Software as a Service (SaaS) is an exciting industry that is packed with inexhaustible opportunities. When doing business with SaaS, it is critical to understand the way metrics utilized in SaaS valuations can boost the market value of your enterprise prior to a sale.
This article covers the basics of SaaS valuations that apply to your business model.
How do SaaS businesses get valued?
It is quite common not to understand how investors attach value to a business. There are several factors that come into play before an investor arrives at their final assessment. These factors might not necessarily have anything to do with the size or rate at which the business has been growing. Check out the following to get a baseline understanding of which methods investors employ to value a particular company.
Seller Discretionary Earnings (SDE)
This is just another way to describe pre-tax and pre-interest profits that are calculated before the deduction of non-cash expenses, benefits of the owner, investments, and other costs.
Seller Discretionary Earnings go a long way in determining the value of a company. What this means is every seller should have an understanding of how SDE is calculated. This will contribute towards more accurate progress evaluation, and it will help you set definite targets when placing your business on the market.
When calculating profits, SDEs take into account the owner's salary as well. They give a clearer picture of the actual earnings currently running the company.
Interest, Taxes, Depreciation and Amortization (EBITDA)
This method works for a company that has rather complicated ownership. The calculations are done in a straightforward manner. The information used to calculate EBITDA can be found easily on the business' balance sheet. The following are taken into account:
- Net income
SDE and EBITDA are almost equal in value with the principal difference based on the fact that with SDE, the operations managers' earnings are also taken into account. EBITDA is often employed when working with companies valued above $ 5,000,000.
What sets SaaS companies apart is that they often have to put forward a lot of upfront investment to boost growth. When making an evaluation with EBITDA, the upfront inputs are regarded as expenses. This is why it would be sensible when dealing with companies that are still growing to measure revenue as well. If a company is not growing at all, there will be no revenue to support the forecast and determine whether it's a good idea to purchase the business. This can be deemed an overvaluation.
Factors influencing how much a SaaS business is worth
The following has to be taken into account for one to have a general idea of whether or not a business is likely to be profitable.
Looking at a business retrospectively can allow one to assess whether or not the company has been profitable or not. This will enable them also to make an estimate of how much growth the business is likely to experience in the future.
The Owner's Responsibilities
A lot of businesses depend on the input of their owners to a great extent. This means that their success or failure is directly proportional to the owner's competency.
To avoid this, owners can set up their businesses to be independent by employing responsible personnel and qualified management. Employment of people who can execute the company's daily tasks with little or no supervision can allow the business to progress without depending too much on one person.
Investors will be more interested in purchasing a SaaS business that profits from a product that is still in its growth phase as opposed to one that's been in the market for a long time.
Investors use customer metrics to determine the quality and pattern of the business's revenue. It helps them decide when they can expect to start reaping the profits from their purchase.
SaaS metrics that matter
Consider the following most commonly evaluated metrics in SaaS valuation for determining the multiple.
- Customer Churn Rate
Customer churn refers to the speed at which customers cancel a subscription to a particular service. It is basically the rate at which a business loses customers.
To come up with such a figure, you simply divide the customers lost within a given time period by the customers at the beginning of that period.
An example is as follows:
Number of customers at the beginning of January = 900
Name of the customer on January month-end = 850
Customer Churn Rate = (Customers on the first day of the month - Customers on the last day of the month) / Customers at the start of the month.
(900-850)/900 = 50/900 = 5%
If the customer church rate is low, then the particular business still has the potential for growth. The lower figure shows that the company is gaining way more customers than it is losing. This lowers the risk of value loss over time, which is a good indicator for investors. A business with a high customer churn rate would, therefore, not be preferable.
The majority of investors prefer a yearly rate that is under 10% for large SaaS businesses. This rate should ideally be zero for smaller companies owing to the fact that they are generally more susceptible to higher customer churn. That is to be expected since older businesses can invest more in customer retention when compared to smaller ones.
- Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV)
Customer Acquisition Cost (CAC) reflects how much it costs a business to acquire a new customer.
To calculate the figure, you have to get the sum of marketing and onboarding costs. You can then divide this sum by the total number of customers acquired over a given period of time.
A quick example:
$10000 + $6000 = the marketing and onboarding cost, divide the figure by 400 new customers, and you have CAC = 40
Customer Lifetime Value (LTV) refers to the mean revenue gained from a single customer in a given period of time.
The calculation is usually done as follows:
Gross margin per customer lifespan multiplied by retention rate / (1+ Rate of discount – Retention rate)
The gross margin refers to the average profits per customer calculated by taking into consideration how much revenue they brought in and how long they have been a customer. You can then factor in the percentage of customers who remain loyal to the business over a precise period (retention rate). Please note that you also have to take into consideration inflation at the typical 10% (discount rate).
Here is an example:
GML = $4200
Retention rate = 60%
Discount rate = 10%
1 + 0.6 – 0.1 = 1.5
We divide the retention rate of 0.60 by 1.5 to get 0.4
We can then multiply that by our GML of $4200.
CLV = 0.4 x 4200
CLV = $1680
The business will be considered a loss if it is churning out more funds to retain customers who are, in turn, not bringing in as much revenue. A business has to have a high return on investment, also known as ROI for investors to consider it a worthwhile investment. Return on investment will tell you if the customers you are acquiring are at all profitable to the business. It also gives you insights on whether or not your marketing strategies are working, and if not, what might need adjusting.
CAC is closely linked with conversion rates. Conversion rates offer insight into the ROI in customer acquisition channels. It gives investors a general idea of the number of value customers attach to your products.
