The Software-as-a-Service (SaaS) industry is constantly growing and evolving, and providing scalable and flexible business ideas to many individuals all over the world. If you are new in this space, then there is a lot that you have to learn to grow and run your business smoothly. One of the main things you must know is how to value a new SaaS business. SaaS valuation is not only necessary for new businesses, but also for mature enterprises whose owners might be planning an exit, setting up ESOPs, or seeking funding.
So if you want to know more about SaaS valuation and need help with how to value a new SaaS business, keep reading! We have covered everything you need to know in this blog.
Importance of SaaS Valuation
SaaS valuation becomes important in assessing the overall financial health and potential of your SaaS business. It is through this valuation that investors and venture capitalists determine the economic value of a company. It is a very important decision you need to make for your SaaS business, and a lot of factors are responsible for it. Let us discuss some important aspects of SaaS valuation:
- It helps assess the overall financial health of your company and manage any risks that may arise.
- A proper SaaS valuation can help you negotiate with investors and owners and get fair compensation when you are looking for funding or selling your company.
- You can take informed decisions to plan for company expansions, product development, investments, and plan strategies.
- You can determine your company’s true value by benchmarking the valuation against industry standards.
- It will help you determine your company’s growth potential and profitability in the future.
- Getting an accurate valuation will help you steer clear from bad investments and selling your business for less than its true value.
The SaaS valuation of your company is one of the most important decisions that you need to make, so it must be accurate and well-informed. Are you wondering how to value a new SaaS Business? There are many ways and many factors to consider, and we have discussed all of them below.
Three Types of Valuation for Businesses
There are mainly three ways for SaaS valuation: EBITDA, SDA, and Revenue. Let us look into them in detail.
1. EBITDA
EBITDA stands for earnings before Interest, Taxes, Depreciation, and Amortization, and it is an important metric for measuring a company’s financial performance. The EBITDA valuation method is mostly used for:
- Larger companies with a revenue of over $2 million revenue and a high yearly growth rate of around 50%
- Companies valued over $5 million.
- Companies that can deliver a strong cash flow.
Most such companies do not have a single owner, and the ownership is divided into multiple shareholders who play a less active role and often a CEO or general manager is hired to take on some added responsibilities. In this system, the expenses and compensation of the owner need to be reflected back into the business, and hence the EBITDA valuation is preferred.
The Formula to calculate EBITDA:
EBITDA= Net Income + Interest + Taxes + Depreciation + Amortization
2. SDE
SDE, or Seller Discretionary Earning constitutes the profit earned by the business owner and his compensation after all cost of goods sold and critical operating expenses is deducted from the gross income. SDE valuation is mostly used for:
- Small businesses with less than $5 million valuation.
- Businesses with less than $2 million in revenue and less than 50% yearly growth.
- The owner still plays an important role and has many responsibilities.
The Formula to calculate SDE is:
SDE= Revenue – Cost of Goods Sold – Operating Expenses + Owner Compensation
3. Revenue
SaaS businesses are different from other types of businesses, and the Revenue valuation method is considered a better indicator than the SDE and EBITDA valuation. This is because, for several growing SaaS businesses, EBITDA generated currently may not be the best metric to measure future growth. Many new SaaS businesses often experience hyper-growth but are not very profitable, and in this situation, a Revenue-based valuation is a better pick to get a better valuation.
The Revenue-based valuation method is suitable for:
- Companies that have just achieved Product Market Fit (PMF),
- The SaaS company should have an annual revenue greater than $2 million and over 50% yearly growth rate.
How to Value a New SaaS Business?
The methods mentioned above are just the formulae for the valuation of your SaaS business. There are many more factors to consider to value your new SaaS business properly. You need to identify your SaaS value multiplier. What is it? In today’s day and age, companies are valued by a multiple to find out the real, long-term value of the business. The bigger your business is, the more long-term contracts you secure, the bigger will be your multiplier.
Most SaaS businesses can have a multiplier range from 3x to 15x to value their business. Usually, this multiplier is clubbed with the EBITDA.
For example, if your EBITDA is $50 million, and your multiplier is 10, then your valuation will be $500 million.
The multiple is affected by several factors, most of which are beyond your control. But some of the most important determinants are:
- Churn or renewal rate.
