How SaaS Company valuations work: Multiples, MRR & Metrics ExplainedBy Jamie Toyne
Cloud-based software is a huge draw for many companies. The ability to store all a company’s data in one reliable place is a must in all types of ventures, from small businesses to giant corporations.
Also known as Software-as-a-Service, or SaaS, this business technology is used to help companies manage their data, servers, and specific coding that is required to run their applications. SaaS software is also fully customizable to suit any company’s direct needs, giving it a clear advantage over on-premise software systems.
How SaaS Valuations Work: Multiples, MRR, and metrics explained
Emerging technology companies revel in new SaaS availability, and with the upswing continuing, that attraction is not likely to burn out anytime soon. This leads to the constant creation of new SaaS companies looking to expand their bottom line with new clients and a growing valuation.
You may be one of those businesses that have perfected your software and begun looking at ways to capitalize on your technological creation. If you are, it could be difficult to determine how much your company is really worth in a world full of harsh competition.
There are many key factors that go into a SaaS company valuation, depending on the size of your business, the projected growth rate, how well the software does compared to others available, and profitability.
The size of the business is largely dependent on recurring payments for any given service. These payments are calculated on an annual scale and can help lead to the determination of the growth of the business and the level of revenue it makes every calendar year. This will be talked about in further detail in the metrics section below.
The growth rate of your SaaS business is the number one element that investors will look to when deciding whether or not to offer you money for your software. Generally speaking, the growth rate of successful companies such as Slack will be doubled in year one and two of being live. It should be glaringly obvious that the growth rate is on an upswing and the company will continue to profit.
After the level of growth of your SaaS company has been factually determined, investors will want to look at profitability. Sound investments require an overall level of both growth and profitability, and SaaS businesses need to show that they aren’t high-risk, low-reward.
This level of profitability is often referred to as gross margin and is calculated based on how much money will be left at the end of repayment of the initial dividends. If it requires too much money upfront without an extensive growth rate, the valuation will suffer.
In a world full of entrepreneurs looking to create the next big thing in SaaS, quality stands to be an important aspect in the valuation of your business. Cloud-based software typically works in the same way, but the quality of data storage and access will differ from company to company.
For a higher valuation, your SaaS company should stand out from the crowd. This quality is often measured as the Net Revenue Retention. This means that your SaaS business should continue to profit even without new customers via systems upgrades from already existing customers.
The tried and true formula
Taking into account the four aforementioned factors in calculating valuation, you can then use a formula to determine the best valuation for your company. That formula is: Valuation= 10 x ARR x GR x NRR.
Although this formula is a great place to start when valuing your SaaS business, there are many other things that investors will want to look at prior to putting their money in your company.
Early-stage company factors
In SaaS companies that are not yet fully off the ground, other factors should be taken into account. There are various ways to show revenue and growth in a company that hasn’t had much data to work with and ensure a steady profit margin, but companies that are just starting out have to consider more than just the numbers.
The intellectual property owned by the SaaS business could be great, but if it’s not better than competitors out there, it could put a wrench in the overall valuation. The payback period will also play a heavy role in the valuation because it’s hard to determine how much profits will grow prior to returning on the initial investment. The lifetime value will also need to be taken into account.
Do standardized valuation processes work for everyone?
It can be easy to use a standard calculation to come to the conclusion of how much your business is worth, but it may not be useful for all SaaS companies. There are certain mistakes that a SaaS company can make that can cause their valuation to be incorrect. For example, comparing your SaaS business to another similar one that has just sold in the market is not a good idea.
You are too far removed from the sale of that particular business, and as such, are not aware of the underground negotiations used to sell or the motivations for both the buyer and the seller. The buyer could be looking at a company to revamp and then flip for a profit themselves. Using other business sales in the same market can be helpful, but it is not the most accurate way to evaluate your SaaS business.
Comparing your business to what’s on the market is also a slippery slope when it comes to arriving at a full and true valuation. This type of comparison should only be used as a template or a guide towards your final calculations because public and private SaaS companies differ in values across the board. Publicly traded SaaS companies cater to everyone that wants a piece of the pie.
For example, Dropbox went public when they integrated with SalesForce.com and valuation was at $8.7 billion in July 2020. The private SaaS venture, AlgoliaNew is only worth $40 million. These two examples are just part of a wider picture, but still, show just how different the spectrum can be for private and public SaaS valuations.
Online business models and SaaS evaluation
Firms that offer valuation services for companies will not generally take into account the key differences between SaaS businesses and other online companies. Even with the range of qualities that differ between SaaS and other types of online businesses’ such as a content-run service business or an online retailer, they are still generally looked at the same way.
This can lead to problematic valuations and inaccurate numbers when it comes to the overall big picture of finding the value of your company. Things that buyers will want to look at include multiples, metrics, and revenue streams. Let’s take a look at how and why these metrics are what really matters in terms of the valuation of your SaaS company.
Multiples are the industry standard that helps decode the value of any given business at any time depending on the current market rates and growth potential. The range of the multiples can vary wildly and will be dependent on a few factors.
1. How involved you are in the business. Many buyers want to know that when they make a purchase, it becomes their property. If you are incredibly hands-on when it comes to your SaaS company, many buyers may shy away from making a deal with you.
2. Growth sustainability. The growth of your company matters—a lot. Investors want to see that profits continue to rise, even albeit slowly, in a consistent way. Companies that have even declined in the past but continue to grow despite that decline will be more favorable than those who don’t.
