What is a SaaS Company?
Before discussing SaaS company valuation, it is helpful to be clear on the definition of a SaaS company.
A software-as-a-service (SaaS) company provides its customers access to software applications over the Internet. The customer pays a monthly subscription fee for access to the software application.
Software-as-a-Service companies offer their services via subscription models. They provide the software or service to customers at minimal upfront cost. This monthly or annual subscription model allows customers to use software without a high upfront purchase requirement. The subscription model also allows the software company to have predictable recurring monthly revenue to fund their engineering and customer success departments. In addition to the affordable monthly subscriptions, all hosting and bandwidth charges are typically included in the monthly fee. This saves the customer from purchasing separately expensive hardware and supporting software licenses (like databases, backup systems, load balances, etc.)
SaaS companies are often called cloud computing providers or online businesses because they store data and programs on remote servers.
How Much Is My SaaS Business Worth?
SaaS company valuations can be millions or even billions of dollars. The very high SaaS company valuation potential is driven by a predictable annual revenue model and exceptionally high EBITDA margins. The beauty of software is that new subscribers can be added for a minimal additional cost. As you look to optimize your SaaS company for an exit, please pay careful attention to the stickiness of your application, and its ability to deliver predictable recurring revenue will be a key area to focus on as you build a valuable business.
The following factors should be considered when determining SaaS company valuations:
Market Size – How much market share does this company have? What percentage of the overall market do they represent? Is the market share defensible?
Competition – Do other companies exist in this space? If so, how big are they? Where are they located? Are there any barriers to entry?
Productivity – How effective of a tool is the software? Can users quickly and easily accomplish what they want, or do they typically need multiple vendors to perform everyday business tasks?
Customer Lifetime Value (LTV) – How many years of usage would a typical user expect? What is the average LTV of each user?
Customer Acquisition Cost (CAC) – How much money must a company spend to acquire one new customer?
EBITDA Margin – How profitable is this company? How much cash flow is generated per subscriber? Are marketing, customer support, and new product development efficient?
Revenue Growth Rate – How fast is the growth rate of the company’s revenues?
Profitability – How profitable is the company?
Technology – How well supported is the technology behind the software? Will it continue to work?
Quality Assurance & Customer Service – How well is the quality assurance handled? Is the company able to build high-quality products capable of supporting thousands or millions of users? How good is the customer service?
Branding – How recognizable is the brand name? How strong is the branding?
Intellectual Property – How protected is the intellectual property? Is it licensed under open source or proprietary licensing?
Legal Challenges – Is the company litigious or involved in multiple lawsuits?
SaaS Company Valuation Methods
The lower middle market (revenue from $3m – $20m) consists of primarily private company transactions with significant daily owner involvement. To arrive at an accurate valuation, buyers of SaaS companies will typically use a valuation process based on a multiple of revenue or a multiple of cash flow. These financial metrics are easy to calculate, and the market rates (multiples) have proven remarkably stable over a significant period.
Revenue-based valuation models will focus on the recurring revenue from the subscription of software licenses. These lower middle market companies will typically attract offers in the 2-4x range from a valuation perspective. Revenue growth rates, the size of the addressable market, customer retention rate (churn), and the quality of the customer base will all determine where in the range the offers concentrate.
Cash Flow Multiples
Mature SaaS companies can also be valued based on their current and future cash flows. Depending on the size of the business, for larger companies with a management team in place, an EBITDA-based valuation multiple would be used. For smaller companies and those without an existing management team, the multiple will be applied to the SDE financial metric (Seller’s Discretionary Earnings) or total owner compensation, including benefits and perks.
A broad range of cash flow multiples is used to value software companies. Typically the multiple will range from 6-12x cash flow. Larger companies with a high average growth rate will be at the top of the range, and small or those with low revenue growth will be at the lower end.
Other SaaS Company Valuation Methods
Of course, transactions occur with seemingly extreme multiples applied to revenue and cash flow. This is usually due to purchasing another asset where the press reports back standard financial metrics. Think of a startup with about $500k in revenue, no profit but 10 million daily users of an application. If the business is purchased for $10m, the business press will report a transaction at 20x revenue, which is an incredible and undoubtedly attention-getting headline. But, the buyer also purchased 10 million users for just $1 each. While less newsworthy and perhaps more nuanced, it is still a meager customer acquisition cost (CAC) if you can convert these users into paying subscribers of another application.
SaaS Metrics that Matter the Most
Churn, Churn, Churn
How long you keep your paying customers is perhaps the most critical metric of a SaaS-based company. A low churn rate indicates a valuable software application delivered with high levels of customer satisfaction, but it also creates a business model with subscribers with high revenue retention. Customers keep paying for years and years. This results in very rapid revenue growth without funding large marketing budgets to replace customers who’ve left.
B2B SaaS Annual Customer Churn rates under 10% are considered attractive.
B2C SaaS Annual Customer Churn rates under 20% are considered attractive.
Customer Acquisition Cost (CAC) is the cost of marketing spending and sales compensation to get an additional customer.
The CAC should include any costs associated with acquiring new users, such as:
- Marketing spend to acquire new users
- Sales compensation to incent new user acquisition
- Costs related to onboarding new users
- Any other indirect costs incurred by the business
The lower, the better for this key business metric.
Average Revenue Per User is what the average subscriber will spend with the company per year. This is calculated by taking the total number of subscribers and dividing it by the total amount they spent last year.
The higher, the better for this annual revenue key metric.
