Want to raise capital? Need to make an important strategic decision?
You need to determine the valuation of your SaaS company.
SaaS valuation can be complex, as it requires several metrics and variables, like the type of business model, the niche you’re operating in and the value proposition.
With this guide, we’ll shed light on the different types of SaaS valuations. We'll explore their importance and how you can avoid the most common mistakes while making calculations.
Let’s get started!
What We'll Cover:
What is SaaS Valuation?
SaaS valuation is the process of determining your company’s present and future value based primarily on growth. It’s an essential metric when you’re looking to get an investment or sell your business.
Investors will look at growth potential or founder-market fit in the initial stages. When a SaaS company matures and you reach later funding rounds, metrics like free cash flow and net revenue retention come into the picture.
You can use SaaS valuation multiples like Price-to-Sales (P/S) and Price-to-Earnings (P/E) ratios. But, you need to adjust these multiples based on different factors like:
- What is your revenue per customer?
- What is your profit per customer?
- How many customers do you have?
- What is your churn rate?
- What is your LTV (Lifetime Value) / CAC (Customer Acquisition Cost) ratio?
- What does your competitor research say about their funding rounds?
The Significance of Accurate SaaS Valuation
Accurate SaaS valuation is important for business owners, investors, and potential buyers.
Here are five key reasons why you need to prioritize it.
- It helps make informed strategic decisions related to expansion, product development, investment, and overall business strategy.
- It provides a basis for negotiations and ensures that you receive fair compensation if you’re looking for investment or putting your company for sale.
- It is essential for determining the value of employee compensation.
- You can know your company's true value by benchmarking your valuation against industry standards.
- It helps assess the company's financial health and manage risks properly.
What are the Types of SaaS Valuations?
There are three widely accepted ways to value your SaaS company by considering the company’s earnings: Revenue, EBITDA, and SDE.
Depending on your SaaS business’ maturity and profitability, you can choose one over the other.
#1 Revenue-Based Valuation (ARR Multiples)
This is one of the most popular SaaS valuation methods. It allows for direct comparisons with companies having similar ARR (Annual Recurring Revenue) values. In this, you set up revenue multiples based on your ARR figure.
To achieve a good valuation with this method, you need an ARR multiple greater than $2 million and YOY growth rates over 50%.
This method is better than EBITDA-based valuation for companies that have achieved a product-market fit or are in the hyper-growth stage, as your revenue will likely grow, but you won’t be massively profitable.
#2 EBITDA-Based Valuation
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This model is more about profit than revenue. This valuation may result in the highest possible multiplier if your business is highly profitable.
For SaaS investors or buyers, this method shows the company’s ability to deliver a strong cash flow and profit.
Here’s the formula you can follow to calculate your company's EBITDA.
As this valuation model takes a lot of different factors into consideration while deciding the valuation multiple, it is often used by companies with an earning power of more than $5 million ARR.
#3 SDE Valuation
Seller Discretionary Earnings (SDE) denotes the remaining value after all expenses (including payroll, overheads, and subscription to tools or services) have been paid, and the business owner’s salary has been added to the calculation to denote the earning power.
Here’s the formula you can use to calculate SDE.
This metric shows the sales efficiency of the company. The more efficiently a company generates revenue, the higher the SDE figure.
This model makes the most sense for SaaS businesses with a sole owner or annual revenue under $5 million. That’s why many early-stage startups set multiples based on SDE.
Key Factors Affecting SaaS Valuation
You may be tempted to pick one valuation model over another based on the growth stage your SaaS business is in.
But you also need to consider other key factors affecting your SaaS valuation.
Annual Recurring Revenue (ARR)
ARR is one of the most important things a buyer or investor may look at while making a decision about whether they want to invest in your SaaS company or not. It also determines the health of your business.
Here’s how to calculate ARR.
These numbers are also generally compared with other competitors in the niche and your past figures.
If your ARR is low, we recommend working through the following processes;
- Boost your lead generation and conversion efforts
- Optimize the onboarding process
- Generate product interest
- Conduct customer surveys to understand where you’re lacking,
- Upsell to existing clients
- Lower churn
Good growth trends (generally a rise in MRR or ARR) show your business is healthy and moving in the right direction. It indicates that customers like your product, and you’re attracting a lot of people to your SaaS tool.
