How to value a software company?
Given that some of the most highly valued companies in the US are software companies, this sector is bound to attract investors and breed innovation. Accurate software company valuation has thus become a critical skill for investors, analysts, and business leaders.
So, let us help you build an understanding of exactly how software companies are valued. In this article, you will see an overview of the software industry in 2024, the best practices for software company valuation, and an example of software company valuation. Read on to know more!

Software industry overview
In 2024, of the 20 most valued publicly listed American companies, 9 are software companies. Unsurprisingly, companies like Microsoft, Oracle, Salesforce, and Adobe are leading the pack in the software sector.
In a report published in March, Morningstar stated that it expected this sector to grow at more than 10% from 2024 to 2027. In the same report, it also noted the importance of switching costs in driving customer retention.
Hence, currently, it is important for software companies to build products that integrate well with related existing processes or to provide a comprehensive solution. Such software products will be difficult to swap out once users get used to them.
According to Gartner, 92% of businesses are considering AI-powered software investments in 2024. The consulting firm also noted that the main concern for 49% of software users is price, while 48% are most concerned with security, and 44% with integration support.
Best practices in software company valuations
Some of the best practices for software company valuations:
Critical mass consideration
The concept of critical mass, originating from economics, refers to a point at which a user base grows large enough for adoption to become self-sustaining, leading to further growth. This concept applies to products like software which can have network effects.
According to McKinsey, at successful SaaS companies, the sum of growth rates and free cash flow rates is higher than 40% and only one in three SaaS companies ever reaches this level. This is called the Rule of 40 and if a company reaches this level, we can assume that it has achieved critical mass.
McKinsey also states that only 16% of companies can continuously perform at this level.
When we make future cash flow projections, we must incorporate these expectations of reaching critical mass. We will see this in the software company valuation example below.
Using a combination of valuation approaches
Software companies can create value for their shareholders through dividend distributions, the sale of intellectual property (IP) rights, and acquisitions. So, in a software company valuation, to capture the value of all these payouts, we must use a combination of valuation approaches.
The income approach helps us estimate the value from dividend distributions, the asset-based approach looks at the value of the IP portfolio, and the market approach estimates the income from potential acquisitions.
Use recurring revenues in your models
Generally, we can divide software users into subscribers and one-time users. Subscribers have found the software valuable and will continue paying for the service. One-time users, on the other hand, are merely testing whether the software fits their needs, with no guarantee of future purchases.
By focusing on recurring revenues from subscribers, companies can build a more predictable and sustainable income stream. This model also fosters long-term customer relationships, as businesses can continuously improve and tailor their offerings based on subscriber feedback and usage patterns”- points out Oliver Auerbach, CEO of Time Tailor.
Hence, the revenue from subscriptions, i.e. the recurring revenues, should be used for software company valuation. This will give you a more accurate picture of the company’s ability to retain customers and build a user base over time.
Software company valuation example
In this software company valuation example, we will be valuing OxyGenesys, a software-as-a-service (SaaS) company. We will use a combination of income, market, and asset-based approaches. The company has not reached critical mass yet.
Income approach
We use the discounted cash flows (DCF) method for valuing OxyGenesys and the discounting rate will be 25%.
We know the following facts about OxyGenesys:
- Net profit margin of 20% on sales
- If critical mass is reached in 2 years, its sales revenue will quadruple in the next year and then grow at 40% annually.
- If not, then it will continue growing at 30% for 3 more years.
OxyGenesys’ financial history is as follows:
Year | Sales revenue (in millions) | Recurring Revenue (in millions) | Annual Growth Rate |
---|---|---|---|
2020 | $18.00 | $15.00 | 10% |
2021 | $20.16 | $16.80 | 12% |
2022 | $23.18 | $19.32 | 15% |
2023 | $27.59 | $22.99 | 19% |
2024 | $34.21 | $28.51 | 24% |
Based on this, let us project OxyGenesys’ cash flows. As discussed above, we will consider the recurring revenue for DCF calculations.