The Customer Lifetime Value (LTV) of a subscriber. How much is the average subscriber expected to spend (minus the marketing costs to find them) on the service before canceling their subscription?
This is calculated by taking the inverse of churn (1/annual churn), multiplying by the ARPU, and subtracting the CAC. You’ll want to maximize the revenue per customer, so the higher, the better for this metric,
Other Considerations When Preparing SaaS Companies for Sale
Most owners find the sale of their bootstrapped business to be an overwhelming endeavor. Thinking through a few of the big topics can help make your business exit a manageable and exciting next step in your career.
Optimize for SaaS Revenue Growth or Company Profitability?
My experience suggests that premium valuations will flow to the SaaS company owner who has optimized for growth at break-even or slight profitability. Growth and scale are powerful valuation drivers, but the ability to control expenses shows an effective management team is in place. Also, you can only lose money for so long before you are forced to go hat in hand to your investors and try to do another raise. Better to dial back the growth rate to maintain control and enforce a disciplined approach to managing the company.
Business Stability: Will It Last?
Will your SaaS company remain profitable well into its second decade?
Can you manage your customer churn rate so that you don’t run out of potential customers in just a few short years?
Is your management team capable of managing a predictable revenue stream by creating annual plans, executing those plans, and producing predictable results?
As the business owner, are you required to be involved in each decision, or can your management team be counted on to analyze each opportunity and arrive at the correct conclusion correctly?
Is the business Transferable? Is it Transparent?
Business owner dependent companies cannot operate without their founders. These businesses generally wind down when the founders retire. These are shorter-term business ventures. Typically they can’t develop and execute an annual plan. Instead, they are reactive in their nature and structure.
While these types of companies can be highly profitable and may serve the needs of the current owners, they won’t be attractive to business buyers.
A potential buyer will want to make sure they can completely understand how your company operates. They will also need to be sure the company can continue to grow and prosper in your absence.
Transferable Go To Market Process:
Your Sales Process Should Be Simple. Your Marketing Process Must Be Predictable.
When I’m speaking with entrepreneurs, executives, and business owners about transferring their SaaS business to another party, my first question is, “How did you bring in all those customers?” It sounds simple enough. Well, it isn’t! There’s a reason why so many startups fail. They don’t have an excellent transferrable go-to-market process. And it should be easy to change from one person to another, right? Wrong.
A common problem for smaller companies is that the founder was responsible for the strategy and planning of everything from creating the product roadmap to signing up clients. They had to build all the sales pipeline, the entire marketing process, and execute the customer acquisition process. The employees followed the process but weren’t involved in the strategy or design of the go-to-market process.
The best way to handle this situation is to hire an experienced management team to help run the company. While you’re working on growing the business, you’ve got another employee helping you keep things moving forward and learning from your example. You need to hire for talent, experience, and skillsets.
Transferable Product Development Process
Software written using industry standard languages with a well documented code base will help ensure the software can be supported and improved without critical technical employees.
If you’ve gotten to a few million dollars of revenue with ten or more employees, you’ve passed the major hurdle of an owner-dependent business, at least from the product development process. Properly documenting your business processes and policies will go a long way to making sure everything is transparent and can be quickly adopted by new owners.
Who’s the Competition: How do you differentiate?
As an owner of a SaaS company considering an exit, you should be aware of your competition. Who else do your subscribers evaluate before they select your product? When you lose a subscriber, where do they go? Understanding the other vendors and having a realistic understanding of their strengths and weaknesses will allow you to compete most effectively and understand who your target subscriber is likely to be.
Who is likely to buy your SaaS business?
Prospective buyers come in all shapes, sizes, and personalities. You’ll have many sale options when it’s finally time to sell the entire business. The main types of buyers for lower middle market SaaS companies are:
- Owner / Operators
- Private Equity Funds
- Family Offices
- Strategic Acquirers
Understanding the current market concerns of software company buyers is helpful in properly positioning your SaaS business when it becomes time to consider an exit. A broker or banker involved in these transactions will be able to evaluate the viability of each segment and discuss the pros and cons of each prospective buyer type.
What are Top-Performing SaaS Companies do Differently?
Top Performing SaaS companies generally share a few common traits with their revenue growth strategy. The best will have multiple customer acquisition channels, insist on annual contracts for their most valuable enterprise customers, offer competitive monthly plans to the SMB subscribers, and demonstrate a low monthly churn rate. This approach to managing actual revenue will produce a predictable cash flow rate and help keep down the sales cost. It also tends to lead to the highest real transaction value for the business.
The top-performing SaaS companies don’t just focus on building software for customers. They also run a well-organized company that evaluates new market opportunities and develops annual plans for new features, new products, and new marketing strategies.
They also build and buy software for themselves to use internally. This means they have tools that help them run their business better, like customer support software, CRM, project management, etc. These tools provide valuable feedback and operational efficiency to the entire organization.
What is a VMS SaaS Company?
VMS or Vertical Market Software are software applications written for narrow segments of users, typically focusing on the specific needs of one industry. These can be highly profitable businesses having a very loyal customer base with a significant share of a small market. Because the markets themselves are narrow, these sectors tend to attract privately owned businesses, usually started by founders with deep vertical market expertise. The lack of significant public company competition can create highly profitable, privately-owned SaaS companies which can be attractive acquisition candidates.
David Jacobs is a licensed Business Broker who provides SaaS business owners with expert advice on valuing their business and selling it. He’ll help you get top dollar for your business.
As a first step, he will determine what your private company valuation would be considering the current market conditions. This will give you a baseline number against which to consider your options. Contact him to get started.