Stable growth points to a solid investment. There is one caveat when it comes to growth: sustainability. In a company that makes a lot of money in a short amount of time, that giant uptick of growth may be problematic for investors because it shows a growth that may not continue at the same rate over time.
3. Age. Track records are huge draws for buyers in the SaaS market. Since SaaS is a fast-growing industry, age may not factor in as much as it would in other companies but being able to prove that your company is profitable, stable, and retains the same amount of quality will give you a better chance at a higher valuation.
There are several metrics that need to be taken into account to drive valuation. They are:
1. Churn. The churn rate is the length of time that a customer will use your SaaS software before canceling. This metric is calculated on an annual scale and uses a calculation based on customers still using the software versus those that discontinued use. Churn leads to a further level of understanding of the length of runway your business has before the complete halt of acquisition.
2. Different SaaS’s will have different churn rates. This is due to the varying style of SaaS options. Self-serve options that appeal to small businesses will have higher churn rates, whereas large corporations will likely have a lower one.
The target of your SaaS business will be a deciding factor in determining your churn rate. Generally speaking, any churn rate higher than 60% in the case of self-serve SaaS spells out problems. For enterprise-level companies, the churn rate should be no higher than 30%, although 10% is ideal. Read our guide to learn how to decrease the churn rate effectively.
3. Customer Acquisition Cost and Lifetime Value. The Customer Acquisition Cost (CAC) and Lifetime Value (LTV) of your SaaS company determine how much money will need to be spent to bring on a new customer (CAC) and how much profit you’ll accumulate from said customer.
For optimal growth, the CAC should be low, whereas the LTV should be high. Having a good high-to-low ratio for both the CAC and LTV will help manage the churn rate. Using these two metrics, getting a proper number to add to your valuation calculation can be done by dividing your LTV by your CAC. The sweet spot for this ratio is 3.
4. Monthly Recurring Revenue(MRR) versus Annual Recurring Revenue (ARR). The MRR and ARR will help you keep track of the revenue your company is bringing in over the course of a month and a year, respectively. These two revenue data streams will be determining factors for potential investors when they look to see how profitable your company is. It’s more likely that MRR is more valuable in shaping how much your company is worth because ARR can be unstable and unreliable in comparison.
Remaining factors to consider
Using the aforementioned factors in considering the valuation of your SaaS company is all well and good, but they shouldn’t be the only points taken into consideration when arriving at a full and true evaluation. Other factors come into play that will play a big role in how much your company is actually worth in the current market.
1. Competition. There is a heavy amount of competition in the world when it comes to new and developing technology solutions. In the world of SaaS, many people know just how popular these cloud-based programs can be and everyone wants to be a part of the profits. There will always be a level of competition that you will have to win out over when it comes to selling your SaaS business.
Investors will likely do their due diligence to ensure that they are putting their money in the right places and when they have the pick of the litter, you need to stand out among the crowd.
Finding yourself a hook to draw in investors and show them that you have something different from the other SaaS businesses available will give you a better chance at gaining a solid deal. For example, companies that offer a fierce SEO strategy or a trademark on their software will fare far better when it comes to entering the market and gaining new investors.
2. The roadmap. Businesses should know where they are going, especially when it comes to trying to find investors. This will document everything that goes on within the company and what parts are being developed, improved upon, maintained, or upcoming.
Many new business owners will want a self-sufficient company in the sense that any changes they need to make will be minimal. If you do have new updates in the works and want to sell your business, it’s best that you either wait on it or provide the investor or new business owner with a sure-fire plan on how to roll out the upgrades so that they have a solid idea on how to execute the new offerings.
3. Sharing knowledge. If you are the sole technical mind behind how everything functions within your SaaS operation, it’s important that you transfer everything you know to a team. Bringing a team of well-trained people to handle the tech aspects of your SaaS will give you a better chance at selling because it will give your investor or buyer the ability to run the company without you at the helm.
4. Acquisition channels. To determine how much your company is worth, you must first figure out how it is going to grow over time. This will come down to the active acquisition channels required to drive growth in the market. Your direct line of marketing will need to be figured out beforehand.
The channels that help grow SaaS companies today include social media advertising, SEO or search engine optimization, brand collaboration to drive SEO strategy and other marketing strategies using content-driven methods, and outbound sales.
Getting involved in high-quality marketing efforts is much more important than participating in many marketing channels. If you don’t have the marketing down, it won’t matter how many channels you appear on.
The valuation of your company will rely on all these above-mentioned influences when it comes to selling or finding investors for your SaaS. When you know exactly how to use these factors to your advantage, you will be able to arrive at a valuation that is true, accurate, and most importantly reflects what will happen if you take an investment or sell your company.
The growth of new SaaS software systems is not likely to cool down in the coming years and the competition between companies will only continue to rise. There is no one metric or factor that matters more than the others. All of the aforementioned factors will play their own pivotal role in the valuation of your SaaS.
Whether you’ve been working at your software for years and have a solid customer base or are just starting out, these are all very helpful ways to come to an accurate conclusion for how much your worth, how much you can sell for, and how successful your company will be in the long run. Having success is, after all, the entire point of creating ground-breaking cloud-based software.
If you’re interested in selling or buying a SaaS business, get in touch with us at Dealflow Brokerage. We’ve bought and sold many profitable SaaS businesses, and would love to help you too.