Factors Affecting SaaS Business Valuations
In our work developing valuation analyses for our clients, and based on our experience with public comparables and precedent transactions, we often plot ranges spanning several tens of millions of dollars. Company valuations do fluctuate because there are a host of KPIs that distinguish a highly profitable SaaS company from an average one. Some of these factors are: total addressable market, growth rate, net retention rate, gross margin and payback period. There are also other factors like the value of IP, which are less quantifiable.
Total Addressable Market (TAM)
Investors often consider market size when making a commitment to a company. The Total Addressable Market, also known as TAM, indicates the upper limit, which is the cap on the amount of money a company can actually make. Investors are typically more interested in TAMs larger than $1 billion. Companies operating in smaller markets than this tend to be valued significantly lower, sometimes by as much as twice their value.
Annual Revenue and EBITDA Growth Rates
The most important factor affecting the valuation of a software company is arguably growth rate. It is expected that the larger a company gets, the harder it is for it to retain high levels of growth. Companies bringing in less than $5 million in revenue could receive valuation premiums if they maintain a consistent rate of growth of over 50% every year. Companies with over $5 million in revenue may also receive premiums for a yearly growth rate of over 35%. These premiums change depending on how big a company is, and how they achieve and exceed their growth thresholds. The premiums may range from 1-5 times for a total valuation of 8-10 times LTM. Based on our internal deal experience, SaaS companies get the higher end of the 1-5 times range when they attain more than $10 million in revenue and are maintaining a constant growth rate of 40, 50 or 60% year after year. It is also important to note that growth begets greater valuation, but so does size.
Regular Revenue Retention Rate
Understandably, predictability is often an important concern for buyers; it is an essential assurance for them if they are to retain as many of their customers as possible. This can be attributed to a couple of reasons. To begin with, losing customers causes the addressable market to reduce, and revenues to plummet. High retention of revenues also translates directly to enhanced predictability of cash flow, which naturally factors into the overall value of the company in the long run. With private SaaS businesses, the average net revenue retention rate is 100%. This factors in changes in sales and price fluctuations. For companies with net revenue retention rates of over 100%, buyers are likelier to pay premiums of 1-2 times LTM. Conversely, lower net revenue retention rates attract lower valuations.
Evaluating Comparable Public and Private SaaS Valuations
An effective way to evaluate private company valuations is to study public comparables. In today’s market, the average publicly traded SaaS company is worth approximately 6.9 times its last twelve months of revenue (LTM). Considering private company stock is not as liquid as public stock and much riskier, it trades for much less. As indicated by the assessment made in SaaS Capital’s White Paper: Company Valuation, private company stock is traded for a discount of around 1.3 times. Following this, median private SaaS company will trade for approximately 5.6x (6.9x 1.3x) LTM. You must therefore constantly strive to find the thing that increases the value of a company, an important question we always pose.
Gross Margin and Net Margin
Gross margins are an effective method of analyzing scalability and profitability. The costs not incurred directly which are necessary for delivering the software are also dependent on the associated revenue; if the costs are fewer, the revenue ends up being higher. Today, a private SaaS company has an average gross margin of 84%. If such a company’s gross margin goes beyond 85%, it may qualify for an increase in valuation. Conversely, SaaS companies with gross margins lower than 75% are likely to receive valuation penalties.
Customer Acquisition Costs and Payback Period
Customer Acquisition Costs (CAC) and payback period are equally important considerations for most buyers looking to invest in or acquire a SaaS company.A good yardstick of a company’s core unit economics and success is how efficiently it uses sales and marketing expenditure to generate new customers. The CAC ratio is a customer’s lifetime value and divides it by the company’s CAC. The perfect CAC ratio is 3:1. A CAC ratio of 1:1 means the company is spending more than it should on acquiring new customers. Similarly, a company with a CAC ratio of 5:1 is not spending enough.
The payback period is just as important. This is how long a company takes to regain any funds spent invested for the acquisition of new customers. Private SaaS companies which take less than a year to recoup these costs are often awarded valuation premiums. Companies with longer payback periods, on the other hand, may receive lower valuations.
Other SaaS Valuation Considerations
SaaS company valuations may also be affected by a host of other factors, some of which cannot be quantified as easily. These include such considerations as being in a market leading position, having valuable IP or being part of a highly effective management team. Any of these can result in higher valuations. We have learnt from our vast experience that an important question for many people looking to invest or acquire ends up being whether they should buy or build. Is it more pertinent to buy a company with already established technological capabilities, or to build this technology for oneself?
For some of the companies we have sold, we are confident to report that this dynamic played a significant role in valuation. We were able to show the buyer that waiting to create and implement certain technology was a lengthy and complicated process, one that would cost them time as well as the potential market opportunity. With this evaluation in mind, the buyer increased their offer significantly. It’s a typical build-vs-buy scenario internal analysis. Buy wins.
In summary, valuations for middle-market technology companies and SaaS companies tend to be subjective. However, taking note of certain metrics like growth rate, gross margin and period of payback can help you improve the valuation of your company in anticipation of a capital raise or M&A process.
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