Creating a software-based startup is one of the most profitable and least expensive domains to enter. The SaaS industry is closing the year with nearly $151 billion in revenue and shows no signs of slowing down. Due to its steady pace of growth, more entrepreneurs come up with innovative software ideas and seek funding to make their idea a reality.
If you find yourself in a similar situation, it’s important to learn how to value a SaaS company. Once you have a better idea of the company’s net worth, you will be better equipped to deal with investment opportunities.
In this article, we outline all the different methods you can use to value your software product depending on the size of your company’s growth. We explain the steps you need to follow when performing an initial assessment, what KPIs to monitor, and other factors that come into play.
How are SaaS companies valued?
Generally speaking, there are two ways to value a SaaS company before you seek external funding. The method you choose to use for your calculations will depend on the current state of your company. In the following chapters, we will explain each of the methods in detail.
How to value a SaaS business - SDE vs. EBITDA
The two different methods you can use to calculate the value of your business are based on:
- Seller’s Discretionary Earnings (SDE)
- Revenue after expenses (EBITDA)
Each metric indicates a different amount and is used to understand different things about your company. Let’s take a look at each method and which one you should use to calculate the value of your company.
What is SDE - Owner earnings
SDE, or Seller’s Discretionary Earnings, is an excellent metric for smaller businesses. SDE represents profitability and adequately measures the underlying earning potential of a company.
For investors: SDE represents the total amount of money a company generates which can be distributed or reinvested in the venture.
For founders: SDE is closely linked to the value of your business. Valuation methods use SDE plus an additional multiplier (that depends on certain factors like sector, growth stage, comparable sales, etc.) to discover the company’s value.
The formula used to calculate your SDE is quite complex, so you might need to watch (and rewatch) the following video to better understand the steps you need to follow:
In short, SDE = Revenue - Operating Expenses - Cost of Goods + Owner Earnings
Since the formula goes through several components of an income statement it can be quite complex for someone with no experience in accounting. Once you manage to get a grip of it, however, you will be able to accurately track the value of your business as it keeps on growing.
Note that SDE is best used to value startups that are growing by less than 50% year over year or generate less than $5m annually. Once the growth of a company exceeds this benchmark, valuators will usually choose EBITDA to calculate the company’s value, as SDE can become less accurate with more parties involved.
Based on revenue minus expenses - EBITDA
Once a SaaS business exceeds the criteria just mentioned, EBITDA becomes the preferred method of valuation. In short, EBITDA stands for the total revenue of a business after expenses have been subtracted. Here’s the formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
This formula better captures a growing business's complexities, from salary compensation and discretionary expenses all the way to owners’ salaries.
EBITDA vs Cash flow analysis
Let us also briefly touch upon the difference between EBITDA and cash flow analysis, as they are both important for founders and investors. While EBITDA is offering a general scope of a business’s health, it does not offer a complete picture, considering things like loan interest, investment income, and taxes. Cash flow analysis is often used to cross-compare these items and get a better image of the business’s health.
The following video gives a more detailed explanation of the differences between the two methods:
Calculating value based on projections and estimations
Although SDE and EBITDA are the most common ways of valuing a SaaS company, you can implement more methods when trying to understand how to value a SaaS company. For example, if your company has just built its MVP product and is not yet generating revenue, you can only make assumptions based on industry data. In this case, the estimated valuation will fluctuate quite a bit and is not very reliable when looking to raise a specific amount of money.
Even established and profitable SaaS companies use such estimations to project additional cash flow for things like subscription-based use participation or fast-approaching product releases.
How to value a saas company - The initial assessment
An initial assessment looks at everything that surrounds the performance of your business and usually determines the long-term viability of a business within a particular industry. Here are the things you need to consider:
- Age of the company
- Owner involvement
- Growth trends
- Churn and other various SaaS metrics
Age of a company
Generally speaking, to prove the validity of the business, product, and general concept, SaaS companies need at least 2 years in the market. After 3 years, the business starts to get a premium on its valuation, given that it has established a user base.
The more passive (or automated) the business is, the more appealing it is to investors. If the founder needs to put in a lot of work to run the business, the overall value will eventually drop.
