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How To Accurately Calculate SaaS Company Valuation Using The Recurring Revenue Model

SaaS Company valuation is a daunting task for VC firms, angel investors, and asset management companies. For this reason, they need a correct valuation model in place to evaluate the Company’s worth. They would only be able to raise capital to finance their growth and expansion plans.

SaaS companies’ importance for the country’s economy can be gauged from the fact that US publicly-listed SaaS Companies have crossed $1 trillion free-floating market capitalisation. Moreover, publicly-traded SaaS Companies have outperformed NASDAQ and S&P500 companies in the last few years.

As investors of SaaS businesses earn hefty returns on their earnings, they are more inclined to invest more and more on this avenue. The fascinating aspect of investing in SaaS Companies is that the SaaS Capital index has grown 1000% between December 2012 and 30 June 2021.

From the economic standpoint, SaaS Company valuation indicates how much investors are willing to pay for the business if the company dilutes its equity.

Therein the real irony lies. How to effectively SaaS Company’s opportunity cost and future growth potential? Along with ensuring correct SaaS Company valuation, you have to make sure you are not leaving money on the table.

Determining the SaaS business valuation can be complex. To mitigate this problem, many business owners seek the help of business consultants.

Many factors could influence SaaS business valuation, such as the industry which the Company targets, business model, and value proposition.

Additionally, as an investor of a SaaS business, you should not limit yourself to a single valuation model. Instead, consider exploring different valuation techniques.

By having a firm understanding of the factors influencing the SaaS business valuation, you can rest assured you are not underestimating your company.

Alan Chen

By the end of this Strategy Session, you will have a clear understanding of the next steps you can take for your business to take advantage of the tax deductions you are missing out on.

By the end of this article, you can understand how to effectively determine SaaS Company’s net worth before diluting your equity.

In this article, we’ll walk you through:

  • What makes SaaS business valuation special?
  • Types of SaaS Company Valuation
  • SaaS Net Revenue Retention
  • Churn and renewal rates
  • Secondary valuation attributes
  • Ways to increase SaaS Company valuation

What Makes SaaS Company Valuation Special?

When it comes to determining the net worth of SaaS companies, there is no industry standard valuation model. In the past few years, the valuation multiple for publicly traded SaaS Companies stood at 16.6 ARR, whereas valuation for private B2B SaaS Companies stood at 12.0 ARR.

SaaS Company Valuation

Source

Here are the factors that make B2B SaaS business sets apart from the traditional company:

  • Multiple revenue streams rather than relying on a single revenue source
  • Relatively high gross margin as the cost to service a client reduces significantly with time
  • High renewal rates stimulate long-term business success.
  • Higher customer retention rate.

Types of SaaS Company Valuation

There are many ways to evaluate SaaS Companies, the most prominent of them all are SDA, EBITDA, and Revenue.

Depending on your business profitability or growth potential, you can prefer one valuation method over another to give a better multiplier.

  1. SDE-Based Valuation

Seller discretionary earnings are the company’s residual income after releasing all the outstanding liabilities. Using the following expression, you can calculate SDE:

Net Revenue – Cost of Goods Sold – Operating Expenses + Compensation Enjoyed by Promoter

For a business with a single owner or ARR under $5 million, valuation through SDE is more viable.

  1. EBITDA-Based Valuation

If your SaaS Company has considerably low customer acquisition cost (CAC), EBITDA-based valuation best suits you. Those investors that evaluate SaaS Companies using the EBITDA-based valuation drive value from the Company’s ability to generate future cash flow.

Furthermore, in EBITDA-based valuation, investors only look at the company profits to make $5 million in revenue and realise a high multiplier. Thus, EBITDA-based valuation gives businesses the highest valuation multiplier.

EBITDA stands for earnings before interest, tax, depreciation, and amortization. It turns out to be insanely beneficial for companies having higher before-tax profits. 

Using the following expression, you can calculate the SaaS Company’s EBITDA:

        Net Income + Interest + Tax + Depreciation + Amortization

This method takes into account a few other factors for more accurate calculation. Thus, EBITDA-based valuation best suits companies with earning power exceeding $5 million ARR.

  1. Revenue-Based Valuation

The most prominent and straightforward method for valuing a business is Annual Recurring Revenue (ARR). Nowadays, more and more investors are switching towards this valuation category.

The revenue-based valuation multiple is perfect for those companies that have just achieved product-market fit (PMF) or have achieved the milestone of $100 million ARR.

SaaS Company with an ARR more significant than $2M and YoY growth of 50%, revenue-based valuation multiples is well-suited for it.

How to Identify Your SaaS Company Valuation Multiple?

With an abundance of startups and investor crunch for tech businesses, all the companies are valued based on the multiple that reflects the actual value. The more dependent a business is on more significant and long-term contracts, the greater is the valuation multiple.

