SaaS Valuation 101 

September 2023

This year the SaaS market is experiencing significant "value compression," characterized by declining revenue multiples, slower growth, and increased scrutiny from investors. This shift is indicative of a broader macroeconomic reset in which rising interest rates, inflation, and fears of a recession have led to a change in investor priorities toward relentless growth with a greater emphasis on sustainable unit economics.

A variety of factors catalyze this compression of value. First, the increased cost of capital, associated with growing interest rates, reduced risk tolerance among investors. This suggests that a real shift has occurred toward profitability over speculative growth and, ultimately, depressed SaaS company valuations. As future cash flows are discounted, so too do the multiples contract, and investment restraint ensues.

The reality today, in fact, is such that many of the SaaS companies that saw great times during and just post pandemic due to digital transformation now face the challenge of slow adoption. Indeed, it has become difficult to sustain these aggressive growth narratives, which were so convincing earlier, with the evolution of market dynamics. Moreover, markets for some sectors, including martech and HRtech, have become too crowded-a factor eroding pricing power and impacting customer retention as well.

Investor caution is palpable, particularly as it pertains to public SaaS. Benchmarks, like Nasdaq's BVP Cloud Index, have collapsed 30-50% plus from highs in 2021. That trend trickles down into private markets where buyers and investors are increasingly demanding their resources are deployed only when the pathway to profitability is clearer.

With these dynamics, SaaS companies have little choice but to understand the drivers of valuations. In fact, paying full attention to sustainable growth with strong unit economics could keep them winning in this environment and position them very well for any future capital raises or potential mergers and acquisitions.

The main drivers of SaaS valuations are essential in helping companies position themselves strategically for capital raises or mergers and acquisitions. These drivers of valuation go beyond the financial performance into market trends, operational efficiency, and qualitative components that show the long-term growth potential and stability of the business. By acknowledging these factors, companies can further refine their operations, enhance their positioning in the market, and thereby negotiate more favorable terms for funding rounds or acquisition deals.

SaaS valuation refers to the process of ascertaining the present and future value of a SaaS company, largely hinged on its growth trajectory. As a SaaS business grows in stages, so do the factors affecting its valuation. Early-stage companies usually depend on founder-market fit and growth potential. Founders and the market tehy are targeting can often be the biggest drivers in increasing valuation by painting a compelling vision to investors. On the other hand, later-stage companies are focused on metrics such as net revenue retention and free cash flow. At Series B, a company has already demonstrated the ability to gain customers and grow revenue. Formal revenue multiples, net revenue retention, and profitability become key factors in valuation from Series C onward.

Different valuation methods apply to the firm's different stages and characteristics. Revenue multiples can thus be applicable in high-growth phases for private SaaS companies. This is in cases where normally investors benchmark the startups based on revenue growth. The SaaS Multiples Method is a common approach determined by using the formula: Company Value = Multiple × Value Driver. Some of the main value drivers under this method are revenue, revenue growth, and profit.

B2B SaaS companies are typically valued based on a multiple of annualized recurring revenue (ARR). This multiple depends on factors like ARR growth rate, net revenue retention, and SaaS market benchmarks. ARR multiples reflect the net present value of future profits, making SaaS businesses attractive to investors due to their high and predictable growth

The appropriate valuation multiple is a combination of both the company's characteristics and wider market conditions. Valuation benchmarks are important to a buyer or investor. In general, companies with less than $1 million in annual recurring revenue command a revenue multiple of around 2-3x. This type of firm focuses on acquiring much smaller SaaS businesses; often, they want to see high profitability, such as 80%, and also want a short payback period, for instance, two years. Revenue growth is one of the biggest determinants in valuation, where the higher growth in ARR, the lower the average multiple. On the flip side, revenue multiples are positively influenced by high revenue growth rates, which can push a business into a higher valuation category.

Multiple arbitrage is another way to increase valuations without improvements in operations. SaaS roll-ups, in which several companies are combined into one entity, often achieve a higher multiple than the individual companies would independently. Understanding SaaS valuations is critical throughout the business lifecycle, from acquisition to operation and eventual sale. An inaccurate valuation can lead to costly mistakes, such as overpaying during acquisitions or selling below value. Unrealistic pricing is one of the top reasons SaaS sales fail.

