SaaS Valuation: How do you value a SaaS company?

The global SaaS market is experiencing significant growth, with various projections indicating its size and growth rates over the coming years. As of 2024, the market is valued at approximately USD 294.20 billion. The U.S. SaaS market will reach approximately USD 225 billion by 2025.

SaaS is Software as a Service. With an expanding market for software, many businesses offer services worldwide through a web-based application using the SaaS business model. Software as a Service reshaped the way companies satisfied their customer needs, making it more efficient in every aspect.

This article helps you to understand how to effectively evaluate a SaaS company’s financial worth based on various factors, including growth potential, revenue metrics, and profitability.

Overview of a SaaS company

A SaaS company is an organization that utilizes software to host an application where its customers can access their services. The company creates and develops a service that they provide to their customers on a web-based platform.

Customers can access these services remotely without any restrictions globally. This service can expand globally without raising the cost of delivery. SaaS companies can be primarily categorized into B2B and B2C. This model can offer greater flexibility, efficiency and accessibility that makes it a vital component of modern technology infrastructure.

How Businesses Benefits From SaaS?

When looking at the benefits of SaaS, multi-distribution is one main factor that helps standardize many applications such as email, customer service, relationship management, web conferencing, and enterprise content management. Other benefits include:

• Low Cost: SaaS eradicates the need for substantial upfront investments in hardware and software licenses, allowing businesses to pay a subscription fee. This model reduces financial risk, particularly for startups and small businesses.
• Convenient with on-demand service: SaaS model applications are accessible from any device with an internet connection, promoting flexibility and supporting remote work environments. Users can log in from anywhere, enhancing productivity.
• No installation: With no need for installation or configuration, users can start using the software immediately after subscription. This rapid deployment accelerates time-to-value for businesses.
• Global Reach: SaaS platforms allow businesses to reach a wider audience without requiring extensive physical infrastructure or sales teams.
• Enhanced Security: SaaS companies typically invest heavily in security infrastructure, providing better data protection than many businesses could achieve independently. Data is often backed up automatically, which helps to reduce the risk of loss.
• Real-Time Collaboration: Many SaaS applications facilitate real-time collaboration among team members, enhancing organizational communication and productivity. Users can work together seamlessly regardless of their physical location.

Valuing a SaaS Company

Valuing a SaaS company can be a complicated process if one is not well-versed with all the terms and factors that assists in doing so.

#1 Understanding SDE or Seller Discretionary Earnings

The Seller Discretionary Earnings (SDE)  is the Pre-tax Income + Owner compensation + Depreciation and Amortization (D&A), Interest + Discretionary Expenses + Non-Recurring Expenses

• Pre-tax Income refers to the net income before taxation.
• The compensation paid to the owner for his work is the owner’s compensation.
• Depreciation and Amortization (D&A), and Interest are added back since the actual expense was incurred at the time of purchase, and Interest represents the cost of borrowing money.
• Other adjustments include adding back Discretionary Expenses and Non-Recurring Expenses, as they do not form part of regular operating expenses.

The SDE (Seller Discretionary Earnings) generally values businesses that are valued under $5 million with no management team and have a slow growth rate. Using SDE is the best way you can reflect the underlying earnings and power of a small enterprise accurately. A majority of the small and medium enterprises rely on the owner, and it is common to have expenses and wages associated with them. The wages the owner pays themselves might not be the same as the market rate. The owner can also record personal expenses under the company’s name to avoid tax. All these expenses are added into the calculation to determine the true and full potential of the earning power.

#2 Understanding EBITDA Margin

EBITDA is the earnings before interest, tax, depreciation, and amortization. It is a financial metric that is widely used to measure the overall financial performance of a business. EBITDA shows how profitable a company is. For deriving the EBITDA Margin, we need to divide the EBITDA by the total revenue of the business. To see where you stand, you will have to calculate the EBITDA margin and compare it to the average of the industry.

For example, Company XYZ has an EBITDA of $100,000.

