Valuation of SaaS business model – overview
In this blog, we shall discuss on important metrics in valuation of a SaaS business.A SaaS business model is very unique and distinct from valuing a conventional IT services firm.
A SaaS business has constant recurring revenues, predictable cash flow, high upfront investment and low cost structure.The business model works on the principle of a non linear revenue model where the revenue growth of the firm is not co-related with the employee headcount.
Valuation of SaaS business
How to value a SaaS business can be very confusing and are source of arguments among buyers, sellers and investors.A SaaS business is generally valued as a multiple of
- Sales Discretionary Earnings
In case of unicorn companies, valuations are at roof top level compared to modest SaaS companies.This is essentially because of the growth rate of unicorn firms which was able to achieve size and growth within a limited time.
Valuation of SaaS business – SDE vs EBITDA vs Revenues
SDE – Seller Discretionary Earnings is primarily used for valuing smaller companies that are privately owned and have a sedate/stable growth.These companies have stable cashflows and generally do not reinvest the earnings back to business for additional growth.
SDE = Revenues – COGS – Operating expenses + Owner compensation
To understand the true earnings of these business, it is necessary to add the owner compensation back to the earnings.This is because the owner compensation is generally not linked to the market rate and is left purely to the discretion of the owner.The owner also adds some of the personal expenses to realize tax savings on the earnings.
Valuation of SaaS business – When to use EBITDA Multiple
As companies grows bigger with more employees and management staff, EBITDA multiple is preferred.As company ramps up, shareholding pattern is fragmented with more investors participating to fund the company.These investors do not have an active role in running the company and would instead hire management personnel to oversee the company operations.These personnel are compensated at market rate and their salaries are linked to the future growth of the company.
Valuation of SaaS business – When to use Revenue Multiples?
In firms with negative cashflows, EBITDA multiples cannot be used.Many firms require upfront investments to build a SaaS technological solution and hence would not break even initially.All the R&D cost are treated as an expense by the GAAP standards.When the customers are happy with the product and are willing to spend more, the SaaS business model scales up and generates incremental revenues at a marginal cost.
Hence using revenues multiples to value a SaaS business makes sense.This is valid only when the revenues are growing at a high rate.If the revenues growth is less, then this model will not work as the valuation is predicated on how soon the company can grow in order to break-even and generate cash-flows for the business.
The multiple chosen for valuing a SaaS business would depend on the answer to the following three questions:
- Is the business reliant on owner?
- What is the growth rate of the business?
- What is the revenues of the business?
If the business is reliant on owner and have a stable low growth rate, then SDE multiple is used, else EBITDA/revenue multiples will be used.
Valuation of SaaS business – Finding the right multiple
After deciding what is the right multiple to be used, the next step is to quantify the multiple which is dependent on the Financial, Operational and Traffic aspects of the SaaS business.
The basic driver for the valuation for an investor is if the SaaS business model is Sustainable, Scalable and Transferable.Any factors that influence these core drivers would affect the valuation.
Valuation of SaaS business – Assessing the worth of the Business
To determine whether the SaaS business requires a premium valuation or to be valued at discount, the following factors needs to be analysed:
Age of the Business
- If the firm has a historical track record of more than 3 years, then one can predict the future growth of the business and whether if the business model is acceptable.
- If the business model is a success, then it is easier to predict cashflows.For business with less than 2 years of presence, the investors needs to take a calculated risk to fund capital as they are not still sure about the viability of the business model.
Owner involvement and his dependency on the firm growth
- If the SaaS firm has a management in place with organized processes and systems, then the reliance on the owner is low.In that case, the investor does not require the owner to continue post acquisition and can replace him.
- If the owner is responsible for the firm success or drives majority of the customer relationships or has built the underlying IP of the business, then the replacement cost is very high.There is also a higher risk of the firm growth to decline after the exit of the owner.
Growth Trends of the business
- The business should show a high growth rate and reflect the customers increased adoption on the firm’s product
- A business that is stagnating or not growing fast would have low demand from investors, where as business that is showing extremely high growth will not be available for sale.
- Hence the right business would be the one where the growth rate of the business shows an upward trajectory year on year.
- A biggest factor for assessing the business is the Customer churn.High customer life time value reflects the quality of the business and lack of competitors for the business
- High customer churn would result in higher customer acquisition costs and low probability of recurring revenues.This will impact the earnings power.
Valuation of SaaS business – Which SaaS metrics matters the most?
Some SaaS metrics are more important than others.While each SaaS business model is unique and metrics to value the business would depend on the uniqueness of the business model, investors give high importance to these following metrics:
- Churn significantly affects the future cash flows of the business.In the longer term, a business having a lower churn will surpass the companies with a higher churn rate by longer margin.