Basically, valuations control the dynamics of the market and intended strategies that buyers would perform post-acquisition. Goals by a firm in choosing an approach, together with experience and the risk tolerance it has, go a long way in deciding valuation approaches. A larger public company prefers using the EBITDA metric as that reflects operating profitability and operational continuity. The utilization of SDE is carried on during mergers and acquisitions concerning smaller businesses and owner-operated ones.

Revenue-based valuation metrics are another set of insights into the value of a SaaS company. The key metrics include ARR, growth rate, net revenue retention, which is an indication of the quality of the product or service, and gross margin, which is a measure of profitability. Non-ARR revenue lines, such as services, implementation, or ancillary hardware revenue, usually receive little or no valuation credit. These streams are normally valued separately using traditional measures and added to the SaaS valuation.

How to Value a SaaS Business: Valuation Methods

Valuation methods are vital in determining the financial value of SaaS businesses. These valuation methods allow different stakeholders to make informed decisions about acquisitions, sales, or strategic growth initiatives. The following are the main methods of valuation in the SaaS industry:

EBITDA Valuation Method

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization-this is another method for estimating the general performance of a company. This method will be used for established SaaS companies with an ARR of $20 million and above. This will give insight into how well a company operates in profitability and is preferred when one intends on long-term sustainability.

SDE Valuation Method

SDE (Seller's Discretionary Earnings) works well for single-owner, under-$5 million-ARR SaaS businesses. This methodology derives the amount of annual profit a single owner may expect, so it fits the operations which depend on an owner's extensive participation.

Revenue Multiple Method

It provides a multiple valuation of a firm from its annual recurring revenue. The method has traditionally been employed to determine privately-held SaaS company valuations. Revenue multiples provide a decent estimate for those companies whose model comprises recurring revenue because they exhibit an explicit future growth potential, besides revenue stability.

Textbook Valuation Formula

A simplified formula to determine an approximate value of SaaS companies includes the following four measures:

The quick and dirty formula is: 10 x ARR x Growth Rate x NRR, the resulting figure adjusted up or down based on gross margin.

The Importance of SaaS Valuation Information

Access to accurate valuation information has wide-ranging impacts on SaaS company owners, potential buyers, and management teams. This further influences the selection of the right valuation multiples for acquisition, sale, or exit.

Key Valuation Considerations


Key Considerations for Multiples

This comprehensive understanding of SaaS valuation methods and influencing factors enables better decision-making for stakeholders in the dynamic SaaS market landscape.

SaaS Valuation Drivers

Everything put together, the valuation of SaaS companies wades into both investor and business strategy perspectives. TRADITIONAL DATA: Historic data is very important in SaaS valuation. It helps in giving as accurate records of financials, which in turn provide more precise valuation metrics to inspire investor confidence in the financial stability of the company.

Management Team: A strong and growing management team contributes to good valuation. It's an indication that the business is growing with a solid headcount plan with great thoughtfulness, where responsibilities are given out without excessive cash flow and burning rate.

Geographical Impact: The valuations of SaaS differ based on different global markets. Fundamentally, US SaaS companies tend to have higher valuation multiples compared to Canadian and European companies. Although the average multiple achieved by US companies stands at 9.3x, the respective multiples achieved by Canadian and European companies stand at 6.7x and 6.2x in that order.

Scale: Growth equity firms investing in smaller SaaS companies within market caps of US$10 million to US$250 million tend to realize huge returns through scaling such businesses.

EBIT Profitability: The increasing cost of the capital has made investors cautious; therefore, the software firms need to prove that they are near to medium-term profitable.

Total Addressable Market (TAM): This is very important in valuation. A big growing TAM means high upside, thus making the business more attractive for investors. For example, a $50 million ARR business with a TAM of only $100 million would need to expand to attract the next level of investment.

Product Differentiation and Competitive Advantages: Unique product offerings and ownership of IP can be key valuation drivers, enhancing the defensibility of products within a competitive marketplace. Conversely, "me-too" products generally create valuation headwinds.

