Of all the industries budding entrepreneurs could build thriving businesses in, none of them make for as appealing of exits as SaaS companies do. Do to the scalability, high profit margin and recurring revenue nature of the SaaS industry, Investors are known to pay premium valuations for strong assets.
In this article, we delve into the sometimes opaque and misinformation-fraught world of SaaS business valuation multiples. We’ll explore the many attributes of a saas business that contributes to it having a higher or lower valuation multiple and better understand what that multiple should be applied to. Additionally, we will explore how the impact of the current interest rate environment impacts saas company valuations and valuations of companies in other industries of the economy.
Our aim is not to encourage anyone to sell their saas company, rather it is to help saas business owners make better-informed decisions on how to go about scaling and running their company and the impact it will have on the saas company valuation they can expect, whether that is now or years down the line.
How Valuation Multiples Work for SaaS Companies
A valuation multiple is a way to come up with an appropriate valuation for a saas company. This is true of SaaS companies, in the lower middle market and virtually every other industry, although there are some other valuation approaches for asset-heavy companies, pre-revenue companies, and publicly traded companies.
For SaaS businesses, the valuation multiple is determined by how desirable the business is and applied to either the annual recurring revenue (ARR), or to the trailing twelve-month (TTM) adjusted EBITDA figure to get the final valuation of the business.
Annual Recurring Revenue Multiples, or Adj. EBITDA (earnings) Multiples. Which is Right for Your SaaS Business?
Revenue Multiple Valuations
Revenue, also referred to as gross sales is a measure of how much money the SaaS company generates before subtracting any expenses. While it is uncommon for companies in most industries to trade on a multiple of revenue, it is not at all unheard of with SaaS businesses.
SaaS companies that are experiencing high growth and are heavily reinvesting discretionary earnings back into the business to drive this growth should trade on a multiple of revenue. These companies are typically earlier stage and have higher total addressable markets (TAMs) than companies that trade on a Adj. EBITDA multiples.
Adjusted EBITDA Multiple Valuation
EBITDA is by far the most frequently utilized metric in mergers & acquisitions (M&A). It is the metric that measures a company’s ability to generate cash before it services its debt or pays taxes. The acronym stands for earnings / net income before interest taxes depreciation and amortization.
This is the most meaningful metric to buyers not only because it will determine what their cash yield is on their investment, but because if they can accurately forecast what their Adj. EBITDA will be in 4-5 years, they can then have a fairly accurate estimate of what they will be able to sell the business for. With this information, they can calculate what their IRR on the investment would be and how much they can pay for the business today and still hit their target IRR.
What is Adjusted EBITDA and How Does it Affect Business Valuation?
to calculate adjusted EBITDA, an M&A advisor or investment banker will take the company’s non-recurring operating expenses (one-time legal expenses, buying out an old business partner, etc.) and add them back into the EBITDA figure. Additionally, if the business owner is serving as CEO of the company and is taking more compensation than the future owner will need to pay their CEO, that owner compensation is added back into the bottom line as well to show the true earnings that are available to the business owner.
Note that the term “Seller’s discretionary earnings” is often used as a synonym for Adjusted EBITDA.
Finding the Appropriate Adj. EBITDA Multiple for Your SaaS Company
As mentioned, the multiple for most SaaS businesses is applied to TTM Adj. EBITDA to arrive at the business value and likely purchase price. However, finding TTM EBITDA is a fairly straightforward equation. After performing due diligence, business buyers and sellers can typically reach an agreement on what that number is. Finding a valuation multiple, however, is more art than science. Note that for smaller deals, business brokers may use the term seller discretionary earnings in place of Adj. EBITDA.
Annual Recurring Revenue (ARR) Multiple for SaaS Companies
As previously mentioned, the majority of SaaS companies will sell on a multiple of their Adjusted EBITDA. Only ~20% of SaaS companies will trade on revenue multiples. Of those that do, the majority of them will be low-mid single-digit multiples.
SaaS businesses that trade on a high single-digit or low double-digit multiple of annual revenue are seldom. When they come about, they meet the majority of the following criteria:
Only monetized recently and therefore have low revenue.
This could be a highly differentiated SaaS company that has a strong development team and strong SaaS product that is being snatched up by a strategic investor or venture capital group right when they started monetizing their product
Mission critical B2B saas
If you have a highly differentiated SaaS that is dominating a niche B2B market, you’re a contender for a high revenue multiple. This is especially true if the saas products that provide adjacent services to your end market are owned by private equity or venture capital groups.