It shows investors that they can benefit from investing in your company and that you may expand in different geographic areas or audience segments in the future and see the same growth.
The faster your business grows and the better your growth trends, the more your valuation multiple will stretch toward the premium end.
Customer Base and Retention
Your revenue will only stay stable/keep growing if you retain your existing customers. It’s also a good practice as you need to shell out a lot of money to attract new customers as opposed to retaining existing ones.
If you’re losing a lot of customers, it signals to your investors that your product is either not up to the mark or too challenging to use. Either way, it’s not a good sign.
To retain your customers, you should engage them, provide them with valuable content, ask for feedback often, provide excellent customer service, offer incentives, and analyze churn when it occurs.
The churn rate shows the percentage of customers who stopped using your product during a specific time period. A high churn rate means your team will be engaged in acquiring more customers to make up for the lost revenue. It also signals that there’s something wrong with your product, service, or targeting.
Here’s how you can calculate it.
A high churn rate also dissuades investors from investing in your company or accepting a high valuation multiple. Most SaaS companies periodically measure churn rate and try to optimize it by setting measures in place such as contacting churned customers, sending surveys, brainstorming with sales and customer teams, etc.
Profitability and Margins
The more profitable your SaaS business is, the more investors and buyers you’ll attract. The different profitability metrics you can calculate and track are net profit margin, operating profit margin, EBITDA margin, return on capital employed, gross profit ratio, etc.
These metrics and ratios help investors measure and evaluate the company's ability to generate future income and profits.
If you’re seeing low profitability, it might make sense to revisit your pricing strategy, reassess customer targeting, find ways to reduce expenses and overheads, re-strategize marketing, expand to new opportunities, cut your underperforming services or features, etc.
Most Common Mistakes in SaaS Business Valuation
Whether you’re overvalued or undervalued, you may face many repercussions because of that. To ensure you’re on the right track, using the right metrics, and calculating the right multiples, here are five common SaaS company valuation mistakes you must avoid.
Neglecting Customer Retention Rates
Not including your customer retention rates can lead to inaccurate valuations. Here are three key reasons how:
- Neglecting retention rates means undervaluing the potential lifetime value of your customers. Investors often consider CLV while making a decision. If this metric is not accurately assessed, it can result in a lower valuation.
- A good retention rate signals that your business will not face unreliable revenue growths and dips.
- High customer retention rates indicate that a business has a competitive edge in customer satisfaction and loyalty. Neglecting this may result in underestimating the company's competitive positioning within the market, potentially leading to a lower valuation.
When you overestimate growth, you create inflated expectations for future revenue and profitability. Often, this leads to an overvaluation.
Overvaluation can result in the misallocation of resources, with companies failing to address fundamental loopholes or challenges and overspending on expansion initiatives.
It might not seem dangerous in the short term. But, you’ll face consequences in the long run when the true growth falls short of initial projections. For example, the company may face market correction, leading to a devaluation by the investors, or future funding rounds may become tough due to lost confidence.
Using Inappropriate Valuation Models
Selecting the wrong model to value your business means you’ll have an overvalued or undervalued figure.
The choice of your valuation model should align with the;
- Nature of your business
- Niche you’re operating in
- Level of growth you’re at
- Revenue and profit your business is generating
You may face some unique situations or risks, so consider that when picking a valuation model.
Failing to Account for Regulatory and Compliance Risks
Regulatory environments can have a big impact on a company's operations. It can affect everything from market entry and product development to ongoing compliance costs. Ignoring these risks can result in a wrong valuation. It may overlook potential legal challenges, fines, or changes in operating conditions that could impact the company's financial performance.
Investors rely on accurate assessments of risks to gauge the stability and sustainability of a business. If you fail to incorporate these considerations into the valuation process, it may lead to an undervaluation.
A thorough understanding and incorporation of regulatory and compliance factors can help you avoid ramifications such as legal suits.
