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 into SaaS valuation.
Software as a Service (SaaS) is a unique and growing industry, which requires special considerations when selling. In this post, we draw on our experience and expertise to delve deeper into SaaS valuation.
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 to a multiple of the company's revenues or earnings. However, most financial gurus consider valuation multiples to be of very limited usefulness due to their wide dispersion. This will give rise to another specific post on this method. You can access Pablo Fernández's conclusions in this link where he explains that this method should be used as a complement to a discounted cash flow valuation. You can also count on an expert in company valuation who, through his experience, can resolve the dispersion and help determine the appropriate multiple.
Most small businesses valued at less than $5 million are estimated using a multiple of seller discretionary earnings. SDE (Seller Discretionary Cash Flow) 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 since 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 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 boil down to the transferability, sustainability and scalability of the business.
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 businesses, investors have increasingly turned to the multiple-based methodology because of its simplicity in the face of limited financial or comparable data. This method stipulates that the buyer should arrive at a valuation by multiplying the seller's discretionary cash flow (DCF) 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.
In addition to the SaaS metrics mentioned above, there are other important factors to be taken into account in the valuation process.
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. Having an expert in company valuation allows a better choice of multiple due to his experience.