Business valuation is a complicated procedure, but an established company can serve as a good starting point. A valuation specialist will examine the company financials and metrics for comparable organizations (when available) to decide which of the three basic valuation approaches—market, cost, or income—is the best fit for the situation.

Company valuations for software as a service (SaaS) are a different breed. Because so many SaaS businesses are startups with little or no revenue history, valuation experts must frequently change their approach. In this post, we’ll look at the many methods an appraiser might use to value a SaaS company.

SaaS Company Valuation Methods

The majority of SaaS companies with sufficient revenue history are valued using a multiple of seller discretionary cash flow (SDE, which is typically used in valuations for small businesses with less than $5 million in annual revenue) or a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). The SDE formula is as follows:

SDE = Revenue + owner compensation – cost of goods sold – operating expenses

After all costs of items sold and basic running expenditures are removed from gross income, SDE indicates the profit left to the business owner; it shows the genuine earning capability of the firm. For bigger companies, EBITDA stands for earnings before interest and taxes. After determining the SDE or EBITDA, SaaS valuation multiples are used to evaluate the business’s worth.

The determination of the appropriate multiple to use is the most difficult part of the process. There are a number of variables to consider when determining the multiple; the following are the most common:

• Owner involvement: Similar to the key man discount often used in business appraisals, owner involvement is a factor in SaaS company valuations. If you are the business, it will be harder to sell the business since your work is what has made it valuable.
• Growth trends: What is the revenue trajectory? Investors typically prefer to see stable growth month-over-month.
• Business age: A longer track record of profitability will translate into a better multiple.
• Churn rate: What’s the annual turnover in the customer base? A high churn rate may result in a lower multiple if the churn is not offset by a high lifetime customer value and a low customer acquisition cost.
• Lifetime value (LTV): What is the lifetime revenue value of each customer?
• Customer acquisition cost (CAC): This variable represents the cost of marketing to acquire customers. CAC must be low enough and LTV high enough to offset churn and ensure long-term growth. Ideally, the LTV divided by the CAC yields a number of three or higher; this figure indicates that the business has a healthy growth rate, and there is some cushion in case LTV goes down or CAC goes up.
• Monthly recurring revenue (MRR) vs. annual recurring revenue (ARR): Though young SaaS companies may be tempted to sell discounted annual plans as a means of quickly improving revenue and cash flow, ARR is less important than MRR for SaaS valuations. MRR is valued about two times more than equivalent revenue from lifetime plans. ARR multiples for SaaS company valuations are lower because monthly revenues are less predictable; churn can only be measured on an annual basis using ARR. So, while revenue and cash flow can be stimulated through the sale of annual plans, in a sale or M&A transaction, the lower ARR multiple for the SaaS company valuation will result in a lower value and sales price.

In SDE- and EBITDA-based valuations, these are the major criteria that will decide the multiple used to calculate the company’s worth. The SaaS value multiples vary from four (for low revenue, young firms with high owner engagement, flat growth, and high churn) to ten (for big revenue, young companies with high owner involvement, flat growth, and high churn) (for higher revenue, more established companies less reliant on owner involvement with growing revenues and low churn).

SaaS Company Valuations For Startups

Valuations for SaaS startups are more difficult to come by. Because new firms often have no sales history, determining a valuation may be difficult.

One method is to calculate the opportunity cost of buying a SaaS company vs spending the same money elsewhere. The corporation may not be worth much when appraised using this method, depending on revenue and multiples.

A Monte Carlo simulation is another possibility. Simulations are done on a wide variety of revenue possibilities in the Monte Carlo model to anticipate likely results; after simulations are run, a pattern emerges. The scenarios and probabilities can be converted into a statistical technique for use in discounted cash flow analysis.

Finally, the safest path for startup SaaS firm valuations is to employ numerous models, dive further into the intricacies of the industry and rivals, and make assumptions with prudence. The general assumptions that apply to more established businesses do not apply here. The variety of elements at play in SaaS firm valuations, along with the difficulties of evaluating startups, makes value determination considerably more challenging and vulnerable to the validity of assumptions made throughout the valuation process.

Need help determining the value of your SAAS company?

Taqeem has assisted businesses in a range of sectors in obtaining accurate asset and business values. For a wide range of enterprises and situations, we have vast expertise applying all valuation methodologies. Our valuation and transfer pricing experts have worked with some of the world’s top corporations.

Contact us to see how we can help your company with your valuation and transfer pricing needs.