Ignoring Operational Efficiency and Scalability
Ignoring operational efficiency and scalability in the valuation process can result in a wrong assessment of a company's true worth.
Efficient operations are a key determinant of profitability and contribute to cost savings, improved margins, and good overall financial performance.
Scalability is essential when you want to expand your SaaS business without proportionally increasing costs. Ignoring scalability may result in overvaluation, especially if projections assume that current operations can accommodate rapid growth.
Focusing on these factors makes your business more lucrative to investors and analysts. It may also ensure a more accurate and reliable valuation.
How to Increase the Value of Your SaaS Business Before a Sale?
You can add a lot of value to a business before making a sale. While there are some strategies that are not ethical or legal, there are a lot of different strategic moves you can make to increase the value. Let’s explore six of them.
Optimize Financial Performance
Let’s accept it. Your financial performance is the first thing any buyer will look at. You can implement some of the following measures to optimize your performance:
- Streamline operations: Reduce inefficiencies and make your business more appealing to potential buyers.
- Strategic cost-cutting measures: Reduce investment in marketing campaigns that aren’t bringing results.
- Seek professional advice: Turn to financial advisors, accountants, or your financial team to present a clean financial record.
- Get creative: There may be ways relevant to your niche to improve your financial performance in a short period.
Enhance Customer Retention
You don’t want your buyers to see a high churn rate that dissuades them from buying your SaaS company. To enhance customer retention and increase the value of your SaaS business before the sale, here are three things you can do:
- Ensure that every interaction with your company leaves a positive impression on your customers. Be proactive with customer support and service.
- Gather feedback and address customer suggestions or concerns. This demonstrates that you value them and are creating a culture of continuous improvement.
- Personalize the customer experience through targeted marketing and communication efforts, tailoring offerings to individual preferences whenever possible.
Strengthen Intellectual Property
Intellectual property acts as a competitive barrier and can increase the value of your sale. This includes;
- Trade secrets
- Unique workflows
- Proprietary algorithms
- Distinct interfaces
You should also involve any individual who was invested in developing the product or writing the code and make them sign an IP assignment for their work.
This is an important step, particularly for sale transactions of over $500,000. If you’re unsure how to proceed with this filing, you can approach an IP legal representative or do a preliminary search on Google.
Strategic Marketing and Branding
Potential buyers are more interested in investing in a SaaS company with a strong market position and significant growth potential. You will attract higher offers if you have a USP in your tool, a large market, and a strong competitive position.
There are various strategies you can use to influence your branding. Here are some of them:
- Create a solid SaaS SEO strategy to improve visibility for your business.
- Focus on targeted marketing campaigns that feel relevant and personalized.
- Enter into strategic partnerships with other brands or relevant influencers in your niche.
- Expand into new markets or segments.
Pricing Strategy Optimization
A well-optimized pricing strategy positions your business as adaptable and financially savvy, appealing to potential buyers in the market. Here are three ways to move forward with this optimization:
- Recheck your pricing: Ensure it aligns with the value proposition your business offers, considering factors such as product quality, brand reputation, and unique features.
- Offer tiered pricing: Consider tiers and offer bundling options to cater to different customer segments and maximize revenue potential.
- Be transparent: Highlight the transparency and fairness of your pricing to build trust with customers and potential buyers.
Comprehensive Documentation and Reporting
Adopting comprehensive documentation and reporting practices is instrumental in increasing the value of your business before a sale. It has two main benefits;
- It facilitates a smoother due diligence process.
- It showcases a well-organized and transparent business, which instills confidence in potential buyers.
It's important to implement robust financial reporting systems that provide accurate and timely information. This allows stakeholders to understand the company's financial health. Ensure the following are up-to-date and accessible;
- Intellectual property documentation
- Compliance records
- Customer relationships
- Employee manuals
- Strategic plans
Keeping good records mitigates risk for potential buyers and positions your business as a reliable and attractive investment. This can lead to a higher valuation in the eyes of discerning acquirers.
The Value of Valuation
Accurate valuation is important for many purposes. Most of all, it helps with making strategic decisions and securing investment.
By following the above steps, you can value your SaaS business with confidence and find ways to increase that value if you’re looking to sell it.
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