The software as a service (SaaS) industry is undergoing rapid growth. Data from Deloitte shows that the industry has grown by 25% each year since 2011, and that trend is only accelerating. This trend makes SaaS valuation increasingly important.
This thriving market has led to significant competition among investors and venture capital to invest in and acquire SaaS companies of any size or stage of growth.
However, the SaaS business model is highly unconventional compared to more traditional businesses. This makes determining an accurate SaaS valuation difficult. By ensuring that the appropriate methods and models are used, SaaS companies can attain more accurate, higher valuations that provide leverage when seeking financing or negotiating sales.
Start-ups and small or medium-sized SaaS companies won’t have the necessary finance roles to handle creating an accurate valuation. Instead, they can rely on fractional CFO services for a variety of their needs, including valuation.
Why Do I Need a SaaS Valuation?
A SaaS valuation is useful to businesses at different stages of growth in different ways. One of the most important times that you’ll need an accurate and reliable valuation is when you go to sell your business. Most buyers will have high standards for the rigor of your valuation, and any mistake could cost you the deal.
In most cases, you’ll need five years of clean books to make the most of any sale opportunity. Beyond that, you’ll also need forward-looking information that clearly demonstrates future prospects. Putting together this information for a valuation ahead of a sale is a major undertaking that you’ll want professionals to handle.
Seeking out investors is another key point in your company’s long-term growth, where the right valuation can make all the difference. SaaS is a notoriously investment-driven industry where companies can go years before reaching profitability. You need to be able to demonstrate the value of your company convincingly if you want to bring in the venture capital you need.
Valuation also plays a role in acquiring credit and financing for your business.
Having an accurate valuation may be needed for routine business activities. You may have equity-based pay arrangements with certain employees that require a valuation to determine these incentives. Your valuation also provides key insights into the current state of your business and its growth over time, allowing you to make the best decisions for your company.
Determining SaaS Valuation With Annual Recurring Revenue
SaaS businesses can operate very differently from other software companies, so it’s important to choose the right approach when considering valuation. One of the most commonly accepted standards when it comes to SaaS valuation is the annual recurring revenue (ARR) model.
ARR is a type of revenue model that properly accounts for recurring revenue such as subscriptions and other contractual agreements. The cash flow from these sources isn’t the same as from individual product sales, and the ARR model ensures that SaaS company valuations accurately reflect the value of recurring revenue.
Calculating ARR relies on determining total contract value, which isn’t always as straightforward as it might sound. Properly handling onboarding and hardware costs associated with services, along with other irregular components of any contract, requires insight into the technical details of valuation methods.
Due to the complexity of this method, your SaaS company may want the help of a firm that offers fractional CFO services to ensure that your valuation is accurate and reliable. With a proper ARR valuation, your business can enjoy a variety of benefits.
ARR provides key insights into your business that can serve to improve forecasting and allow your business to take action to ensure continued revenue growth, minimize churn rate, and better understand the overall state of your company.
ARR provides an accurate picture of revenue for most SaaS companies. Other SaaS metrics may be appropriate depending on your individual business model. Similar methods can be used based on monthly recurring revenue (MRR), and there are a variety of other approaches using gross margin and other metrics.
SaaS Company Valuation Multiples
Once your business does have a clear and accurate understanding of its revenue, there’s still the challenge of deriving the valuation from those numbers. SaaS valuation multiples are values that revenue can be multiplied by in order to arrive at the final valuation.
Revenue multiples may be used for a variety of businesses, with those multiples having different values depending on the industry, location, business size, and other factors. SaaS is far too broad a field to have a single SaaS multiple to handle all cases, so there is instead a range that can account for many variables.
SaaS businesses’ key aspects – sustainability, transferability, scalability
When considering SaaS multiples, the three most important factors are the sustainability, transferability, and scalability of the business.
Evaluating these factors can be challenging, as they encompass a broad assortment of information about your business.
The number and nature of employees, business size and growth rate, income trends, competition within the niche, and many more all play a part.
The age of a SaaS business is one of the most important aspects of its valuation. Research from Startup Genome shows that 9 out of 10 start-ups eventually fail. Most of those failures are early, so an older, more established business can achieve a higher valuation. In general, the three-year mark is a crucial threshold for SaaS companies.
The churn rate is also essential. Being able to demonstrate solid customer metrics inspires more confidence in the longevity and growth rate of a SaaS business. A closer look at lifetime value and customer acquisition cost can also help establish higher SaaS company valuation multiples.
In many cases, especially during the early stages, the multiple for any given SaaS business will also depend on the level of owner involvement.
If the current owner carries out significant, highly technical work to keep the company running, it raises the question of what happens once the company is sold. Even when tech founders stay on board, they generally receive a substantial salary that will have to be accounted for.
Implementing all of these factors to create an accurate valuation requires extensive experience and insight into how the financial aspects of SaaS businesses work.
In order to produce a valuation that accurately reflects value, private SaaS companies will often rely on on-demand CFO services.
Ensuring That Your SaaS Valuation Is Accurate and Complete
There are plenty of methods that can provide you with a rough idea of your company’s value through some simple calculations. However, this isn’t the same as having a professional valuation done. You may be overlooking key factors that could skew the valuation significantly. Most importantly, buyers, investors, and lenders will want to see detailed data and assumptions to support this valuation.
Ensure your SaaS business has an accurate and complete valuation by partnering with the team of tenured CFOs at Michigan CFO. We provide a full range of fractional CFO services, both in-person and virtually. For everything from budgeting to forecasting and valuation, we provide professional services at a cost you can afford.
Featured Photo Credit: Alex Kotliarskyi