How To Value A SaaS Business
Jun 08, 2020
You’re ready to sell your SaaS business and finance the next chapter in your life—an early retirement maybe, or another SaaS business.
You know you might be able to get some amount of money for it. Based on conversations with other founders and people who are experts in this, you’ve got a ballpark idea, an order of magnitude maybe.
But do you know how to value a SaaS business?
How to value any business
Up until recently, SaaS valuations were heavily influenced by the unicorn economy, where valuations are based more on future projections than current profitability.
But most SaaS businesses aren’t unicorns. Most will be somewhere between a typical small and medium-sized business (SMBs) and a high-growth Silicon Valley rocket ship. And so how you value a SaaS business should probably fall somewhere in between.
How most business valuations work
Generally speaking, there are three ways to calculate the value of a business:
1. You can add up the value of all of its assets and subtract its debts to come up with its book value. This is what you’re left with if you liquidate your business, i.e. sell off all its assets, pay off all its creditors and keep the difference.
2. You can look past the numbers and base it on what similar companies are going for on the market, an expert’s opinion, or even your personal gut feeling.
3. Finally, you can base it on your company’s earnings—SDE, EBITDA, revenue multiples, these are all earnings-based valuation approaches—and project the value of those earnings into the future using some kind of multiple.
SaaS businesses use approach #3 because most of their assets are intangible, because SaaS people are focused on data and results, and because the most valuable thing about a SaaS business is usually its earnings and its customers.
How to use earnings to calculate the value your SaaS business
Most SaaS business valuation methods use one of two kinds of earnings: seller discretionary earnings (SDE) and earnings before interest, taxes, depreciation and amortization (EBITDA).
SDE is generally better for smaller single employee-owner SaaS businesses, and EBITDA works slightly better for multi-employee businesses. But both methods generally involve three steps:
1. Calculate revenue.
2. Subtract the costs you incurred generating that revenue.
3. Take what’s left over and apply a multiple.
Step 1: get your financial records together
If you aren’t already keeping close track of your business revenue and expenses using some kind of accounting or analytics solution, now’s the time to start.
Most serious buyers will want access to this information anyway, so you’ll want to catch up on your bookkeeping and accounting sooner than later.
If you haven’t already, make sure to bring together things like:
Revenue data from your payment gateway (i.e. Stripe, PayPal)
Any financial statements you have for the business
Individual customer sales data
Invoices and receipts for big discretionary/one-time expenses
Step 2: calculate SDE
SDE measures how much of your earnings are left over once you take into account the cost of goods sold (COGS) and any other expenses that are absolutely essential to your business:
SDE = Revenue – COGS – Essential Expenses
This is what your company earns, before subtracting anything else—software and equipment costs, employee salaries, taxes, interest, etc.
Ever heard the expression “you have to spend money to make money”? That’s what the cost of goods sold (COGS) is—the money you spend to provide your customers with a product.
SaaS companies usually have a very low COGS, because the cost of providing one extra customer with one extra subscription to your product is usually close to zero. That’s a big reason why people start SaaS companies in the first place: once you’re set up, they’re easy and inexpensive to scale.
But that doesn’t mean there aren’t any costs involved. When calculating COGS, look out for things like:
Web development costs
Customer support labour costs
These are also sometimes called “critical,” “operating” or “overhead” expenses. They’re all the things you spend money on that don’t directly relate to your product, but that your business couldn’t function without. They include things like:
Accounting and legal fees
Advertising and marketing costs
Non-essential expenses might include things like:
Travel, meals and entertainment
Non essential repairs and upgrades
Step 3: extrapolate using a multiple
Calculating your SDE for the last twelve months gives you a pretty good idea of how much money it might earn in the next twelve months. But your business isn’t going to stop running one year from now (at least we hope it won’t).
SDE doesn’t tell you how much it might earn in the long term, which is what we need to figure out if we want to figure out the total value of a business.
That’s where multiples come in. They’re a number that you multiply your SDE by to calculate the total value of your business.
Most small to medium-sized SaaS businesses these days command a multiple of somewhere between 2.0 and 4.0.
But they can also vary widely by growth rate, company size, the assets you have, and hundreds of other variables. This is what people who do this professionally spend most of their time thinking about, and the process of calculating multiples can get pretty complex and subjective.