Scenario 1: Critical mass reached
Year | Sales revenue (in millions) | Recurring Revenue (in millions) | Annual Growth Rate | Expenses (in millions) | Free cash flow (in millions) | Discounted cash flow (in millions) |
---|---|---|---|---|---|---|
2025 | $44.47 | $37.06 | 30% | $35.58 | $1.48 | $1.19 |
2026 | $60.48 | $50.40 | 36% | $48.39 | $2.02 | $1.29 |
2027 | $241.94 | $201.61 | 300% | $193.55 | $8.06 | $4.13 |
2028 | $338.71 | $282.26 | 40% | $270.97 | $11.29 | $4.62 |
2029 | $474.19 | $395.16 | 40% | $379.35 | $15.81 | $5.18 |
Scenario 2: Critical mass not reached
Year | Sales revenue | Recurring Revenue | Annual Growth Rate (%) | Expenses | Free cash flow | Discounted cash flow |
---|---|---|---|---|---|---|
2025 | $44.47 | $37.06 | 30% | $35.58 | $1.48 | $1.19 |
2026 | $60.48 | $50.40 | 36% | $48.39 | $2.02 | $1.29 |
2027 | $78.63 | $65.52 | 30% | $62.90 | $2.62 | $1.34 |
2028 | $102.22 | $85.18 | 30% | $81.77 | $3.41 | $1.40 |
2029 | $132.88 | $110.74 | 30% | $106.31 | $4.43 | $1.45 |
The valuation for OxyGenesys will be the total discounted net profits. Only 1/3rd of all SaaS companies will achieve Rule of 40 and only 16% can maintain this level. This means that, as per our earlier discussion, only 5.33% (16% × 1/3) of companies can achieve critical mass. Based on this, we will assign weights to both scenarios.
Scenario | Valuation | Weight | Weighted valuation |
---|---|---|---|
Critical mass reached | $16.41 | 5.33% | $0.88 |
Critical mass not reached | $6.67 | 94.67% | $6.31 |
Valuation as per income approach (Total) | $7.18 |
Market approach
The details of peers of OxyGenesys who were listed or recently were involved in mergers and acquisitions (M&As) and funding rounds are as follows:
Company Name | Recurring Revenue (in millions) | Valuation (in millions) |
---|---|---|
SoftWave Systems | $1.25 | $4.50 |
CloudNexus | $0.82 | $3.00 |
NextGen Solutions | $1.00 | $3.75 |
DataStream Inc. | $1.50 | $5.00 |
SysPro Analytics | $0.95 | $3.30 |
To calculate the market valuation multiple, we must divide the total valuation by the total recurring revenues of all companies in the market.
Market valuation multiple = Total valuation of all companies/Total recurring revenues of all companies
In this example, the total valuation of all companies in the market is $19.55 million and the total recurring revenues are $5.52 million.
So, market valuation multiple = $19.55 million ÷ $5.52 million
= 3.54
When we apply this market valuation multiple to OxyGenesys’ expected recurring revenue in 2024, we will find its valuation.
OxyGenesys valuation = Expected recurring revenue in 2024 × Market valuation multiples
= $1.14 million × 3.54
= $4.04 million
Asset-based approach
In the asset-based approach, we simply review OxyGenesys’ balance sheet and subtract total liabilities from total assets.
OxyGenesys’ balance sheet items look like this:
Particulars | Estimated Value (in millions) |
---|---|
Assets | |
Cash | $1.00 |
Software/IP (at cost) | $3.50 |
Customer Contracts | $2.00 |
Office Equipment | $0.20 |
Goodwill | $0.50 |
Total Assets | $7.20 |
Liabilities | |
Accounts Payable | $0.30 |
Debt | $1.50 |
Total Liabilities | $1.80 |
So, OxyGenesys valuation = Total assets – Total liabilities
= $7.2 million – $1.8 million
= $5.4 million
Final valuation
Since OxyGenesys is nearing critical mass, it is unlikely to consider IP sales or acquisition. Therefore, we should assign more weight to the income approach than the other methods.
Approach | Valuation (in millions) (A) | Weight (B) | Weighted valuation (in millions) (A × B) |
---|---|---|---|
Income | $7.18 | 0.6 | $4.31 |
Market | $4.04 | 0.2 | $0.81 |
Asset-based | $5.40 | 0.2 | $1.08 |
The final valuation of OxyGenesys (Total): $6.20
Decode the value of your software company with Eqvista!
Valuing software companies requires a nuanced methodology that combines a modified version of the income approach with market and asset-based approaches. The critical mass concept, combining various valuation methods, and focusing on recurring revenues are also key to accurate assessments.
We demonstrated these points through the OxyGenesys example where, in the income approach, we took a weighted average of the cases where the company would and would not reach critical mass.
By applying the theoretical knowledge presented in this article, investors and analysts can better understand the true value and potential of software companies in an ever-evolving market.
To get an accurate and detailed software valuation report, consider relying on Eqvista’s NACVA-certified valuation analysts. Contact us to know more!