• Total revenue = $1 million.
• The margin of EBITDA is 10%.

Company ABC has an EBITDA of $120,000.

• Total revenue = $1.8 million.
• The margin of EBITDA is 6.667%.

Company ABC has a higher EBITDA (120,000) when compared to Company XYZ (100,000). But the margin of EBITDA is smaller than XYZ (6.667% to 10%). When viewed from an investor’s perspective, XYZ is more favorable.

#3 Understanding Revenue

The major factor that differentiates SaaS companies from traditional companies is that they have to invest a considerable amount upfront to boost their growth. When determining the EBITDA, these amounts that were invested will be considered as expenses.

Here is where revenue becomes more essential. Since the upfront investments are deemed as expenses in growing companies, it becomes essential to measure the revenue. In case the company does not have any revenue, there will be no data to support the forecast, and you will not be able to accurately determine if it will be profitable to purchase the business. With fewer data available, the amount determined can be overvalued.

ARR multiples are the ratio between Annual Recurring Revenue (ARR) and company valuation. The Multiple can be found by dividing the Valuation by ARR. i.e., Multiple = Valuation / ARR.

This is an important metric used to measure the value of private SaaS companies.

SaaS Valuation Multiples

SaaS valuation multiples help to evaluate one financial metric as a ratio of another metric. These multiples help investors and business owners gauge how much a SaaS business is worth based on its financial performance and growth potential. It consists of various factors, but what matters more is the transferability, sustainability, and scalability of the business.

EV/Revenue Multiple

The most prevalent metric for SaaS valuation, especially since many companies prioritize growth over immediate profitability. This multiple reflects the enterprise value (EV) relative to revenue. For instance, if a SaaS company has a revenue multiple of 5.0x, it means the company is valued at five times its annual revenue.

Assuming that it generates $10 million as annual revenue. With 5.0x as the revenue multiple, the  valuation of the company would be:

Valuation = Revenue X EV/Revenue Multiple
    = $10 million X 5 = $50 million

ARR Multiple

Investors often look at multiples of ARR, particularly for companies demonstrating strong recurring revenue streams. A common threshold for favorable valuations is an ARR greater than $2 million, with year-over-year growth rates exceeding 50%.

EBITDA Multiple

For more mature SaaS companies with significant earnings, the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiple can be used. This metric focuses on profitability and is beneficial for companies generating high profits.

Factors Influencing Valuation Multiples

As of late 2024, SaaS companies’ median EV/Revenue multiple has seen fluctuations but recently stabilized around 7.6x, according to an article by Aventis Advisors. This can be attributed to improved profitability trends and positive market reactions to innovations like AI integration within SaaS products.

For SaaS companies, the multiple a company gets is dependent on several factors. SDE multiples of such companies range from 3x to 5x. Here are a few important factors that helps to find the multiple:

• The SaaS company’s age: If the company has been running for a couple of years and has a track record with sustainable earnings, it will be easy to evaluate the forecast. If the company has been running for 2 years, the valuation multiple will be higher than a startup. If it has been running for more than three years, investors will present a higher multiple.
• Growth Rate: Investors find it appealing if your company has a sustainable and predictable growth rate. A company thas a more predicted and stable growth rate is more attractive than a business with distorted and unpredictable growth rates.
• Market Trends: No owner will want to sell their company that is growing rapidly in a trending market. The ideal place for a company to be is in a more consistent trending market along with sustainable growth.
• Customer Metrics: One of the most essential metrics in the SaaS valuation is the consumer metrics. Investors have a close eye on these metrics; one of the metrics is Churn. Churn is a common metric in this companies that offer services on subscription.

Important Metrics to Consider While Valuing a SaaS Company

While valuing SaaS companies, you must consider the essential metrics that provide insights into the financial health, growth potential and overall value. Understanding these metrics is crucial for investors, stakeholders, and business owners.