The More Desirable Your Business is to an Investor, the Higher Multiple They Will Pay
At a high level, it really is that simple. However, different buyers will find different industries and business traits appealing. Some will like a niche industry (small total addressable market) with as few competitors in it as possible. Others will favor a SaaS company in a larger industry where there may be more of a growth opportunity, even if it means they will have to invest more in technology and marketing to stay ahead of their many competitors. However, there are some other factors here that are seen as highly desirable across the board. We’ll go into further detail on these below.
Related Content
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The Factors That Make a SaaS Company More/Less Valuable:
Highly differentiated SaaS
Recurring revenue
High growth rate
Mission critical service. I.E. the end market must use either your service or a competitor. CRM service, compliance filing software, etc.
Proven sales funnel and/or marketing process. This could be one marketing process, but it is a benefit if the saas company has multiple customer acquisition channels.
High gross margin (90%+ is common)
Business size. Ideally your saas business drive $5m+ in recurring revenue. Larger business typically equates to a higher valuation multiple.
A large total addressable market or the ability to expand into adjacent ones
Recurring customer base without customer concentration. Having too much of your revenue coming from a few customers can drastically decrease your multiple. This could be either annual recurring revenue and billing, or monthly recurring revenue.
Assignable customer contracts
Positive customer metrics such as high ltv and low customer churn rate. Showing positive customer feedback and retention is very helpful in proving out the future growth potential of the business.
Clean, well-organized financials. (most SaaS companies use outsourced CFOs or have an internal CFO).
Strong management team in place. This is especially true for larger companies. While the saas business model is highly automated, having a strong team in place is a necessity with larger SaaS companies.
Well represented by a professional M&A firm such as Raincatcher
Valuation Multiples in Different SaaS Industry Sub-sectors
SaaS valuations can differ by the subsectors they are in due to a variety of key metrics and factors such as: industry growth rate, customer acquisition cost for SaaS businesses in that sector, customer lifetime value, and how many other difference software companies are offering competing solutions. Understanding these sector-specific differences is crucial when assessing the value of saas businesses. Let’s explore some subsectors of the saas market that have been in high-demand from investors and the factors that contribute to their valuation multiples.
CRM SaaS:
CRM SaaS refers to a cloud-based delivery model for customer relationship management (CRM) software. In this model, the CRM software is hosted and maintained by a third-party provider and made accessible to users over the internet. Instead of installing the CRM software on their own servers, businesses can access and use the CRM application through a web browser.
This is B2B saas and should offer both a high customer lifetime value and a very low churn rate given that it will take a business owner a lot of time and effort to move from your solution to a competitors. However, this high LTV comes at a price as it will also likely have a high customer acquisition cost and require strong marketing and sales team to be in place.
Marketing SaaS:
Marketing SaaS refers to cloud-based software applications and tools that cater specifically to the needs of marketing teams and professionals. These SaaS solutions are designed to streamline and enhance various aspects of marketing activities, making it easier for businesses to manage their marketing efforts effectively. Marketing SaaS platforms cover a wide range of functionalities and can be used for different marketing purposes, such as digital marketing, content creation, email campaigns, social media management, analytics, and more.
Due to marketers demand and readiness to adopt new saas tools, there is a rapidly growing market of saas businesses that serve digital marketers. SEMrush has recently gone public on the nasdaq while private equity groups are scooping up marketing automation tools such as HootSuite.
Process Automation SaaS:
Process Automation SaaS (Software as a Service) refers to cloud-based software applications that automate and streamline various business processes. These SaaS solutions are designed to replace manual and repetitive tasks with automated workflows, improving efficiency, reducing errors, and saving time for businesses.
Process Automation SaaS platforms provide a visual interface that allows users to create, manage, and monitor automated workflows without the need for extensive coding or technical expertise. These workflows can be tailored to specific business needs and can encompass various departments and functions, such as sales, marketing, finance, human resources, customer support, and more.
Because these tools are so integral to their clients day-to-day business operations, they are in high-demand from private equity investors. Additionally, most of these tools are not confined to an end market of just one industry as their service has broad appeal to any industry that may need process automation. Because of this, they will have competition from other saas businesses, but the winners in the space will trade at high multiples.
AI Integrated SaaS:
As with every emerging technology, investment groups such as private equity firms and venture capital funds are excitedly watching to see how entrepreneurs will integrate AI with their SaaS company to improve the offering for the consumer.
