SaaS Valuation: How to Value a SaaS Company + Tips for Improving Valuation

Whether you’re planning your exit, seeking VC funding, or setting up ESOPs, a SaaS valuation is a must.

Our article:

• Explains different SaaS valuation methods.
• Introduces key metrics that can affect your company’s value.
• Covers common valuation mistakes.
• Shows how to leverage PLG strategies to boost the value of your SaaS business.

Let’s get to it!

What is the valuation of a SaaS company?

As the name suggests, SaaS valuation is the process of establishing how much your SaaS company is worth – and how much it may be worth in the future.

Companies normally conduct valuations when they’re raising VC funding, setting up employee stock option plans (ESOPs), preparing to go public, or considering a sale or a merger.

Why is an accurate valuation for a SaaS business important?

An accurate valuation of your SaaS is important for several reasons.

When seeking funding, it tells you how much equity you must give up in exchange for capital. An overvaluation can make it hard to raise funds, while an undervaluation means giving up more of the company than necessary.

Likewise, an accurate valuation matters a lot when you’re planning your exit strategy. It helps you set realistic expectations and choose the best timing for the sale or IPO.

When it comes to running the company, a reliable valuation is essential for strategic decision-making as it helps leaders assess the impact of various strategic initiatives on company value.

Moreover, a valuation offers insights into the company’s financial health and is important for financial planning. It helps with risk management and financial goal-setting.

Finally, accurate valuations are also important for regulatory compliance and taxation purposes.

Three types of SaaS business valuation

There are 3 main ways to value a SaaS company: SDE, EBITDA, and revenue-based valuation.

SDE valuation

Seller Discretionary Earnings, or SDE, is used for small businesses valued at less than $5 million, especially if they’re slow-growing (less than 50% YOY), generate less than $2 million in revenue, and the owner still plays an important role in the company management.

SDE is the profit of the business owner and his compensation. To calculate the figure, deduct overheads from the gross revenue and add the owner’s compensation (salary, dividends, etc.).

EBITDA valuation

EBITDA is the alternative valuation method used for larger companies (over $5M), growing faster (over 50% YOY) and generating higher revenue (over $2M).

In such companies, there is usually no one owner but more shareholders who play a less prominent role, and the day-to-day running of the company is in the hands of a management team.

What does the acronym mean?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. To calculate the metric, add all 4 of them.

Revenue-based valuation

SaaS companies aren’t like most other businesses and so neither SDE nor EBITDA are accurate ways of assessing their value.

Let me explain:

In SaaS, you pour lots of cash into product development upfront. As this investment is expensed in SDE/EBITDA, the metrics often equal zero.

This doesn’t mean that the company can’t generate profit in the future though. That’s why revenue is a better indicator of the company’s future value – as long as it keeps growing.

How to value SaaS companies?

Choosing one of the above valuation approaches and calculating the metrics is just the beginning.

To calculate the estimated SaaS value of the company, you need to apply a multiple to the figure.

For example, if your EBITDA is $70M and the multiple is 10, the estimated company value is $700M.

Choosing the SaaS valuation multiples is the true challenge as numerous factors may affect them, including the financial performance over time, operations, the customer base, customer acquisition channels, and the niche.

For example, if the company depends a lot on organic search to acquire new customers, it may be vulnerable to algorithm changes.

When determining the multiple, a valuer should consider the sustainability, scalability, and transferability of the current business performance.

Important metrics that impact SaaS valuation

Several metrics are important in the SaaS valuation process. Let’s have a look at a few key ones.

Monthly recurring revenue

Monthly Recurring Revenue (MRR) measures the predictable revenue a SaaS company expects to receive every month.

How does MRR affect SaaS valuations?

It indicates that the company has a strong, stable cash flow, which is evidence of good financial health.

MRR is calculated by multiplying the Average Revenue Per Account (ARPU) by the number of accounts. So, if you have 300 paying customers and the ARPU is $35, the MRR is $10,500.

MRR = $35 x 300 = $10,500

Annual recurring revenue

Annual Recurring Revenue (ARR) is the yearly equivalent of MRR projecting the recurring revenue for 12 months. The metric is used by companies with quarterly or yearly subscription plans.

Valuers use ARR as a ‘big picture’ indication of the company’s financial health and the metric is used in some value calculation formulas.

ARR is calculated by adding all recurring revenue from subscriptions as well as add-ons and upgrades.

So, if you have 100 on the basic plan paying $100 a year and 100 on the premium plan costing $500 per annum, your ARR is $60,000.

ARR = (100×100) + (100×500) = $60,000

Customer acquisition cost

Customer Acquisition Cost (CAC) measures the average cost of acquiring a new customer

It’s calculated by dividing the total acquisition costs, made up of marketing and sales expenses, by the number of new customers acquired. So if you spend $100,000 a year on marketing and $300,000 on sales, and you manage to secure 1000 customers, the CAC is $400.