 Stage-Specific Valuation Considerations

• Pre-revenue/Early-stage: This is often priced in based upon the founder's ask, the product pipeline, and perceived market opportunity.

• Growth Stage: Revenue multiples and growth rate become the main drivers.

• Mature Stage: EBITDA, SDE, and cash flow become relevant to the profitability metrics.

Pre-revenue companies usually go through less stringent valuation processes, where valuations are majorly driven by the founders based on their projections.

Qualitative Factors and Due Diligence

In addition to quantitative reasons, qualitative reasons are also vital in valuation. This ranges from the management team to company culture and the underlying business story. Cultural fit is an important factor in any acquisition for operational continuity.

Transparency and cooperation from the seller is key to due diligence. Signals of issues or problems would be deceit, refusing to show all information, or unclear ownership of IP. Complete information from a cooperative seller means that is a good omen.

Multiples and Market Assumptions

They should not look in isolation at the multiples but also consider other factors like FCF conversion, discount rates, and growth assumptions. And lastly, interest rates play an important role. Interest rates fell during COVID-19, and that buoyed up the multiples. But interest rates and the cost of capital must be put into a realistic long-term perspective as a base for valuation.

This has raised several red flags pertaining to overvaluation of assets and incorrect assumptions over FCF margins. Current multiples may implicitly assume AI-driven margin improvements, but future growth for public SaaS businesses is unlikely to exceed historical trends.

Importance of Net Dollar Retention (NDR)

NDR accounts for the revenue a business generates from its current customer base, excluding the acquisition of new customers. The positive value of NDR signifies that expansion revenue due to upgrades, cross-sales, and increases based on use outpaces the one lost because of churn or downgrades. An NDR of 140% can yield a higher valuation than 100% year-on-year revenue growth.

Why Investors Care About NDR:

§  High churn and CAC can offset high ARR and revenue growth.

§  Revenue from existing customers is more valuable since CAC has already been paid.

§  Generating revenue from existing customers increases lifetime value while keeping CAC stable.

How to Calculate NDR: To find NDR, take the ARR at the beginning of the period, add expansion revenue, subtract churn and downgrade-related income loss, and divide by the starting ARR. Multiply by 100 to get the NDR rate.

Strategies to Improve NDR:

§  Upsell and Push Upgrades: Provide free trials for higher-tier options to encourage users to choose premium features.

§  Introduce Usage-Based Pricing: Let your user pay more organically by increasing their usage.

§  Sell Services with the Product: Sometimes, bundling services together with software can multiply revenue in a very short time, shorten payback periods, and improve user success.

Ultimately, SaaS valuation is a multi-faceted dynamic process dependent on quantitative and qualitative elements; maximum value can only be realized and proper investment decisions made when these elements are fully known.

Adding Value to a SaaS Business

Maximizing value for a SaaS business prior to sale demands a strategic and multi-faceted approach. Combining the highest levels of financial optimization with operational improvements and customer-centric initiatives will significantly drive valuation outcomes. Below are some key steps and considerations:

Shifting Valuation Focus

Historically, growth rate has been the leading driver for SaaS valuations, followed by retention rates, gross margins, market size, and sales efficiency. Profitability now plays a much more critical role as the market shifts. Today, investors increasingly look for businesses that demonstrate a solid path to sustainable cash flow and net income.

Subjectivity of Profitability

What constitutes profitability will differ from investor to investor. For some, it's a matter of actual cash flow; for others, it's a function of accounting measures such as EBITDA. Whatever the definition, profitability is invariably tied to sales efficiency and effective cash flow management.

Strategies to Enhance Valuation

1. Enhance Sales Efficiency

As interest rates and the cost of capital grow, sales efficiency and closing in on break-even become very important. Founders can increase profitability by:

• Strategic price increases.

• Streamlining the sales process to lower acquisition costs.

• Cutting unnecessary expenses.

2. Reduce Churn

A reduced churn rate points toward a very satisfied customer base and stability. Onboarding programs, great customer service, and optimization of the product will keep customers and preserve recurring revenue.

