers who pay $15 every month. Then your Monthly Recurring Revenue is,
MRR = (5 x 10) + (10 x 15) = 50 + 150 = $200
The formula for calculating Annual Recurring Revenue for a bigger licensing period is below,
ARR = ((Price of Unit 1/ Contract Period) x No. of Subscribers) + ((Price of Unit 2/ Contract Period) x No. of Subscribers) +…
For example, if you have 10 subscribers with $10000 contracts for 5 years and 20 subscribers with $20000 contracts for 2 years, then the following is your ARR,
ARR = ((10000/5) x 10) + ((20000/2) x 20) = 20000 + 200000 = 220000
Customer Acquisition Cost (CAC)
Customer Acquisition Cost (CAC) is the average cost that a company must spend on sales and marketing in order to acquire a customer in a given period of time. It is preferred to have a lower CAC, especially when your churn rate is higher. CAC correlates to Customer Life-time value to determine the profitability of a business.
CAC = (Total Sales and Marketing Cost/No. of Customers Acquired)
To give an example, if your total spend on sales and marketing is $50000 and you have acquired 250 customers at the end of the year, your CAC is,
CAC = $50000/250 = $200
Customer Lifetime Value (Customer LTV)
Customer Lifetime value is an important metric that provides the value of how much your customers would pay in their lifetime. The higher the customer LTV, the higher is your customer loyalty to your brand.
Customer LTV = Average monthly revenue per customer/Monthly Churn
CLTV: CAC Ratio
The ratio between Customer Lifetime Value and Customer Acquisition Cost, essentially provides the profit you make out of each customer. It is important that the LTV of a customer is always higher than the acquisition cost. In fact, the right ratio of CLTV:CAC is 3:1. Anything less than that is not desirable.
For example, if your CAC is $100 and your CLTV is $500, then your ratio would be 5:1 which is good.
Net Revenue Retention (NRR)
Net Revenue Retention is by definition the opposite metric to the churn rate. It is also known as the Net MRR Renewal rate, Net Negative Churn rate, or Net Dollar Retention Rate. It calculates the ratio of total expanded revenue over a period of time minus the churn with the MRR at the start of that period. The period can be typically a month or a year.
A Net Revenue Rate of more than 100% is always good and means that your business is expanding. This is a good indicator of growth and increases interest in potential buyers. The formula for calculating NRR is below.
NRR = (Monthly Recurring Revenue + Expansions + Upsells – Churn – Downgrades) / MRR at the start of the month
YoY Growth Rate
Year over Year Growth rate provides the percentage of growth in revenue in the current year when compared in the last year. This can be a great indicator of company growth, the increase in subscriptions, and capital efficiency.
YoY Growth Rate = ((Current Year Revenue – Past Year Revenue) / Past Year Revenue) x 100
TAM, SAM, & SOM
TAM is the Total Addressable Market which measures the size of the market a SaaS business can target. The market size can be anything from countrywide to worldwide. However, this is the total market, and expanding to the entire market can only be a long-term goal.
SAM is Serviceable Addressable Market. It determines the size or percentage of the total market that you can address due to various factors including location, marketing, etc. Essentially, it gives the size of the market you can try to compete in given your current business size and circumstances.
SOM is Serviceable Obtainable Market which is a metric that can be used to determine the size of the SAM that you can capture. This metric is used to determine the realistic goal that you can try to achieve within the determined market given your capabilities and competition.
Customer Acquisition Channels
The customer acquisition channels that your business uses to attract customers, be it digital marketing, SEO, ABM, etc. are important for the valuation of your business. The more channels you have, the more robust they are, and the more your business value.
A potential buyer would be interested in buying a business that has a clear acquisition strategy. They can expand into new strategies while refining and scaling the current ones.
Net Present Value (NPV)
Net Present Value provides the amount that a business is going to make throughout a given period of time. It is calculated to today’s money value and the investment is subtracted from it. A positive net present value indicates that the business is going to grow and generate revenue.
If your business is expected to generate $20 Million Dollars in the next ten years and if the investor is investing $2 Million dollars today. Then it means that the business is going to make $18 Million more than the investment which is a good indicator for business growth and value.
Three Ways of SaaS Valuations
There are various factors involved with SaaS valuation and it can vary for each business. However, the best way that most of the SaaS company valuation happens is through Revenue Multiples.
Revenue Multiples:
Using Revenue and revenue multiples for valuation is one of the most common and best ways to value a SaaS business. EBITDA and SDE value a business based on its profitability i.e. their earning potential. However, a SaaS business usually has to invest upfront in marketing, hiring, and other such practices to boost business growth. This would be added up to the expenses, resulting in less EBITDA. Also, as a result of all upfront investments, the business is expected to grow with more customers coming in and recurring revenue.
Revenue Multiple = Valuation / Revenue
The valuation and revenue data of publicly traded companies are readily available. These can be used to arrive at a common multiple. The multiple can then be used to determine the value of your business in the future.
