If you’re looking to understand SaaS company valuations, understanding the relationship between revenue, growth, EBITDA, and valuation is critical. In this article, we’ll explore how founders can use multiple-of-revenue and profit multiples to determine their company’s value. We’ll also show how these metrics are calculated and discuss why it’s crucial for business owners to pay attention to them when developing their strategy for growth. Sometimes it makes sense to sacrifice short-term profit for faster revenue growth. Other times, owners should maximize profit and cut back on revenue growth.
When valuing SaaS companies, consider multiple factors.
You should know that SaaS company valuations are more than just a one-size-fits-all process. Multiple factors influence the value of your business, so it’s helpful to consider each of them as you determine your company’s probable worth to an acquirer.
- Growth: Potential revenue growth is critical in valuing a SaaS business. As discussed in previous articles, growth indicates that your company can continue to be profitable and increase its value over time. A fast-growing firm will generate more revenue than one with slow growth, which means it’ll have more cash flow available for reinvestment into itself or to pay to the owners.
- Profitability: Profitability also plays a vital role in how much investors are willing to pay for a particular company. Since investors want their money back with interest, they won’t want to invest in any company whose profits aren’t high enough either now or in the future to pay dividends.
- High Growth Potential companies may be managed to deliver negative profit to make additional cash available to accelerate the current growth rate. “I’ll take less now but expect more in the future is the basis for almost all VC investment.” While this is a valid and often used strategy for well-capitalized, high-potential businesses, management should have an active plan to revert to profitability in a short period if necessary.
SaaS company valuations are often calculated using a multiple-of-revenue method.
When valuing a SaaS company, your valuation will be calculated using a multiple-of-revenue method. This means that the valuation of your company is dependent on its revenue. The multiple-of-revenue method uses two numbers:
The first number is a multiplier. This multiplier represents how much investors are willing to pay for every dollar of revenue generated by your business. The second number is your total subscription revenue (ARR or MRR) over some specific period, like 12 months.
There’s no set rule about what multiple should be used for this calculation—it all depends on what the market conditions are at the time of your valuation, how well-positioned your company is in its target market, how fast your company is growing, and the size of your addressable market.
Additionally, more prominent, less risky companies have higher revenue multiples for the same growth rate than smaller companies. In the lower middle market ($3m-$20m in revenue), the revenue multiples are typically in the 2-6x range.
Valuations can also be driven by profit.
In addition to revenue growth, profits (cash flow) can also be a key consideration in valuations. The reason for this is simple: investors want to know that the SaaS company they’re buying will be able to generate a return on their investment (ROI).
Profitability (cash flow) can also factor into how much debt you take on when acquiring a company. The ability to apply leverage to the purchase price will permit acquirers to buy a larger company (or pay more for a smaller company) than their available equity would permit.
When valuing a software company on cash flows, typical multiples used in the lower middle market are 6-12x. Differences will be based on the size of the addressable market, growth rates, market share, and the size of the SaaS company.
The difference in valuation between high profitability and high growth can be staggering and should dictate different strategies for your business.
The difference in valuation between high profitability and high growth can be staggering. By putting together reasonable projections for the next five years, you can see which strategy is most appropriate for your business.
Assuming you have determined that one of these strategies is appropriate for your business, there are three key questions to ask:
- What is the size of your addressable market?
- What are your current personal financial needs from the business?
- What is your timeframe for continuing to run the business?
The answers to these questions will help determine which strategy is most appropriate for your company. If, for example, you have a large addressable market and your personal financial needs from the business are minimal, the best strategy is to “let the horse run” and grow the business as large as possible. This will get you the best exit when the time comes.
On the other hand, if you have significant financial needs or limited growth prospects, you should optimize current profitability and cash flow.
While growth is the primary driver of value, the relationship between growth and valuation is complex.
While growth is the primary driver of value, the relationship between growth and valuation is complex. Growth does not constantly improve the value of a company, and it can be unpredictable or unsustainable.
Growth can be misleading, especially when it comes to startups. Many new businesses fail because they don’t have enough capital to support their growth. Even the most promising startups often don’t make it past the first few years because they underestimate additional costs related to growth or overestimate revenue and build a cost infrastructure that is vastly too large for the actual size of the business.
Sometimes, taking a more conservative approach to project future growth makes sense.
When you have a very early-stage company, it may make sense to take a more conservative approach to project future growth, especially when trying to value the company. This doesn’t mean that you should always be conservative. However, suppose the company is still in the proof of concept. In that case, it’s okay to assume that there are potential risks with any projections and be conservative as you model out the revenue and cash flow growth into the future.
Companies with positive EBITDA enjoy high valuations because they are less risky than pre-profitability startups.
EBITDA is a good indicator of cash flow. A company with positive EBITDA is more likely to make its monthly payments on time and, thus, less risky than pre-profitability startups.
EBITDA also indicates managerial discipline, indicating how well a company can control costs while maintaining growth. This makes companies with positive EBITDA less risky than startups that are hoping for growth without controlling costs in the meantime.
In conclusion, it’s essential to understand the buyer pool and valuation differences between high revenue growth and increased profit if you’re looking to sell your company.
Finding a buyer can be more challenging if you have a high-growth SaaS business with negative EBITDA. The buyers are out there, but they can be more challenging to find with negative cash-flowing companies.
But suppose you have a profitable or break-even SaaS business with steady revenue growth over time. In that case, there will be plenty of buyers who will be interested in purchasing your company.
I specialize in helping SaaS business owners exit. If you need help preparing your business for sale, determining a fair market valuation, and finding qualified buyers, please get in touch with me for a consultation.