If you don’t want to get into the weeds, use the following cheat sheet:
Growth rate Valuation Cheat Sheet
Variables that could influence the multiple for your SaaS business
Hundreds of variables could go into calculating a SaaS multiple, but most of them have to do with how scaleable your business is, how sustainable its earnings are, and how easy it is to transfer your business to a new owner.
This has to do with how easy or difficult it is to grow your business. If you’re well-established in a small niche market and post modest year over year growth, you probably have less scalability potential than a similar business in a larger market.
Buyers will look out for three things in particular when they evaluate scalability: your growth, the size of your business, and the age of your company.
If you’ve ever wondered where those sky-high unicorn valuations come from, multiples based on astronomical growth projections are your answer.
Software businesses spend a lot of money up front, but after that it’s fairly cheap for them to take on additional customers, so growth is a big deal in SaaS. The better a SaaS company’s growth prospects, the higher the multiple and the valuation.
Year over year growth rate valuation cheat sheet
THE GROWTH RATE OF YOUR GROWTH RATE
Your growth curve—is it declining? Flat? Or is it curving upwards, signalling that your growth rate is growing? The shape of your growth curve can be just as important to your multiple as the actual rate it happens to be growing at.
Growth curve valuation cheat sheet
If you’re a larger, multi-employee company, odds are that your customers are also on the larger side. Maybe you’ve even got some enterprise clients. The opposite usually holds for smaller businesses—most of their clients are usually also SMBs.
That’s why your company’s current size also has an impact on how scaleable it might appear to a potential buyer. If you already have a foothold in a larger market, it’s a whole lot easier to scale than if you’re starting from scratch.
Generally speaking, SaaS businesses get an age premium. If you’ve been in the business for a few years, an outside buyer will see you as a safer bet than a company that only has a few months of financial records.
But this cuts both ways, especially if you’re a high-growth business with lots of potential. Some buyers prefer the riskiness of a less-established business over the modest returns of an established business.
This has to do with your company’s ability to maintain its financial performance, and it’s mainly based on churn, and to a lesser extent on things like billing, acquisition costs and LTV.
This is how quickly your customers turn over. If one out of every twenty of your customers unsubscribes from your product every month, you have a monthly customer churn rate of 5%. Dollar churn rate is just that calculation, but for dollars instead of customers (this is useful if you have lots of different pricing tiers).
Churn trend also matters—if you graph out your churn rate, and the curve is sloping upwards? That means churn is going up and that your business might command a lower multiple.
Want to learn more about churn? Check out FirstOfficers Ultimate Churn Guide here.
Customer churn valuation cheat sheet
Generally speaking, people on the hunt for a SaaS business to buy prefer that you charge your customers monthly rather than annually, mainly because the former is more predictable.
CAC AND LTV
Customer lifetime value (LTV) is how much money a customer will pay you before they churn out, and customer acquisition cost (CAC) is how much money you need to spend to get your next customer. The higher the LTV and the lower the CAC, the higher the multiple.
LTV valuation cheat sheet
There’s also transferability—how easy it is to transfer ownership of your business to someone else without messing with its revenues. That depends on factors like:
How involved are you in day-to-day operations? Are you managing a support team from arms length and focusing on other projects, or are you deeply involved in every aspect of the business?
How easy would it be for someone with no technical knowledge to run your business? Whether this is an asset or liability for you depends a lot on the background of the buyer.
Does your SaaS business have access to a technology that gives it a unique competitive advantage in the marketplace?
So how much is my business worth?
Provided you’re on top of your financials and you follow the steps above, getting a decent ballpark valuation for your SaaS business should be relatively straightforward.
If you’ve run the numbers and still aren’t sure you’re doing it right, give our free valuation tool a try.
Things your business owns.
The value of your company’s assets minus the value of its liabilities.
How quickly do your customers turn over? Learn more here
The money you spend to provide your customers with a product.
Customer acquisition cost (CAC)
How much does your business have to spend to acquire one more customer?
Customer lifetime value (LTV)
How much money will your customer pay you before they churn out?
What you owe your creditors.
The money your company brings in.
Is your growth rate going up, down or staying flat?
How fast is your business growing?
What happens when you sell your company’s assets (rather than the company as a whole) and pay off your creditors.
A number that finance people will multiply your earnings by to arrive at a valuation.
How good are your company’s growth prospects?
How sustainable are your company’s earnings?
How easy is it for someone else to take over?