- Revenue (MRR or ARR)
Let us discuss them below:
1. Churn Rate
The customer churn rate is the percentage of customers you lose in a given month or year. The churn rate varies across business types and sizes, but for most SaaS companies, an average of 5-7% annual churn rate is considered healthy. SaaS businesses can also calculate the renewal rate because their revenue mostly depends on the renewal of monthly and yearly subscriptions of customers. Maintaining around 90% customer renewal rate is considered healthy. However, churn rate remains the more popular metric, and this is the formula to calculate it:
Churn Rate= Number of lost customers during a given period X 100
Customers at the beginning of the period
2. Revenue (MRR and ARR)
The MRR or Monthly Recurring Revenue is the predictable revenue earned by a SaaS company every month from their recurring subscriptions. It indicates a strong and stable cash flow for your business and can help you understand the overall business health profitability. It can also help you identify issues and problems to fix. If the churn rate on MRR is high, it means that customers are dissatisfied with your service and you should ensure better customer support.
Investors mostly prefer to see the MRR over ARR as it is more reliable to understand the financial health of the company in detail.
The Formula to calculate MRR:
MRR = Average Revenue Per Account (ARPU) X No. of Accounts Per Month
The ARR or Annual Recurring Revenue looks at the revenue earned by your company in a year, and it is especially pertinent for SaaS companies that provide yearly and quarterly subscriptions. This metric is used for calculating SaaS valuation to provide a ‘big picture’ view of the company’s financial health in a year. It includes the recurring revenue earned from subscriptions and also extra add-ons and upgrades.
You can calculate the ARR of your company using this formula:
ARR= (Sum of Subscription Revenue for the Year + Recurring Revenue from Add-ons and Upgrades) – Revenue lost from Cancellations and Downgrades
Secondary Metrics for SaaS Valuation
The revenue (MRR and ARR) and customer churn rate of a company are important metrics to calculate the SaaS valuation, but it is not everything. Several other factors affect the SaaS valuation, and we will discuss some of them here.
1. Customer Acquisition Cost (CAC)
CAC or Customer Acquisition Cost measures the average spend to acquire a customer and it is an important metric that helps you understand the value and efficiency of your customer acquisition efforts. Companies usually try to maintain a low CAC to CLV ratio as it signals efficient and sustainable growth.
The formula to calculate CAC:
CAC= (Total Sales and Marketing Expenses) ÷ (No. of New Customers Acquired)
2. Customer Lifetime Value (CLV)
CLV or Customer Lifetime Value is the total value that a customer brings to your business. It is a key metric for your SaaS valuation with which you can evaluate the health and potential success of your SaaS business, and also predict future revenue and profit.
The Formula for CLV is:
CLV= Customer Value X Average Customer Lifespan
Customer Value= Average Purchase Value X Average Purchase Frequency Rate
3. Net Revenue Retention (NRR)
NRR is the percentage of revenue retained from existing customers in a certain time period. It indicates customer satisfaction with your products and services and includes subscription downgrades, subscription churns, and expansion revenue. For most SaaS businesses, an optimum NRR is around ~100%, but it varies according to business size. Most small to medium-sized SaaS businesses can maintain an NRR of 90%, while enterprise-level businesses can maintain up to 125% NRR.
The Formula for NRR is:
NRR= (Starting NRR-Downgrade NRR-Churn NRR+Expansion NRR) ÷ Starting Capital X 100
4. Gross Margin
Gross Margin is the percentage of total revenue that remains after deducting the cost of goods sold (COGS). The cost of production and delivery of services like raw materials, labor, and distribution costs are included in the COGS. Ideally, the gross margin for SaaS companies should be 75-80% or more.
The formula to calculate Gross Margin:
Gross Margin= [Revenue – Cost of Goods Sold (COGS)] ÷ Revenue
5. Year-on-Year Growth (YOY)
Year-on-year (YOY) growth rate measures the percentage change of growth from the previous year. If the growth rate is faster and higher, the company can have higher value. The YOY growth rate indicates the company’s ability to expand its revenue and operations. Most investors and SaaS buyers prefer a business with a 10-20% growth rate and do not prefer companies with a growth rate of over 40%.
The Formula to calculate YOY growth:
YOY Growth Rate= (Company Revenue of Current Year ÷ Previous Year Revenue) X 100
6. Total Addressable Market (TAM)
TAM or Total Addressable Market helps you understand how big the market is and your potential of growth in it. It refers to the overall revenue opportunity that your product or service can earn if it acquires 100% of the market. TAM becomes an important metric to help you identify untapped markets, optimize product offerings, and stay one step ahead of your competitors. For SaaS businesses, a $100 million TAM is considered small, and you should target a TAM close to $1 billion to get investors interested.
The Formula to calculate TAM is:
TAM= Number of Potential Customers X Average Revenue Per Customer
Tips to Increase SaaS Valuation
- Provide Better Customer Experience: You can employ several strategies to provide a better experience to customers, ensure customer satisfaction, and improve your retention rate. Try to understand your customers’ preferences and dislikes by getting regular feedback through in-house surveys, customer portals, email, or phone. Incorporating in-app messages and guidance, developing better onboarding strategies, and customer support services can also help optimize customer experience, improve retention rate, and in turn improve your company’s value.