3. Optimize Pricing

Execute comprehensive pricing that can considerably increase revenues. It involves understanding customer behavior and value perception and finding a balance between affordable and profitable, considering competitor pricing. 4. Protect Intellectual Property and Brand Strong intellectual property rights and brand protection go a long way in making a SaaS business more defensible and hence more attractive to buyers. 5. Solidify Marketing Infrastructure

New acquisition channel development and diversification create a strong marketing strategy that can assure sustainable growth. Indeed, good marketing practices do reflect a firm's capabilities of attracting and maintaining its clientele with minimal costs.

6. Development of New Products or Revenue Streams

The introduction of new products or revenue streams with at least three to six months of proven performance can dramatically increase valuation.

7. Standardization and Process Documentation

This helps at the time of transition to new ownership and adds value to your business due to properly documented operating procedures and knowledge transfer protocols. 

Key Drivers of SaaS Business Valuation

Valuation of a SaaS business considers both quantitative and qualitative factors in detail. Each factor plays an important role in determining the overall value of the company, which guides the decision-making process of potential buyers and investors.

Quantitative Factors: The Hard Metrics

Quantitative factors provide objective insights into the financial health and performance of a business. They are often less open to interpretation and are evaluated using a scorecard ranging from "poor" to "excellent," weighted by importance.

1. Annual Recurring Revenue (ARR) / Recurring Revenue Growth

Growth in ARR is a key metric for the SaaS company. Companies with growth rates of 30% to 40% or more are considered excellent. Fast-growing companies usually command a higher valuation because of their potential to expand in the future.

2. Rule of 40

This benchmark combines the growth rate and the EBITDA margin, with a combined figure of 40% or higher considered excellent. It has been used as a balanced metric between profitability and growth.

3. Gross Revenue Retention Rate: The revenue retained from existing customers, with >90% retention considered excellent. High retention rates ensure customers are satisfied and revenues predictable.

4. Net Revenue Retention Rate

Net revenue retention includes expansion revenue from existing customers. A rate of more than 100% is considered excellent and means upsells and cross-sells compensate for churning in a positive way.

5. Lifetime Value to Customer Acquisition Cost (LTV: CAC) Ratio  

This metric measures customer profitability and marketing efficiency. A great ratio ranges between 8.0x and 10.0x or higher, indicating that customers bring in much value over the long term compared to their acquisition costs.

6. Percentage of Recurring Revenue  

Recurring revenue offers predictability. Companies with more than 90% recurring revenue are considered very attractive.

7. Gross Margins

Gross margins will be indicative of the scalability of the business model. Anything more than 80% margin is excellent for a SaaS company.

8. Client Concentration

This would relate to a measure of the revenues generated from the top 10 clients. Less than 20% concentration is excellent; it means that revenues are diversified and stable.

9. Total Revenue

While this is important, it represents lesser significant weight compared to growth metrics. It doesn't capture customer experience or retention trends as well.

10. EBITDA Margin

The EBITDA margin measures profitability, and the margins above 30% are considered excellent.

Qualitative Factors: The Intangible Elements

These qualitative factors are going to be much more subjective and require additional insight into the marketplace dynamics and strategic positioning of the company.

1. Delivery Model Cloud-based or service-oriented delivery models are preferred since it is highly scalable and flexible.

2. Product Differentiation

A well-differentiated product offering places a company for competitive advantage and premium valuation.

3. Technology Leadership

Those businesses which on the back of leading-edge technology are considered great as innovation in most cases leads to customer adoption.

4. Market Growth

Operating in a fast-growing market is an advantage and indicative of future growth potential.

5. Market Attractiveness

Investors like high demand markets and relatively better competitive landscapes.

6. Management Team

A deep and capable management team speaks to operational stability and strategic foresight.

7. Total Addressable Market

Evidence of a large, unserviced market would underpin future scale:

8. Market Position

Strong market position through brand recognition and customer loyalty may increase the valuation in which:

By evaluating both quantitative and qualitative factors, investors can develop a holistic view of a SaaS business's value, identifying growth opportunities and potential risks. Understanding these metrics allows business owners to make informed decisions to enhance valuation and secure favorable capital raise and exit strategies.