AI-integrated SaaS refers to cloud-based software applications that incorporate Artificial Intelligence capabilities to enhance their functionality and provide intelligent automation, data analysis, and decision-making support to users. A saas business that leverages AI technologies like machine learning, natural language processing, computer vision, and predictive analytics to deliver more advanced and personalized services to customers. Because this is an improved saas business model, buyers will see the differentiation and be willing to pay more for the business.
It’s important to note that these are just a few examples, and saas valuation multiples can vary within each sector based on company-specific factors. Factors such as revenue growth, market positioning, competitive dynamics, and other saas metrics such as CLTV, Churn and CAC also play a significant role in determining valuation multiples.
Moreover, macroeconomic conditions and industry trends can impact valuation multiples for all saas businesses. Factors such as interest rates, unemployment, and geopolitical risk have meaningful affects across the whole economy and will thereby impact saas valuation for both public saas companies and private saas companies alike.
When assessing valuation multiples in different other saas businesses and sectors, it is crucial to consider a comprehensive set of factors that are specific to each sector and individual company. This includes analyzing financial performance, growth prospects, competitive advantages, industry trends, and broader economic conditions. By conducting a thorough analysis of many factors, investors and stakeholders can make informed decisions when valuing saas businesses in various sectors and identify opportunities for potential investment or strategic transactions.
Thinking About Selling?
If you are entertaining selling your company, feel free to request a consultation with one of our saas business brokers or M&A specialists to learn about our unique process and why we believe it is the best in the industry.
Who Buys SaaS Companies?
While potential buyers are trying to get your business for the lowest price they can, if your business is desirable enough to sell and you’re working with a quality business broker like Raincatcher, you’ll likely get multiple prospective buyers making offers for your business. This is important as it helps give us (and our clients) negotiating leverage with the buyer and helps get the highest value of your business.
Generally speaking, if your business is over $2m in profit, we’ll get 5+ offers for it from private equity groups and strategic buyers alike. Private equity firms are teams of investment professionals who manage money for outside investors (typically this is high net-worth individuals or pension funds). They will look to buy all or a portion of the business on behalf of their investors.
Strategic buyers are companies who have a strategic affinity in buying your business. This means they could be a similar saas company. Or, they may be a service business that sells to the same end market as your saas business does. While they are few and further between, strategic buyers can typically pay a higher price for the business than a private equity buyer.
How To Increase the Valuation of Your SaaS Company
In addition to increasing the appeal of your business in the various areas mentioned above, most buyers would like you to stick around with the business for a reasonable transition period post-close. This will not only help them get comfortable with the operations of the company post-close, it helps assure that leaders in key departments will remain in place for the buyer.
Additionally, if you have a clear plan on how to help the buyer increase the company’s future earnings, the potential acquirers would be excited to see this and may be willing to pay a slightly better multiple.
Other Methodologies for SaaS Company Valuations
While saas company valuations can be made as simple as taking earnings before interest taxes and multiplying it by the appropriate valuation multiple, there are several other more academic approaches that are used by wall street to asses a saas company’s worth.
Discounted Cash Flow Analysis Valuation
This is projecting the future cash flow of a saas business, applying a discount rate to them (for time and perceived risk) and trying to come up with the saas company’s value based on the present value of those future cash flows.
The most common way to forecase the saas businesses future cash flow is to assume that the operating expenses and profit margins are all unchanged and that the revenue growth rate is a fixed annual percentage, such as 8%. A discount rate (say 20%) is then applied to this future cash flow.
Example; a saas business generates $1m in EBITDA and is projected to grow at 8%. In this scenario, next years cash flow will be $1,080,000. By applying a 20% discount to that figure we get a present value of $864,000.
Note that this example only forecasts cash flow for one year and does not incorporate important factors such as the companies terminal value.
Growth Capital Valuation
Business valuations for entrepreneurs looking to sell their business differ from the company valuation when the owner wants to stay in place and continue to lead the business for years to come. Due to the high revenue growth potential that the saas business model offers, growth investors will sometimes look at saas businesses to invest in.
Growth capital investors (such as venture capital groups) look at saas valuations differently than other potential buyers would. Instead of being focused on the companies cash flow in the near term, they are focused on how differentiated the technology is, how large the market is and how large they can grow the business. They are typically longer term investors than private equity firms are. Some venture capital groups will only invest into saas companies if they believe they can take the business public within ten years or they can sell the business to one of a number of public companies in that time frame.
Request a Consultation
If you are looking to sell your SaaS business we invite you to reach out to get introduced. We’d be happy to discuss our auction process and how we help SaaS business owners and other lower-middle market business owners achieve maximum value with our proprietary auction process.
