Valuation of a SaaS company: 3 key variables

Knowing how to value a Saas, Software as a Service, company is essential in a unique and growing industry that requires special considerations when selling. In this post, we draw on our experience and expertise to delve deeper into SaaS valuation. In addition, you can access our Investment analysis of the SaaS sector where we show the main trends and developments in the sector. 

In this article you will be able to expand your knowledge on the following contents:

• How to value a Saas company?
• The multiple and variables to consider when valuing a Saas company
• Valuation methods in a Saas company
• Other factors to take into account in the valuation of a Saas company
  
  
  

How to value a Saas company?

How to value a SaaS company is perhaps one of the most controversial and ambiguous debates among entrepreneurs, investors and small business advisors at the moment. It is common practice to reduce the valuation by applying a multiple to the company's revenues or earnings. However, most financial gurus consider valuation multiples to be of very limited utility due to their wide dispersion.

Pablo Fernández explains that this method should be used as a complement to a discounted cash flow valuation..

SDE: Seller Discretionary Cash Flow

Most small businesses valued at less than $ 5 million are estimated using a multiple of the seller's discretionary earnings. SDE is the profit left to the business owner once all costs of goods sold and critical operating expenses have been deducted from gross income and in which any owner's salary can be included for tax efficiency as most small businesses are owner-operated and therefore have a salary and associated expenses.

However, the situation changes as companies grow. In larger companies, there are more employees and more management staff. Similarly, the ownership structure tends to become fragmented with several shareholders typically playing a less active role in the business. In this case, a new earnings before interest, taxes, depreciation and amortisation (EBITDA) benchmark is used.

Measuring revenue growth makes sense for SaaS valuation, but it is very important to keep in mind that this valuation philosophy is based entirely on growth. If the SaaS business is not growing, then the revenue is not there to support the predicted profit in the future. This means that there is considered to be some correlation between sales growth and the multiple applied as we will see in the next section.

The multiple and variables to consider when valuing a Saas company

The multiple is one of the most important pieces of the equation and is affected by dozens of business-related factors. These factors cover a wide variety of financial, traffic and operational aspects, but ultimately come down to the transferability, sustainability and scalability of the business.

1. The age of the business A longer track record demonstrates a buyer that has proven to be sustainable and is also easier to predict in terms of future earnings.
2. The following should also be taken into account trendsThe key is to invest in a business that is trending steadily and ideally upwards. Therefore, the faster the business grows, the more the multiple will extend towards the top end.
3. Finally, it is necessary to take into account the "Churn as customer metrics are of vital importance to SaaS business owners and, consequently, of great interest to business buyers.

Valuation methods in a Saas company

One of the methods we use is known as Earnings-Multiple. In a public company, this tends to manifest itself as P/E, EV/EBITDA and EV/Sales multiples or other iterations of these core metrics.

In the world of internet business, investors have increasingly turned to the multiple basis methodology because of its simplicity in the face of limited financial or comparable data. This method stipulates that the purchaser must arrive at a valuation by multiplying the seller's discretionary cash flow (SDC) by a multiple that is appropriate for the business. However, as mentioned above, the variability of multiples limits the applicability of this method and may require third party support.

Other factors to take into account in the valuation of a Saas company

In addition to the SaaS metrics mentioned above, there are other important factors to be taken into account in the valuation process.

1. Customer acquisition channelsRecognising the higher churn rate experienced by small, SME-oriented SaaS businesses, customer acquisition is understandably a focal point for assessing the longevity of these businesses.
2. Product life cycle, All software needs development to keep up with customer requirements or to further grow the business. For this reason when the company goes to market, it is generally good practice to have the product at a high point in its development lifecycle, in other words, it does not require a major upgrade in the short term.
3. Competition, Competition in the industry is of great interest to buyers when evaluating a SaaS business. Clearly, it is important to understand the level of competition for any potential purchase. In SaaS it becomes an issue of great interest due to the generally larger number of VC-funded players in the industry and the high development costs associated with the business model. A smaller SaaS business in a highly competitive niche will tend to find itself underfunded and unable to compete with companies backed by larger capital.

In conclusion, we can say that Saas models provide greater predictability to future flows in general based on a high recurrence. Therefore, the market tends to apply the multiples method because of its simplicity, forgetting its high dispersion.