An overview of methods and metrics for valuing a SaaS (software-as-a-Service) company.
The core method of valuing any business is to apply a multiple to its underlying EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation). This also applies to SaaS (Software-as-a-Service) companies. Earnings should be adjusted for any one-off costs or income, and usually focus on a current and forward view of trading rather than looking at historic results. After all you want to get the growth opportunity priced in.
Growth and potential are then factored into the multiple applied. We would usually benchmark this against market data – but typically for a decent business, double digit EBITDA multiples are not unusual, and these can equate to a decent multiple of revenue. You’ll merit a higher multiple if the fundamentals of your business are strong. We would look at factors like intellectual property, quality of management, customer base, cash flow dynamics, and scalability. Having a clear development route map for your products is also important.
For SaaS businesses, it’s also useful to look at revenue multiples, as there is some correlation, particularly where a business has been investing heavily in growth and this has depressed EBITDA. This is what drives the Rule of 40 which is discussed below.
SaaS companies come with a host of sector specific metrics that are worth a look. They won’t directly factor in to valuation – but if you rate well on them it should increase your multiple. And it will certainly make the business easier to sell. Here are the key metrics most buyers or investors will look at.
In our experience the key metrics that a buyer or investor will focus on are churn, and momentum (i.e. sustained growth – which analysis of the other metrics can hint at). A buyer wants to know that the business will continue to grow.
Two things might drive an even higher multiple are Scale and how you rate on the ‘Rule of 40’.
Scale generally helps to increase the value of a business relative to its peers. And Scale wise there’s evidence to suggest a bit of an inflection point such that SaaS companies above £20M Enterprise Value which are also growing strongly get much higher multiples.
The rule of 40 basically says that a SaaS company’s combined growth rate and profit margin should exceed 40%. It has become popular as a high level test of success for SaaS. It reacts to the differing strategies you might pursue and attempts to balance the conflicting priorities of growth and profitability. Put simply if growth was the only important criteria you could simply invest all your cash in growth with no regard to profitability.
On the other hand many successful SaaS companies could make significant short term profits if they simply stopped investing and focused on generating profit from their existing business. Both growth and profit are of interest to investors and buyers of SaaS companies, and the Rule of 40 is a neat way to balance these potentially conflicting objectives.
Younger companies with a high growth rate might beat the benchmark due to rapid growth but more mature businesses where growth is tapering off will need to improve performance and profit margins to do well on this measure.
It’s an achievement to beat the Rule of 40 in your latest results – but the real challenge is to beat it consistently every year. Bain & Company studied the performance of 124 publicly traded software companies to see which had outperformed the Rule of 40 – only 16% had done so for all five years surveyed.
This approach of course also works well for all the SaaS related business models that are emerging, so many in fact that XaaS or “Anything as a Service” is now used to describe the delivery of all sorts of IT related services through the Cloud. These include Monitoring as a Service or MaaS (confusingly this is also Mobility as a Service referring to transport management platforms), Communication as a Service or CaaS (delivery of VOiP, VPNs, and Unified Communications), Function as a Service or FaaS (allows users to develop, run and manage application functionalities without building their own infrastructure), and AIaaS (Artificial Intelligence – i.e. Google’s language translator). There are probably more being coined all the time.
The rules are different if you are an early stage business. The logic is similar to the Rule of 40. The trouble is that net income, or EBITDA, takes a while to materialise even though the underlying business is doing well. Sales and marketing costs must be invested upfront which can make new customers unprofitable in the short term. As the business grows, acquiring more customers makes things worse short term – because you’re spending more upfront on customers that will be profitable over their lifetime.
For these reasons, Annual Recurring Revenue is often used as a better indicator than EBITDA for early stage SaaS and you’ll often see only a weak relationship between valuation and profitability. Even then you do need to drill down into the qualitative features and metrics discussed above. And for a start-up, it’s often the narrative, the pitch to investors that carries the day.