- Companies with high churn rates indicate that the solution does not align to the customer needs.The business needs to invest more on the product to build a compelling offering and invariably this investment needs to come from the investors.
- Unless the firm with higher churn rate compensates by adding new customers at a rate faster than churn rate at lower acquisition cost, companies with high churn rate will not find demand from investors.
How much Churn?
- The churn rate is dependent on the customer segments the SaaS business serves.If the SaaS business serves the SMB/SME companies, then the churn rates would be higher than those firms that serve enterprise businesses.
- The SMB business have lower budgets to spend, have higher chance to get acquired and low probability to exist.In the same vein, the acquisition costs is very low for a SMB customer segment.Hence a SaaS business that is focused on SMB customer segment should give importance to high customer acquisitions due to the higher churn rates on the average.
- When the SaaS business serves the enterprise customer base, the churn rate is low.This is due to the higher switching costs and the higher budgets that enterprise customers have.This excess cash flow from serving enterprise customers can be reinvested by the SaaS business in serving these customers which would further boost the customer retention rate and reduce the churn.
Customer Acquisition Cost (CAC) and Customer Life Time Value (LTV)
- Customer Acquisition Cost – CAC is the total sales and marketing expenses spent to acquire an additional customer.This metric would depend on the business model, market and competition.In general, lower the CAC, better would be the cashflows.
- Customer Life Time Value – LTV is the total revenues that the SaaS business would get from a customer, when the customer is paying for the business services.A higher LTV would mean that the customer is happy with the firm products and services.
- As CAC and LTV would depend on the SaaS business model and the markets it operate it, a ratio of LTV/CAC is used to compare different SaaS businesses.
- Investors would put a higher valuation on a SaaS business when LTV/CAC > 3
- This means that if there is a dip in LTV due to churn or increase in CAC due to higher sales expenses, the SaaS business would still remain profitable.
MRR v/s ARR
- Startup and Mid size SaaS business offer subscription plans that are monthly and annually.Generally, these firms would include an additional discount for annual plan compared to a monthly plan to ensure higher cash-flow predictability.This excess cash-flows can be used to reinvest in business.This approach would not give a higher valuation.
MRR > ARR > Lifetime
- For a higher valuation monthly revenues are better than Annual revenues which is better than life long subscription.This is because higher MRR would mean that the customer needs are fulfilled and are continuing to spend on the product.If there is a dip in MRR, then the firm can take action in either refining its product or improve customer service.
- In case of ARR and Life time revenues, the firm does not have any insights on the customer satisfaction.If the customer needs are not fulfilled, then the churn will increase which would result in lower cash-flows and additional acquisitions cost
Valuation of SaaS business – Other important metrics
Apart from the above essential metrics, other metrics that also play an important role in valuation is:
Customer Acquisition Channels
- In case of SaaS businesses whose customer segments are in SMB, it is important that customer acquisition rate is higher than the churn rate so that the business looks viable.
- Premium valued SaaS business have multiple channels for customer acquisition.They rely on content marketing to improve their organic search ratings and also employ paid advertising channels to bolster the customers acquisition rate.
- It is important to measure the acquisition costs spent for converting a prospect from organic search through content marketing to paid customer.
- A premium SaaS business initially spends heavily on customer acquisition, but when the product is aligned to the customer needs and enough awareness is raised, then the marketing cost comes down.
- This is because the product speaks for itself.
Product Life Cycle
- The maturity of the SaaS business in product lifecycle plays an important role in valuation of SaaS business.
- The new owner/investor should ensure that the product is updated to latest technology and does not require an upgrade post acquisition.
- In case, the product requires an upgrade post acquisition in order to be aligned with the competitors, then the investors need to spend additional cost on product development.
- The owner involvement in development of the IP of the business impacts the valuation.
- When the owner builds an IP which is proprietary, the investor have to depend on the owner post acquisition.
- Normally, the investor would like to replace the owner with another employee or would want to outsource the SaaS development to another company.In that case, the quality and revenues of the SaaS business should not be affected.The business should be easily transferrable.
- Competition plays an important role in determining the funding for the SaaS business.
- When the SaaS business operates in highly competitive industry, then VC funds are not inclined to invest additional funds.As majority of the funding goes in development costs, many such businesses do not have a complete offerings due to the lack of funds.
- Valuation of a SaaS business is different from a conventional service business and requires deeper understanding of the business models and employing a right valuation multiple to assess the business.
- In 2019, SaaS business have the highest valuation multiples as acquirers are looking at recurring revenues, predictable cashflows and low operating costs.