In regards to raising capital, owner involvement may be less relevant, but helps you understand how detailed the initial assessment is when learning how to value a SaaS company.
Any company seeking investment needs to show active involvement in industry-related trends, and how these result in sustainable growth over time. The quicker the rate of growth, the higher the valuation.
Churn is a word that refers to the average loss rate of customers. It is a critical component when evaluating a SaaS company since most operate on subscription-based models. Potential investors will want to ensure that churn rates are at least lower than new acquisitions.
Other metrics you may consider are the customer’s lifetime value (CLV), as well as the cost to acquire the customer.
Checking performance - important KPIs for saas companies
Time to dive deeper into some of those critical metrics mentioned earlier. We will refer to these as key performance indicators (KPIs).
Observing the churn rates of a software product is one of the most important metrics to consider, and indicates when (and if) a startup needs to introduce changes to the product, its design, or the way customers use it.
- A high churn rate indicates an inferior product, lack of product-market fit, or a preference for competitors. A feedback session usually helps out to resolve such issues.
- According to Bessemer Venture Partners, aproximatelly 5-7% annual churn is acceptable for larger SaaS businesses.
- Smaller SaaS companies can operate with higher churn rates, depending on their stage of growth and industry type.
Cost of Acquisition and CLV
- The lower your cost of acquisition compared to the CLV, the better.
- There are no benchmarks for these numbers, but acquisition costs are part of marketing, and marketing usually allocates 5%-20% of revenue towards acquisition and retention strategies.
- Generally speaking, the cost of acquisition should not exceed 30% of the customer’s lifetime value.
MRR and ARR
- MRR refers to Monthly Recurring Revenue, whereas ARR refers to Annual Recurring Revenue.
- MRR is more accurate when calculating revenue numbers, and gives a better idea of the eventual valuation numbers for the company in question.
Other factors to keep in mind
Although the previous metrics are comprehensive, there are still more factors to consider. These are:
Customer acquisition channels
- Channel spread: the more diverse a company’s acquisition channels, the better. This prevents dependency on any one channel and proves that there is a market for the product across many types of channels.
- Channel competition: When learning how to value a SaaS company, it is important to know the defensiveness of each acquisition channel. Channels whose organic presence is strong lead to more visitors. This is more sustainable in the long run and helps companies understand their audience. Although paid customer acquisition is a great short term fix, it is costly and doesn’t compound as organic marketing does.
- Conversion: Traffic and clicks are great, but you will eventually need to turn these into leads and customers. The % of traffic that converts into paid customers is an important metric to consider when trying to establish the net worth of your company.
- All companies go through several lifecycles and need to follow roadmaps to ensure their ability to track and achieve goals. Being able to indicate the ability to meet deadlines and achieve growth benchmarks is also a good way to bump up your company’s valuation.
- Ideally, when a SaaS company seeks funding, the business model should follow an upward trajectory and indicate a healthy return on your efforts.
- This is a bit paradoxical. Most investors are not technical, so the simpler you explain the concept of your business, the higher your chances of getting funding.
- That said, the more technical the company (and thus harder to copy), the higher its perceived value. If the product is unique, the competition is less, which means that the market share it attracts is higher.
- When looking to value a SaaS company, make sure that business relationships are already set in place. Technical outsourcing, for example, should be a given if the company does not wish to do so in house. This way, the core team can focus on sales, marketing, and relationships, while external partners take care of product development.
Figuring out how to value a SaaS company can be unclear, especially when you wish to do so on your own. Here are the most important takeaways:
- There are two methods for valuing a SaaS company: SDE, EBITDA. You can also measure a company’s value by looking purely at their revenue, but this won’t say much and is rather inadequate to the other two options.
- During the initial assessment, consider a company’s age, owner involvement, industry-related trends, and churn rate.
- Closely monitor churn, your customer’s acquisition costs and lifetime value, MRR vs ARR, and other key factors mentioned above
We hope that this article gives you a better understanding of how to value a SaaS company. For further reading, make sure you check out our marketing tips for SaaS startups.