- Monthly Recurring Revenue (MRR) vs Annual Recurring Revenue (ARR)
In modern times, a lot of SaaS utilizes the subscription model, which is usually monthly or yearly. Because of this, Monthly Recurring Revenue (MRR) is often used also to value a business. It is the amount of income that companies make through their recurring client subscriptions.
To calculate this amount, you just calculate the sum of the recurring revenue for a given month.
MRR = Σ Recurring Revenue for the specified month
The calculation below simulates a business with a 30-day subscription of $300. The service had 2 subscriptions in the month of January. An additional subscription was made in February, thereby adding to the existing MRR.
January: 300 + 300 = $600 MRR
February: 300 + 300 + 300 = $900 MRR
March: 300 + 300 + 300 = $900 MRR
Investors also take into account what is known as Annual Recurring Revenue (ARR). It is more or less like MRR but is measured on a yearly basis.
To calculate this figure, it's just a matter of adding up all the recurring revenue the business reeled in over a yearly period.
ARR = Σ Recurring Revenue
With MRR and ARR, you can then come up with an MRR/ARR ratio. It is also a critical piece of information. A lot of investors prefer that the MRR be more than ARR. While Annual contracts might quickly boost revenue, they do not give a clear picture when it comes to whether the business will keep making profits or not. Apart from that, a lot of companies offer annual subs at hugely discounted rates. If you add up subscription amounts of 12 months, they will sometimes double a single yearly subscription. With that in mind, you can see why a high MRR is more preferable to investors than a high ARR.
- Revenue Churn Rate
Investors will also take into consideration the percentage of revenue gained, otherwise known as the revenue churn rate.
To arrive at this figure, it is just a matter of dividing the initial MRR with the amount lost during the particular month. You should, however, not include any user upgrades when making this calculation.
The following is an example of a revenue churn rate calculation.
Initial MRR in the month of January = $600,000
MRR at January month-end = $500,000
MRR acquired from existing customers in upgrades = $40,000
Revenue Churn Rate = [(Start of January MRR - MRR January month-end) - MRR gained from January upgrades] / MRR beginning of the month
(($600,000 – $500,000) – $40,000)/$600,000 =
($100,000 – $40,000)/$600,000 =
($60,000)/$300,000 = 2%
If the answer is a positive figure, it becomes a clear indication to the investor that the company in question made losses in that particular period of time.
How to increase the value of your business before a sale
There are a lot of factors that affect the value of a SaaS business, as seen in this article. The good thing is the majority of them can be easily regulated by the company in question. This much applies to metrics as well. How then does one go about increasing the value of their business to make it more appealing to investors?
As seen before, churn is quite an essential factor when it comes to SaaS business valuations. It would work in a business' favor if it can be reduced as much as possible in the period leading to a sale. Some of the factors that can be improved include boosting customer satisfaction and experience. This allows you to retain more of the customers that engage your business, and there creates some sort of a closed-loop. Apart from decreasing churn, this will also work in favor of your other metrics as well.
It is crucial to keep a detailed record of the following:
- Up to date Accounting
Always maintain clear and up to date accounting records and have them ready whenever you wish to make a sale. All investors will want to take a look at your accounting records first before you can negotiate a deal..
- Standard Operating Procedures (SOP)
If you were an investor, you would also likely want to be presented with clean and well-documented operations. This will indicate the order and seriousness with which the business is run. An organized company is definitely more appealing to investors.
- Source Code
It is also essential to keep a well-documented source code as this will help those investors who have plans of scaling the business. This is quite important if the company is a startup.
Collect Customer Metrics
In modern businesses, customer metrics are the pillar of most successful enterprises. Every company should ensure that they have detailed customer metrics, as this will be an indication of just how strong the business actually is. There are several solutions that can be made use of to gather and analyze customer metrics.
Outsource development and support
SaaS enterprises that have a higher potential for passive income usually fetch a market value than those that need active participation from the owner. This is why it would be beneficial for a business to outsource tasks and work closely with appropriate third parties like contractors if need be. This reduces the knowledge base needed by anyone looking to take over the business. Investors might not want to dig deep into the nitty-gritty of how a business is run. It should be a well-oiled machine that can run itself independently.
Hold off releasing new products
It is also essential to put a pause when it comes to launching new products if you are looking to make a sale. The reason is simple. Customers take time to warm up to a product, and by the time you want to sell, they might not be fully engaged; therefore, you won't be generating any profits from it.
Secure Intellectual Property (IP)
Always apply for trademarks when it comes to intellectual property to make sure that your innovations are indeed the property of your business. This will also improve the value of the company.
How to Sell a SaaS Business
There are four basic ways of selling your business.
There are a lot of networks that allow you to list your business for sale and attract interested buyers. This would be a good option if you fully understand the sale process since you might have to deal with the buyers on your own.
Just like any other Auction, you can also have buyers bid for your business. The business will then be sold to the highest bidder. This is advantageous as it allows you to get a premium offer for your enterprise. You will, however, have to pay a listing and success fee to the auction service that you would have employed. This option is excellent if you have experience selling businesses.
Hiring a broker
Brokers can help you to get a premium offer for your business. They will also handle most of the sale and ensure your IP, data, and other vital processes are secure throughout the sale proceedings.
To ensure that the process is smooth and quick, you should make available all the documents needed to make the sale. A broker will also charge their own fee, which is usually between 10% and 15% of the final sale.
You can also choose to deal first hand with investors and buyers. While this might cost less in terms of services and other selling related costs, you need to be a very experienced seller. The process might also be prolonged. It is definitely the least preferred method of all, as there are a lot of risks involved in selling a business.
Over to you
Now that you are furnished with details about the valuation and sale of SaaS businesses, you can begin planning for a successful, timely exit strategy today by leveraging these insights. If need be, you can aslo hire the services of a professional to help you deal with your sale. All the best! Cheers to early retirement!