August 30, 2022 by Adam Hoeksema
A SaaS valuation can be a tricky thing to approach, especially if the company is in the pre-seed or early stages of funding. Valuations commonly revolve around yearly revenue, and if you’re not at this stage, you’re going to have to look for other metrics to get a feel for your company’s value.
On top of that, these valuation metrics aren’t all there is to consider before reaching out for capital; there are also the long-term effects of handing over equity, planning ahead for later rounds of funding, and the documentation you’ll need to get there.
This can be a pretty overwhelming process, but thankfully we’ve compiled some details that should be relevant to you if you’re in any of these situations.
What is SaaS Valuation?
For anyone beginning their fundraising journey, the first question they might be asking is how much is the company worth? And that’s a good question because every single business identity is unique; meaning that you can’t just look at your competitors to find out how much your company is worth.
SaaS companies in particular face special challenges with this, since they’re not always definable by current trends and metrics. Many SaaS companies blur the line between art and science, or entertainment and education, and fill such specific niches that it can be hard to get a handle on the framework they’re going to be using.
This is the nature of SaaS valuation, and it’s an important step toward securing your next fundraising cycle with investors or banks. Ultimately, a SaaS evaluation is the means by which investors and owners can calculate the economic value of a company.
Each valuation of a company is affected by lasting and current trends, numerous financial factors, and countless other metrics such as business models, value propositions, and industry.
These valuations are used to both find and exit investors and need to be accurate and agreed upon for a company to know its share value, as well as identify the risk/reward ratio, opportunity cost, and quality standards. Because of how each of these factors is unique to every company, there’s no one-size-fits-all solution to SaaS valuation.
What it comes down to in the end is understanding the company and the market, identifying and analyzing all of the drivers and attributes of value, and striving to calculate the best deal available based on these data.
For all of this, it’s always going to be trickier when your startup is pre-revenue or at the start of revenue generation. For all kinds of SaaS companies, there will be a solution. Have a look at some of the different valuation options for companies of every scale.
There are Different Types of SaaS Company Valuation
With pre-revenue companies, it may be worthwhile looking at public and private companies to disclose revenue and valuation for your comparison. Then, it’s a matter of adding in some of the ‘soft value’ attributes that we will go over later.
However, regardless of the size of your company, there are three main ways to run a SaaS company valuation.
Valuation Based on EBITDA
Earnings before interest, taxes, depreciation, and amortization (EBITDA) are perhaps the better choice for a company whose growth percentage plus profit margin has reached 40 or above. This metric is a quick glance at the health of your company and can imply to investors that it has the ability to deliver a strong cash flow. This may also be the case if other metrics such as customer acquisition cost are low.
This model is about reaching high multipliers as quickly as possible, and as such this may give you the highest multiplier. It’s calculated by:
Net Income + Interest + Taxes + Depreciation + Amortization
Typically, valuation method covers factors that are available or inherent only to established businesses, so it’s not usually a good place to look for startups. SaaS companies with more than $5 Million ARR may be eligible for EBITDA evaluation.
Valuation Based on SDE
Seller Discretionary Earnings are basically what’s left after all the expenses are paid, and the owner has removed their salary from the outgoings. This is a great method for early businesses and startups and is a lot simpler than the previous method.
In fact, it’s the most common metric used to value small businesses in general. What it boils down to is a declaration of the total financial output your business would provide to a sole owner/operator. It’s calculated by the following equation:
Revenue - Cost of Goods Sold - Operating Expenses + Owner Compensation
This is a good way to get a feel for your company’s value that you can quite easily do yourself, if your documentation is in order. It’s not as accurate as some methods, but it’s designed to work with less of a financial record.
Annual Recurring Revenue (ARR) is one way to value a business when looking for buyers or investors who are happy to pay in multiples of the current revenue with the mind to get an ROI on that investment over a calculated time period.
Of course, that time period depends on the multiples and on the accuracy of the ARR calculation. This is becoming a more common form of valuation for private equity firms and is typically used for companies that have reached the level of reliable recurring revenue.
This means if the business has made it to the $1M bracket, or has achieved product-market fit, it may be ready for revenue-based valuation. In general, if you’re looking for rapid growth, a revenue-based valuation is better than an EBITDA valuation in that you won’t need to be profitable quickly; simply to grow revenue.
So, there are different methods for different company stages, and for many small businesses and startups, it’s really only the SDE evaluation that’s going to be useful, but just in case you’re looking to estimate a fair ARR multiple, let’s go a little over what that takes.
A bit About ARR Multiples
The valuation of your SaaS Company depends primarily on how trustworthy it appears. For early-stage companies, say, with sub-million ARR, the defining characteristics of value to investors will be the following:
- More defendable assets you own
- Longer you’ve been in Business:
- More predictable your revenue stream
- Faster your growth rate
- The Stronger your Tech Value
- The better your Team
- And the Sector you’re in
These companies are typically expected to bring in something along the lines of 1-3x ARR multiples.
For SaaS companies bringing in 1- 10 million in ARR, the factors change a little. First of all, these companies may have been around for a little longer.
These companies could expect to see a 2-4x ARR, and this rate really won’t be likely to increase into the 6-8X ARR multiples until they get above 10 million ARR, so we’ll focus on the smaller businesses for now.
But how is it calculated? The ARR multiple is basically a ratio between a company’s valuation and its ARR. It’s a metric that gives an overview of the company’s value and it’s reached by dividing the valuation by the ARR for the same period of the valuation.
For example, for a small startup worth $1M, that’s earning $200k ARR, the calculation would define its ARR multiple as 5X.
So, ARR is one of the metrics used in SaaS valuation, and we’ll go into it in a little more detail in the next section, as well as breaking down some of the other metrics that are handy.
