Is there any organization left that does not make use of at least one SaaS application as of 2022?
This piece of information singlehandedly proves that SaaS companies are exceptional tools from which people derive value through constant usage, especially in the most recent era of the internet.
While it is evident that the users obtain value from the products they use and services they get to bring about the statistic above, believing that each SaaS business is as valuable and profitable would be a naive assumption.
For that reason, this article will focus on the worth of your software company and the ways to boost it for a more healthy business.
Let's dig into it!
3 Ways to Calculate SaaS Company Valuation
It might come off ambiguous, but there is no one direct way to tell whether a software company is valuable or not.
However, business owners can draw an approximate conclusion by using a valuation method that goes through a different valuation process with different business metrics and evaluates the profitability and maturity of your entire business at the same time.
Here are three methods you can use to arrive at an accurate valuation of your company:
- SDE-based Valuation
- EBITDA-based Valuation
- Revenue-based Valuation
To value your business, you can make use of these SaaS business valuations that are based on the actual earnings of the company at hand.
Let's examine them one by one and decide which one would be the best for your business.
1- SDE-based Valuation
SDE (Seller Discretionary Earnings or sometimes called Seller Discretionary Cash Flow as well) is the amount of money that is left after the deduction of all expenses, such as payroll, overheads, software expenses, etc. from the final gross income, and the addition of salaries into the profit value.
The most crucial step is adding the owner's salary and dividends back to the profit for this business valuation method to show the earning potential of the company.
Here is how it unfolds:
Most of the time, SDE is considered a beneficial tool for small businesses that are under $5 million in annual revenue (ARR) with a single owner that runs the business properly without a management team.
2- EBITDA-based Valuation
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is exactly what it stands for; it is a useful instrument to utilize when inspecting a larger company's earning power and deciding whether it is capable of yielding a strong cash flow or not.
Here is the formula of EBITDA:
As SDE is a better option for small businesses, EBITDA is more suitable for larger companies that are above $5 million in annual revenue (ARR)—especially companies with high profits and have an intricate ownership structure that includes more employees and managers.
3- Revenue-based Valuation
Compared to other business models, SaaS businesses have more chance to achieve product-market fit in a short period of time and last longer, thanks to the accurate predictions of the future growth in terms of revenue. For this reason, revenue valuation is based on the growth rate only to label a company as a valuable business.
However, it is highly recommended for the business owners who consider applying revenue-based valuation on their SaaS business model to meet these conditions beforehand to get a successful result:
- ARR greater than $2 million
- Revenue growth over 50% from year to year
- The company's reliance on its current owner is not required.
Moreover, it is sometimes possible to come across a scenario where you need to utilize this method due to an incorrect representation of future earning potential, such as the currently produced EBITDA margin staying at zero—which would push you to use another method that takes both current and future growth into consideration to yield a more valid prediction immediately.
3 SaaS Metrics That Affect The Valuation Process
All three business valuations above can help you understand the future cash flow of the business that is required for a life-changing exit in the eyes of potential buyers, whether you own a public company or a private company. However, you might need to take some valuation drivers into consideration to have a valuable business as well.
Here are three of those key metrics:
1- Churn Rate
As a business owner, you need to track the record of your business in order to evaluate your profitability for both your business and potential investors' sake. One of the key metrics that have a hand in customer satisfaction is the monthly churn rate.
Customer churn rate is the number of customers you lose within a specific time period—usually displayed as a percentage. A high churn rate indicates that your customers cannot find the value they are looking for in your product or service; therefore, they cancel their subscriptions.
Meanwhile, a low churn rate expresses that your product or service is able to meet your customers' expectations and fulfill their needs.
The calculation can be done on a monthly or yearly basis—annual churn can also help you forecast revenue. The formula is rather easy for such a key element, too. For example, the monthly churn rate is obtained by dividing the number of customers you lose over a month by the total number of customers you have during the same month.
It is quite important to note that there is no acceptable churn rate in the SaaS industry as it is a multiple that changes according to many factors, such as the product or service you provide or the size of the business; however, you should always try to keep it lower than 10% as a rule of thumb.
2- Customer Lifetime Value (CLV)
Customer lifetime value (CLV or often CLTV) is the average revenue a customer brings during the time they interact with your business. The higher the customer lifetime value of a customer, the more valuable that customer is to your business. Its duty is not to only indicate the importance of a customer but also to observe and predict growth for the long haul.
3- Customer Acquisition Cost (CAC)
Customer acquisition cost is literally the amount of money you spend to expand your customer base. More precisely, it is the money you spend on marketing and sales when acquiring a single new customer. So, the less you spend to obtain a new customer, the more interesting you become in the eyes of potential investors, as this growth lever provides a new path to profitability.
To find your CAC, you must divide the total marketing and sales expenses by the number of new customers acquired during a specific time period.
It would be worthwhile to note that a good CAC depends on the business truly.
However, one thing is certain: You should always keep an eye on your LTV/CAC ratio since these two measures go hand in hand to help become a business valuation method that proves your business model to be thriving. Further, it is advised that you have a higher LTV than CAC—to be exact, at least three times higher.
5 Ways to Improve Business Valuation
When you are on the stock market to sell your SaaS company, you will see that you need the best advice on exit strategy due to the fact that it is highly competitive out there, especially in the public markets where the value of your company matters more than anything else.
As discussed above, the significance of your work is observed through the metrics and evaluations of your valuable business. That is why when exit planning is on the road; you should find ways to increase your SaaS company's worth as much as possible.
Luckily, I have readied a few actions that you should put to work even before the 'exit' bells start to ring for the sake of your company value:
✅Reduce churn. Reducing your churn rate will not only end up raising LTV but will also enable you to spend more on attaining new customers—which will impact the whole LTV/CAC ratio in a good sense.
✅Avoid discounts. As the exit time rears, it would be a wrong move to start changing your pricing as it will affect the MRR and suddenly alter the growth.
✅Enhance customer experience. Starting with focusing on your customer support team, in the long run, might not be a bad idea since the service and support you provide constitute one of the legs of customer retention.
✅Secure intellectual property. As soon as you step into the game, your IP is not the only thing that matters; you should secure anything that makes you gain a competitive advantage, such as trademarks and patents for your products. This step will help you along the sale process, just wait.
✅Make use of acquisition channels. Expand your marketing acquisition channel and keep your customers through the customer success that channel brings.
It is quite important to place value in your own value. Whether an exit is the subject of the talk, each SaaS company must go through a business valuation process to see how much its business is worth.
That is where I stepped in to present to you the methods and metrics regarding the value of SaaS companies and some quick tips to improve your business valuation.