Generally, investors are willing to pay 3x and 15x of the annual revenue of a SaaS Company. During the business valuation of SaaS Companies, the listing price will be:

                Average net worth for the last year x multiple

 How exactly can you determine SaaS multiple? While some of the deciding factors are beyond your control, here is a list of valuation attributes to look for:

  1. Revenue (ARR or MRR)
  2. Churn and renewal rates

Without any further ado, let’s dig deeper into these attributes.

  1. Revenue Size (ARR or MRR)

As an owner of a SaaS Company, you need to have a stable and reliable cash flow that can be categorized into the following segments:

  • $1-$2 million

This is below the threshold size most SaaS investors or VC firms consider. However, your SaaS investor will be very specific in their company selection.

  • $5 million

You have reached product-market fit and started expanding your business at this stage. The very next step to achieve growth could be geographical expansion. 

Smaller SaaS Companies that hit the target of $5 million ARR are attractive to investors and buyers due to their scalability. Multiples here can reach $5 million, but not greater than $10 million.

  • $10 million

Your SaaS Company becomes more appealing to VC firms and retail investors at this stage of growth. Investors at this stage are more likely to offer multiples between 10X and 15X. However, your valuation multiple depends on the growth potential of the SaaS Company.

  • $100 million

With $100 million annual revenue, you must have achieved the T2D3 growth. Private equity firms and retail investors are likely to offer double-digit revenue multiples at this stage.

It is tempting to know that SaaS Company usually has two types of valuations. Non-recurring revenue like professional services, setups fees, migration charges, and recurring income is categorised as annual recurring revenue (ARR) and monthly recurring revenue (MRR).

Retail investors always prefer MRR over ARR due to its reliability. To maximise your SaaS Company’s valuation while selling your stake, emphasise increasing MRR rather than ARR. 

If you want to earn how to increase your SaaS business MRR along with ARR, just stick with us till the end of this article.

  1. SaaS Net Revenue Retention (NRR)

SaaS NRR is the recurring revenue earned from an existing customer within a specific time. It includes income earned from the subscription renewal, subscription downgrades, and cancellation of subscriptions.

SaaS NRR is the better way to quantify customer churn rate, and it indicates all the positive or negative changes in the customer churn rate. Almost all the SaaS Companies have a median NRR of 100%. However, SaaS companies with a higher ACV (Annual Contract Value) product can expect a higher NRR.

For SaaS Companies whose customers are small and medium enterprises, 90% NRR is acceptable. Whereas for Enterprise SaaS, 125% NRR is considered good.

SaaS Company Valuation

Source

  1. Churn and Renewal Rates

A SaaS Company’s churn rate can be evaluated based on months or years. It is worth mentioning here that the churn rate may vary significantly based on your customer base and a targeted market. There exist three ideal markets for SaaS products SMB, enterprise, and MidMarket.

If you want a healthy valuation of your SaaS business, you need to keep your churn rate within the range of 5-7%. It indicates only 5 out of 100 customers cancel the subscription. 

For SaaS Companies whose customers are SMEs, your churn rate might be a little bit higher because the success ratio of small startups is significantly low. However, for SaaS Companies serving enterprise customers, a churn rate greater than 10% is deemed devastating for the business.

 On the flip side, you can calculate your company’s churn rate using the renewal rate. As the SaaS business heavily relies on subscription-based revenue, the existing customers are more likely to convert it into renewing customers. 

A renewal rate above 90% is considered healthy and optimal. Nevertheless, churn rate is a prominent metric as it is often coupled with automatic renewals that assist in a better valuation.

Secondary Valuation Attributes 

Investors always consider other attributes of the company: our company age, industry, and the long-term assets that often come with it. 

Although the quantitative analysis tool is relatively scarce, they are more subjective and cannot be explained with a simple equation.

Let’s discuss each of them separately:

  1. Gross margins
  2. Scalability
  3. YOY growth rate
  4. Age 
  5. Owner involvement
  6. Diversity
  7. Value proposition
  8. Company assets
  9. Marketing foundation
  10. Market valuation
  1. Gross Margins

A gross margin is a difference between net sales revenue and the cost of goods sold. Simply speaking, it’s the saving on each dollar of sales to finance other business expenditures and investment plans. A good SaaS business usually has an 80% gross margin.

  1. Scalability

As a SaaS entrepreneur, you need to be crystal clear on how large a company can increase and at what cost. A company with $10M net revenue is likely to undergo more significant acquisitions, and a company that crosses the $50M benchmark could consider issuing another IPO.

  1.  YoY Growth Rates

It indicates how much a company has grown concerning the preceding year. By analysing a company’s financial progress, you can compare key metrics like net revenue or gross revenue.

