SaaS stands for Software as a Service. What is a SaaS company? Using the SaaS business model, a SaaS company offers to host an application where their customers can get access to their services.
In this short read, you will learn how to value a SaaS company.
Why SaaS Companies are Effective and Valuable?
One of the main reasons for the popularity of SaaS businesses is multi-distribution, which helps standardize applications for customer service, enterprise content management, relationship management, web conferencing, and email. Other benefits of a SaaS company include the following:
- No custom software installation is needed
- On-demand service
- Professional data management services
- Data processing, storage, and collection in larger quantities
- Accessibility from different locations
SDE vs EBITDA vs Revenue Multiple: What’s the Difference?
There are three types of SaaS valuations based on the actual earnings of the company.
SDE Valuation Multiple:
SDE stands for Seller’s Discretionary Earnings, it is used to determine the historical cash flow of a business. It is used as a recasting process starting with the net profit of a business, from either the business tax return or the yearend income statement.
The business owner’s salary, benefits, non-cash expenses (amortization and depreciation), and non-recurring expenses (litigation or move), are added to their net profit to get the SDE. Small businesses usually benefit from SDE because these businesses typically spend much on personal benefits like entertainment and transportation.
SaaS EBITDA Multiple:
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA has a similar concept to SDE, although calculations are normally used for larger businesses that need more disciplined financial reporting.
The manager’s salary is not added back in EBITDA calculations, whereas the manager’s salary is added back in SDE, assuming that the buyer is going to replace the seller as the owner or operator of the business.
SaaS Revenue Multiple:
Company valuation based on revenue factors in the growth rate. SaaS companies can prove their market fit and lasting power better than other business models because of the MRR (monthly recurring revenue), which is the predictable revenue of a business. Your business’ MRR growth (monthly and yearly) can be used to predict future growth in terms of revenue. This is one of the reasons why many SaaS companies may not make money or lose money even with high valuations.
The rationale comes back to LTV (lifetime value) and CAC (cost of acquisition) combined with churn (rate of customers leaving). The SaaS company might be pulling in huge revenues at the start, while burning through cash, with a low churn rate.
Startups Need to Know How Much Their SaaS Business Is Worth:
It is important for businesses, especially startups, to know how much their business is worth. They should be aware of how to evaluate a business worth. SaaS company valuation can be complex, but an established business would be able to give a good starting point. Company financials and metrics are contributing factors in determining which of the three basic valuation approaches can be used—market, cost, income.
Startups don’t have the luxury of revenue history, making it quite challenging when establishing its value. One strategy is to value the opportunity cost of purchasing against investing the same amount. However, depending on the revenue and SaaS multiples, the value of the company may not be much.
One other approach on how to value a SaaS company is the Monte Carlo simulation, wherein simulations are used on a wide variety of revenue possibilities to determine potential outcomes. The moment simulations start running, a pattern will start to appear and the scenarios and probabilities will be converted to a statistical approach that will be used in a discounted cash flow analysis.
For startup valuations, the safest direction is to use different models, dig further into the specifics of competitors and the market itself, and be cautious in making assumptions because general assumptions for more established companies do not apply to startup businesses.
What to Consider for Your SaaS Business:
There are different variables on how to value SaaS companies:
1) Age of Business:
SaaS businesses that have been in the market longer have proven their sustainability, making it easier to predict profits in the future. A two-year-old business is the preferred entry point, then at three years old and above, businesses begin to receive a premium multiple. Though younger businesses are still sellable to a slightly smaller investor group, there will be higher risk tolerance.
2) Owner Involvement:
Part of the selling point of a SaaS business is the potentially predictable and passive income it can generate. Businesses that already have a team in place are more appealing than those that would need more work from the owner. Another concern is the owner’s technical involvement. If the investor decides to replace an owner performing a highly-skilled role, two things may happen, either it increases the replacement cost or put off non-technical investors, which then reduces overall demand for the business.
3) Growth Trends:
Only a few Investors, if any, would attempt to buy a declining SaaS business, and correspondingly, most owners won’t sell a rapidly growing SaaS business. A business that is modestly trending upward would be a good buy. It is expected that the faster the business grows, the more the multiple will stretch to the premium end.
A customer churn rate may result in a lower multiple, especially if the churn is not offset by a low customer acquisition cost and high lifetime customer value.
What are the Common Mistakes and Misconceptions to Avoid?
Comparing your company to a competitor that just sold:
Never compare because you don’t know their full story. You don’t know if that competitor undersold their business or if they were just good at negotiating. Likewise, you are not aware of the buyer’s motivations. It is possible that selling the company was part of your competitor’s strategic acquisition, which actually sells for the highest premium because a strategic buyer is always willing to pay extra to acquire that asset. It is also possible that the business has issues but the buyer was confident that they can fix the problem and turn the business around.
Comparing your company to the public market:
Keep in mind that most public SaaS companies are worth more than private SaaS companies since people can “buy in” anytime and everyone has the chance to purchase stock as against a select few in the private space.
These companies also have a huge chunk of the market, and they are well-funded with talent and capital. They are on a different level compared to most bootstrapped entrepreneurs. You can refer to the public data to help find your own valuation, but take note that the sale of private companies is usually heavily discounted compared to the big guns on the public market.
Relying on a “one-size-fits-all” valuation service:
Most valuation firms will value SaaS businesses just like other businesses, even if SaaS is different from other online business models. There may be a few overlapping factors, but a SaaS business boasts of an e-commerce store or a content business, that others don’t have.
In the end, with all those distinct features, SaaS businesses receive higher valuation multiples compared to other online business models.
How Covid19 has an Impact on SaaS Valuations:
A lot of SaaS companies experienced a steady growth in revenue because of the work-from-home set-up.
Covid19 has affected all kinds of businesses. There was an increase in SaaS valuations in 2020, which was the time when businesses started to make adjustments to cope with the pandemic due to the forced lockdowns. Companies started to find ways to keep their operations running, and Zoom became the center of it all. A lot of SaaS companies experienced steady growth in revenue because of the work-from-home setup.
Is Your SaaS Business Ready to Sell?
If you are ready to sell your SaaS business, there are four avenues to consider:
- Marketplace – you can list your business in networks like BizQuest or BizBuySell.
- Auction – you can put your business up for auction and sell it to the highest bidder.
- Broker – you can get the services of experienced business brokers to handle the sale.
- Direct – you can handle the sale yourself by using the cold approach.
SaaS businesses continue to enjoy huge growth potential for 2022 even as the pandemic continues to affect the whole world. Make sure to focus on how to increase your business's valuation to maximize its full potential.