- Optimize Your Pricing: You need to optimize your pricing strategy to improve your company’s value. Make sure to review your pricing regularly as per the inflation rate, and take effective steps to counter it with an annual price increase. Of course, you must ensure that you are adding more features, functionalities, customer support, extra incentives like access to webinars and guides, and more to validate the increase in price. As a SaaS business, you can provide a freemium model that attracts enough customers with its free features and also nudges them to upgrade to paid tiers for a better experience. This will help you reach a wide audience base who can try out your product and also benefit your company.
- Strategize to Reduce Churn Rate: Customer churn rate is one of the important metrics affecting SaaS valuation, so you should take the necessary steps to reduce it. You can look into product analytics and quantitative data of customer feedback and understand where they churn and why. You can use the data and insights to strategize better customer experiences to help them realize your product value. Think of automated notifications about new products and discounts, personalized onboarding, feature adoption, and contextual prompts that can reduce the risk of churning.
- Work on Product Differentiation and Market Positioning: Another way of improving your company’s valuation is by creating a product differentiation and positioning marketing strategy to help your business provide a unique experience among competitors and address market gaps. Focus on diversifying your marketing acquisition channel, set up new acquisition channels, and take steps to not only attract new customers but also retain old ones. You can achieve this by building your company’s full marketing funnel with effective strategies to nurture customers and add value to their experience.
- Optimize Scalable Growth Strategies: One of the best ways to achieve a successful SaaS business is by increasing your revenue without increasing the customer acquisition cost. You must take some effective steps to achieve this. Firstly, you can improve your revenue through upsells and cross-sells, and you can easily convince your customers to spend a little more money to get more features and functionality. Focus on organic ways to attract customers, like providing a freemium plan or free trials to encourage them to try out your product. Try to provide a good experience to your customers, and they can in turn help in promoting your products.
- Protect Your Brand’s Intellectual Property: As a SaaS business focused on providing unique solutions to customers, you should take extra steps to protect your intellectual property. It will help secure your unique business solution and prevent competitors from using your assets in their products. You must own the rights to your intellectual property by patenting and trademarking your products and assets so that no one else can exploit them. While hiring employees, you can add confidentiality clauses that strictly forbid them to share the company’s patented information with others. When you have a patented or trademarked solution, it helps you stand out among competitors and get investors more interested.
Common Mistakes to Avoid During SaaS Valuation
Now that we have discussed the ways to improve your SaaS valuation, let us look at some of the most common mistakes that owners make while valuing their new SaaS business:
- Comparison with Public SaaS Companies: Most public SaaS companies are huge and have higher valuations. They have access to lots of resources and capital, greater market share, a well-established customer base, the best talent, and more. Comparing your private business with public companies will not be fruitful.
- Comparing Your Company with Competitors: Researching your competitors usually helps your business, but comparing your business with them, especially with valuation may not always help. Of course, if they have reached an impressive valuation, then you should try to achieve that for your company as well. But no two companies in the industry are the same, even if they have similar niches. You have a unique solution and a unique value proposition, so you will have different challenges to face. Moreover, you do not know the in-depth details of how your competitors reach a certain valuation, so it is better to focus on your own company.
- Following a Valuation As Per General Market: SaaS companies have a different business model as compared to other online or software development companies. Therefore, not every valuation service will be suitable for you. They will only end up providing an inaccurate valuation, so you should not rely on them.
- Only Focusing on Revenue Multiples: Only focusing on your revenue multiples is not enough. There ar several other factors (as mentioned above) that affect your valuation, like the quality and scalability of your products, market condition, competitors, quality of your team and management, and more. These factors also affect your revenue in the future, so considering them is necessary.
- Overestimating Growth Rates: It is amazing if your SaaS business is showing exponential growth in the beginning, but you must avoid overestimating your growth rates. The SaaS business landscape is constantly changing, and this practice may not be useful in the long run. There may be other challenges and risks as well, so you shouldn’t only rely on the current growth rate. Moreover, overestimating your growth rate may create unrealistic expectations for investors, and if you fail to keep up with the same rate, securing future funding may get difficult.
Avoiding these mistakes can help you immensely to set the right valuation for your SaaS business and attract investors with your best practices.
Final Thoughts
Getting your SaaS valuation is an important and essential step for SaaS businesses. It helps you a lot in the long run, from getting funding and investments to selling your company. Therefore, you must know how to value a SaaS business and the important determinants that affect it. We have discussed all of them in detail in this blog. We hope you will find it helpful!