Top SaaS Valuation Metrics to Consider in Sub-Million SaaS Company Valuation
There are many other useful metrics in SaaS company valuation, including the sector, the IP laws, and the Year-on-Year growth rate, all of which could have their own sections. But for this article, here are four of the most important:
1. ARR multiples
We’ve covered the basics of this, but it’s a good idea to know what makes a good target for a SaaS multiple benchmarks.
Though the median ARR multiple is as high as 17X, a much more realistic target for early-stage companies, and as a general rule in SaaS companies, the ARR multiple is much closer to somewhere between 4X and 9X.
The reason this metric is so useful is that it gives a decent idea of how the company has been valued and tracking helps understand how much a potential buyer or investor would be willing to spend on the company.
Another version of revenue tracking is Monthly Recurring Revenue. This has numerous benefits over ARR since the monthly revenue can often reflect a more accurate picture of what’s going on, especially if looking to sell.
For example, offering discounted annual plans can generate a sudden boost in cash flow upfront and make the business look more profitable, but this won’t be reflected as a strong MRR, something which many investors might prefer to see over ARR since the latter is less predictable.
3. Churn Rate
The churn rate correlates negatively with customer engagement. That means SaaS products that are on a more self-service model will have a higher churn rate than those for which the vendor is in much closer contact with the customer.
This variation can be anything between 5% to 70%, which is a colossal range, and anything over 60% is quite unsustainable. Ideally, for many SaaS products, a churn rate of less than 30% is a sign of a healthy position, but again, this depends on the industry. For self-serve models, investors may be more lenient and expect a healthy company to experience up to 60%.
Conversely, with high engagement, many people would expect a rate of 10% or lower. As always, it depends on other metrics and business model factors. This means it’s not a metric that can be used alone to determine company value, but it is a very significant sign of health when measured alongside other metrics.
Churn, then, should be a major focus for most SaaS companies, but a precursor to churn and a heavy influencer of it relates to customer acquisition.
4. Customer Lifetime Value and Acquisition Cost
These two metrics are highly related, so they’re in the same section. The cost of acquiring new customers (CAC) is how much you spend on getting prospects into paying customers, defined as the price per single customer. This includes marketing, engagement, sales, onboarding, and any costs relating to retention that can be divided across the number of customers to provide an average figure.
The lower this cost, the more profitable a company is, but there is the factor of lifetime value; the amount of money you can be expected to gather from each customer throughout the length of their stay with your product.
This value has to match and exceed the rate of loss from churn in order for your company to be on a profitable trajectory.
So, from all this, you may now have a better idea of how valuations happen and the metrics that are useful, but you’re probably still stumped on how exactly to come to your specific valuation multiplier.
How to Value a SaaS Company
In this section, we’re going to go over some key pointers to consider and some steps to take when finding your SaaS valuation multiplier.
Remember, a multiplier is the long-term value of your company. This means that the longer you’ve been around, and the more reliable your cash flows are, the higher your chances of hitting a high multiplier.
The person conducting the valuation is as much of a factor as anything else, so be sure to get more than one, if you think the result is unfair or unrealistic. For pre-revenue or early-stage software companies, it’s not always as simple as leaning on ARR or even MRR.
Start with considering what investors want to see:
- The valuation is simply one part of a long-term process. You should also be looking into their input, as well as how your dilution will increase over time, all of which are interconnected.
- The funding round is likely to be only one of many, so consider how that will affect your employees and your role down the line, so do the math relating to how future rounds will affect all of this.
- Founders with too little equity in the company show signs that there’s not enough commitment and that their goals aren’t aligned with those of the investor.
All of these calculations should culminate in an honest assessment of how much capital you actually need right now. If you’re looking for investment, realize that it’s only necessary to ask for what you need to reach the next round. The less you ask for, the less equity you’ll have to give away.
So, knowing about your company’s value is more than just about valuations. It’s also a matter of long-term changes and impacts on your personal stake in the company. If you’ve got that all sorted, there’s one more thing you should be aware of.
Get Your Documents in Order!
It’s no good going through all the trouble of calculating these metrics, paying for a valuation, figuring out your desired capital rounds, and all of the other complexity that comes with warming up for investment – if you haven’t got your papers straight.
Your business plan should contain all of your market research, financial projections, and a clear statement of your designs and direction for your investors to take a look at. Further, it’s not just a compilation of your imaginative dreams for the future of your company; it’s also a testament to your honesty, critical thinking, and rigor.
That’s because investors will jump straight to your financial statements and scrutinize them for inaccuracy or overly-optimistic thinking. The accuracy of these papers is a statement of your commitment to doing business the right way.
If you want some help producing reliable saas financial pro forma statements, check out our Saas financial projection templates or you can work directly with our experts to build a custom financial model to be best prepared for valuation. You’ll find templates suitable for your specific company, and customizable to your specific needs. They’ll help you build a professional-looking set of papers for your business plan, which will dramatically boost your chances of securing investment.
Hopefully, now you’re a little closer to understanding how to value a SaaS company. Of course, your specific needs will determine the route you take, and each situation is different, but for all startups and small businesses there are some fundamentals.
Either calculate your monthly or annual revenue or if you are pre-revenue, look at how you present your company to early-stage investors. This means making sure you’re demonstrating commitment and attention to detail.
The best way to do this is by having your papers in order. Real, accurate market research and financial projections are key to showing your prospective investors that you’re serious and competent.
And remember, if you do have revenue and you’re looking for buyers or investors, don’t try to inflate your ARR by offering discounts! They’ll show up as unreliable metrics and you’ll end up with a lower valuation when your MRR is inspected!