Valuation of a SaaS company


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Valuation of a SaaS companyKnowing 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?

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.

Valuation of a SaaS company

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.

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The multiple and variables to take into account

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.

  1. The age of the business's longer track record demonstrates a buyer who has proven to be sustainable and is also easier to predict in terms of future earnings.
  2. Trends should also be taken into account, the 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 higher end.
  3. Finally, churn has to be taken into account as customer metrics are of vital importance to SaaS company owners and, consequently, are of great interest to business buyers

Valuation methods

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.

Other factors to be taken into account in the assessment

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 channels: recognising the higher churn rate experienced by smaller SME-oriented SaaS businesses, customer acquisition is understandably a focal point for assessing the longevity of these businesses.
  2. Product lifecycle: 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 venture capital 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. Having an expert in company valuation allows a better choice of multiple due to his experience.

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