#1 Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV)

The CAC (Customer Acquisition Cost) is the total sales and marketing costs incurred to attain one additional consumer. The less your company spends to get an additional customer, the better. There cannot be an average that applies to all companies since it is a different LTV (Customer Lifetime Value). The average amount that a company earns throughout the time a customer pays for the service they subscribe to is the LTV. The higher the amount, the more precious each customer is to the company. Similar to the CAC, the LTV has no average amount that all companies can use.

The amount will differ depending on factors such as the competition, market, business model, etc. The LTV/CAC ratio is required in valuing SaaS companies. These two numbers will be compared to each other to determine a ratio that shows if the company is making more than they are spending to acquire a customer. The ratio will also determine the ROI of the marketing and if the strategies for growth are actually working. Generally, the ideal LTV/CAC ratio is 3 for a majority of SaaS companies. This allows a cushion zone to account for any increase in the CAC or dip in the LTV, and the company will still be able to generate stable gross profit.

#2 Churn Rate

Usually recorded in percentage, the churn rate is the number of customers who stopped using your services by unsubscribing within a specific time period. One of the most important SaaS growth metrics is the churn rate, as it tells investors if the company will be able to sustain growth.

A high Churn rate indicates that it is not suitable for the SaaS recurring business model. The ideal rate is below 10%, if the business has a churn rate below 5%, it will put your company in potential investors’ sweet spot.

#3 Monthly Recurring Revenue (MRR) vs Annual Recurring Revenue (ARR)

Owners are often tempted to sell their annual plans at a reduced price to improve the company cash flow in small or medium self-funded SaaS companies. While this may be necessary in many cases, it holds the company back from the valuation perspective. The SaaS growth metric of revenue that values an investor is based on the periods: Monthly recurring, Annual Recurring, and Lifetime.

Even if the growth is slow, by selling monthly plans, you eventually achieve higher valuations. The MRR often outweighs the advantages of short-term cash flow boost as data shows that it is generally valued around two times more when compared to lifetime plans of equivalent revenue.

An average SaaS company has an MRR to ARR ratio of 5:1. Let us take an example, a company has 10 customers that are paying $200 per month and 5 customers that are paying $100 per month. This makes the MRR $2,500. If 2 customers have subscribed to a yearly renewal agreement for $250 then the ARR will be $500.

These products are generally annually priced at 10-20% lower than the monthly plans. SaaS products that have a higher ratio of annual plans will see a lower valuation. This is because the revenue is not only less predictable but also unstable.

Evaluating SaaS company metrics throughout company lifecycle

As a SaaS company grows, there are different key metrics that you need to know as it helps to understand organizational health. Additionally, it also helps to determine the best way you can optimize your business. Throughout the company lifecycle, the process to determine each metric and its importance keeps changing. Here are the various stages and the key metrics important in them:

• Super early stage – Businesses that are in their super early stage look for product fit and have less detailed financials. As they move on from early-stage funding to Series A the metrics necessary are the MRR and/or ARR, the CAC and the marketing and sales cost.
• Early stage – When the company gains traction and starts to move, they look for expansion and growth through the Series C and D rounds of funding. The key metrics in this stage are: the ratio of CLTV and revenue, gross margin, Churn rates, and ARR.
• Growth stage and Public Companies – In this stage of the life cycle of a company, there are many magical moments such as an IPO. New metrics are on the top of the priority list as the management is not looking at the future to gain more visibility. They look at the overall expenses, deferred revenues, their EBITDA, growth in the number of customers over the years.

Ready to value your SaaS company with Eqvista?

To find a value for your SaaS company, valuation multiples are essential as they all contribute to the valuation. Once you evaluate your company, the next step will be your sale options and exit strategy. It is best to involve a professional broker to give you a good idea of your company’s worth. They will accurately calculate the SDE profit and advise based on the previous transactions and the business assessment.

Eqvista provides services that help your SaaS valuation process through expert analysis, user-friendly tools, and regulatory compliance support. We help SaaS companies achieve accurate valuations that reflect their true market potential, facilitating informed decision-making for growth and investment opportunities. Learn more about our 409a valuation services!