However, using a common multiple for the entire SaaS industry cannot provide the right valuation. Hence, if you need to find the right multiple you can choose a similar type of SaaS business and calculate your multiple based on that. This would be more accurate than a common multiple since you’re getting more specific while calculating the multiple.
Finding the Revenue Multiple:
Finding the revenue multiple is one of the most crucial pieces of the puzzle. However, there are a lot of factors involved that can affect and determine the revenue multiple. Some of these factors are financial, operational, customer acquisition, etc. Following are some things that you have to consider while calculating the multiple,
1. Gross Margins – Gross Margin is the difference between net revenue and the overall costs divided by the net revenue. It is a metric that provides the percentage of revenue that is remaining after deducting the costs involved with running the business and offering the product/service.
Gross Margin = ((Net Revenue – Costs)/ Net Revenue) x 100
If the Gross Margin value is high, it means that the company has more room for scaling its business and high profitability. This in turn increases the revenue multiple and thereby the chances of investment. However, a low Gross Margin means that the business is struggling with operating costs and thereby the chances of an investment becomes less.
2. ARR Growth Rate – As stated before, ARR is Annual Recurring Revenue and the ARR growth rate is an important indicator of SaaS company growth and thereby an important factor in determining the revenue multiple.
ARR Growth Rate = ((ARR during the previous year – ARR during the current year)/ ARR during the previous year) x 100
ARR Growth rate indirectly represents the growth in revenue. This gives an understanding of a SaaS company’s capacity to retain existing customers and add new customers. This affects the multiple directly and thereby the chances of attracting an investment.
3. Rule of 40 – Rule of 40 is used as a metric to determine the company’s financial health and growth potential. However, it is important to know that the Rule of 40 is not a definitive rule or guarantees success.
Rule of 40 = Annual Revenue Growth Rate + EBITDA Margin
Annual Revenue Growth rate is the growth in revenue year-over-year. EBITDA Margin is the ratio of Earnings Before Interest, Taxes, Depreciation, and Amortization to total revenue.
If the sum of both is more than 40%, then it means that the company is doing a good job at managing its financials and has better profitability. If it is less than 40%, then it means that the company needs to better manage its finances and improve its profits.
4. Retention Metrics – Retention metrics are all the metrics involved with the customer loyalty, satisfaction, and the long-term revenue potential of a SaaS company. The following are the retention metrics involved with finding the revenue multiple,
- Customer Churn Rate
- Revenue Churn Rate
- Net Revenue Retention (NRR)
- Customer Lifetime Value (CLTV)
- Customer Acquisition Cost (CAC)
- Payback Period
5. Recurring Vs. Non-Recurring Revenue Mix – This represents the percentage of revenue that comes from recurring revenue (SaaS product) and from non-recurring revenue (Services such as implementation, integration, etc.). It is important for a SaaS company to higher percentage of revenue coming from recurring means. A company with more recurring revenue has higher growth and revenue potential in the long term.
6. Top Customer Concentration – It is important that SaaS companies have revenue coming from a diverse customer base. Top customer concentration is the factor that analyzes the customer base to see if the revenue is coming from a concentrated group of customers. This factor can affect the profitability and growth rate of the company in the long term. Companies with a concentrated customer base carry higher risk and are a concern to investors.
7. Dollar Value of Bookings and TCV – Dollar Value of Bookings gives the total contract value of new customers signed over a period of time. Total Contract Value (TCV) provides the full value of the contract including both existing and new customers over their full contract period.
Both these factors give the value of customer contracts and thereby the weightage of contracted customers to the total revenue. A higher value means more growth potential and is a positive sign for investors.
Simple Formulae for SaaS Company Valuation
Let’s get one thing on the table. There are no simple formulae for calculating the value of a SaaS company. Finding the value of a SaaS company depends on a lot of factors and it usually varies from business to business. However, the following formulae by David Cummings can help you better value your SaaS business or at the least give you an idea of what’s your worth.
David Cummings is an authority when it comes to SaaS valuation. He considers the following factors very crucial for the valuation of all types of SaaS business despite the myriad of factors involved. The factors are,
- Annual Recurring Revenue (ARR)
- Gross Margin
- Growth Rate
- Net Revenue Retention
The formula is as follows,
Company Value = 10 x ARR x Growth Rate x Net Revenue Retention
Based on the growth rate and net revenue retention, a SaaS company may be worth 15x based on a high rate and it can be 2x if there is high churn and less growth rate.
Conclusion:
It is important to have the SaaS valuation accurate for potential buyers, business owners, and managers. Without the accurate value, you will be blindfolded while making buying or selling decisions. No one likes a bad investment. So, if you are looking to buy or sell your SaaS business hire an expert M&A advisor who can help you with the same.
Sett & Lucas is an M&A advisory that specializes in the field of IT Services, Enterprise Software, Digital Marketing M&A, and Private Equity. If you are looking for trusted professionals to help with your selling and valuing your business, you are at the right place. Reach out to us today and let’s talk shop.