Most SaaS investors prefer companies growing within the range of 10% and 20% and avoid companies showing 40% YoY growth. Companies offering 50% to 100% YoY growth raises a red flag.

  1. Company Age

Angel investors and VCs avoid investing in companies in an infant stage. Instead, they only invest in companies at least two years old. Companies that are three years or more old receive an attractive valuation.

  1. Owner Involvement

If you want to diversify the equities of SaaS companies, you are supposed to keep an owner involvement in the company management at a bare minimum. Furthermore, the business model of your SaaS Company should be easily understandable because most investors come from a non-technical background.

  1. Diversity

No single client can contribute to 10% of total sales because it shows lacks lack of diversity in your customer base. If 50% of your business revenue is coming from one single client, no seasoned investors will consider your business as a lucrative investment opportunity.

  1. Value Proposition

What are the customers’ pain points your product aims to resolve? Are you delighting customers with your proposed solution? What makes your product specials and what’s your strategy to outperform competitors?

Your ability to capture the loyalty of your ideal customer profile (ICP) solely relies on who are your targeted customers and what value is you providing to them? Without a clearly-defined business objective, your ideal customer could not understand why they should buy your service.

  1. Company Assets

While evaluating your SaaS Company, you should pay close attention to what proprietary tools do your company have? Experienced staff, number of software subscriptions, and size of employees are perceived as the company assets as they can add significant value to a company.

  1. Marketing Foundation

How you run a marketing campaign for your product plays a decisive role in determining the valuation multiple. Some of the well-known marketing strategies for B2B SaaS Companies are:

  • Search engine optimization
  • Email marketing
  • Content marketing
  • Referral programs 

By leveraging the above-mentioned marketing techniques, your SaaS business can expand its customer base and can retain its existing customer base. Eventually, your SaaS Company becomes more attractive to potential investors. 

  1. Market Valuation

Although it might not seem crucial at first glance, the valuation of your competitors’ SaaS Companies can significantly contribute to your company valuation. If a vast majority of public limited SaaS Companies are traded at $25M, do not underestimate or overestimate your company.

Different Ways to Increase SaaS Company Valuation

Up until now, you must have learned how to evaluate your SaaS Company using the recurring revenue model. Therein the questions arise. Is there any way to increase the worth of your SaaS Company?

We aren’t going to conclude this article without discussing the strategies to increase your business worth. Eventually, you can raise the desired money you want to finance your long or short-term strategic goals.

  1. Balance Growth with Profitability

As the SaaS entrepreneur, you are supposed to ensure the balance between growth and profitability. To accomplish this goal, you need to have efficient systems and management in place. Moreover, you need to invest in an efficient and the most up-to-date technology and cut down overhead expenses.

Improved operational efficiency triggers improved margin. Margin is the difference between the selling price of a product and the cost of goods sold. The greater the difference, the better will be business financial performance.

Furthermore, you should also give utmost prominence to the sustainability of the product. Otherwise, your revenue growth is unlikely to last longer.

  1. Focus on ARR/MRR

The difference between ARR and MRR is that ARR provides a broad perspective of the SaaS Company’s recurring income. Whereas MRR provides a narrow picture of the SaaS Company’s recurring revenue. ARR can also be perceived as 12 times your MRR.

Even though all the SaaS Companies emphasize promoting their annual subscription plans, tracking accurate MRR levels is also important. Because investors also consider MRR to know whether the growth is stable or not.

  1. Understand Competitor Strategies

To stay relevant in the market, pay close attention to your competitors’ R&D initiatives and their growth objectives. Stay up to date with the latest industry trends and the continuously evolving industry landscape. Use this data to frame and execute your growth strategies.

While evaluating SaaS Companies or any other startup, investors always look at customer engagement with the product.  

  1. Upsell Strategies

With an appropriate upselling strategy in place, you convince your existing customers to buy additional services apart from the basic subscription plan. Effective upselling strategies consolidate your bottom line and help with retaining existing customers. 

  1. Protect Intellectual Property Rights

Trademarks and copyrights are an integral part of any business. Likewise, for SaaS Companies planning to raise capital by selling their stake, securing intellectual property rights is more important.

Ownership of the intellectual property of business gives you a competitive edge over your competitor and boost your credibility. 

Conclusion

Investors always look for lucrative investment opportunities. As we have already discussed, SaaS Companies outperformed all the listed S&P500 companies. Thus, SaaS is an attractive investment vehicle where you can compound your investment in a short time. 

As an investor of SaaS Company, you must be aware of the business model and the revenue model of the company you are planning to invest in. 

Without adequate knowledge of the SaaS industry and the key growth metrics of the SaaS business, you’ll end up making the wrong investment decision. For this purpose, we strongly recommend you consider seeking the help of a platform freecashflow.io specialized in SaaS Company valuation. 

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