CAC = (100,000 + 300,000)/1000 = $400

Naturally, the lower the CAC, the better as it indicates efficiency in attracting customers and enhances a company’s valuation by improving profitability prospects.

Customer lifetime value

Customer Lifetime Value (CLTV or LTV) measures the total value of the business that an average customer brings during the relationship with the company.

The higher the LTV, the better as it means that the company is good at retaining its customers and driving account expansion.

However, the metric is only valuable when contrasted with CAC. It doesn’t matter how much the customer brings if it costs way more to acquire them.

To calculate LTV, multiply the customer value by the average customer lifespan.

So if an average customer spends $10 a month and over 3.5 years, their LTV is $420.

Customer churn rate

Customer churn rate is the percentage of users lost in a given period.

The metric is key to the valuation because it has a long-term impact on the business and its ability to generate revenue in the future.

To calculate the churn rate, divide the number of users lost by the total of all customers at the beginning of the period and multiply it by 100. So if you start the month with 200 customers and lose 7, the churn rate is 3.5%.

Churn rate = (7/200) x 100 = 3.5%.

Gross margin

Gross margin measures the percentage of total revenue that exceeds the cost of goods sold (COGS), excluding other costs like sales and administration.

Higher gross margins indicate a more profitable core operation and can increase the valuation multiple.

To calculate gross margin, subtract COGS from the total revenue and divide it by the total revenue.

So if your revenue is $10M and the cost of goods sold is $3M, the gross margin is 70%.

Gross Margin = (10-3)/10 = 700

Net revenue retention

Net Revenue Retention (NRR) is the percentage of revenue retained from existing customers over a specific period.

To calculate NRR, deduct MRR lost due to downgrades and churn from the starting MRR, add expansion MRR, and divide it by the starting MRR. Next, multiply it by 100.

Confusing? Let’s break it down.

Say, your MRR at the beginning of the month was $10,000. During the month, you lost $3,000 because of downgrades and churn but gained $5,000 through upsells. Your NRR is 120%.

NRR = ((10,000 – 3,000 + 5,000)/10,000) x 100 = 120%

A positive NRR like the above is an indication that the business is growing and will have a positive impact on valuation.

Total addressable market

Total Addressable Market (TAM) tells you how big the market is and, consequently, what the growth potential is. A larger TAM makes a company more attractive to investors unless it has already achieved 100% market share.

TAM is expressed as the overall revenue that the company could generate with 100% market share.

To calculate it, multiply the average revenue per customer by the number of potential customers.

So if there are 50,000 potential buyers and each can bring $100 per annum, the TAM is $5M.

TAM = 50,000 x 100 = $5,000,000

How do you know the number of prospective customers? You can estimate it based on market research.

YOY growth rate

Year-on-Year (YoY) growth rate is the percentage of revenue growth relative to the previous year.

To calculate it, deduct last year’s revenue from this year’s revenue, divide it by last year’s revenue, and multiply by 100. So if your revenue last year was $5M and this year is $5.5M, the YoY growth rate was 10%.

The YoY growth rate is a reflection of the company’s ability to expand its operations and revenue. Provided it’s sustainable, a high growth rate will have a positive impact on the valuation.

Mistakes when conducting SaaS company valuations

Because of the multiple factors and various valuation models, it’s easy to make mistakes when estimating your company value.

Following a one-size-fits-all approach to valuation

There are valuation services that allow you to value your SaaS company almost instantly.

The problem?

They use only a limited number of factors, like the growth rate, and general formulas in their valuation. Such valuations fail to consider the unique circumstances of your company and its market.

It’s like valuing your house using an online calculator, without taking into account the local market dynamics, the fittings, or your neighbors. Using a national price index isn’t going to be any more accurate for the same reason.

To avoid the mistake, use professional SaaS valuation services or experts with experience in your niche.

Comparing your company with public SaaS companies

Another common mistake is comparing your company to public SaaS companies.

Such companies have a huge advantage over you. They command a higher market share and have access to more capital, an established user base, and enough resources to attract the best talent.

Consequently, their valuations are likely to be way higher than yours.

Comparing your SaaS business with competitors

When valuing your SaaS company, you may be tempted to compare it to your competitors. Surely, if they achieve a certain price, you should be able to get the same.

But here’s the catch:

No company, even in the same sector or niche, is like yours. You have a unique value proposition that comes with its risks and opportunities.

Moreover, you don’t know the nitty-gritty of the deal and the factors that influenced the price.

Focusing solely on revenue multiples

As mentioned before, revenue is just one of the factors to consider when valuing your SaaS company.

If you rely solely on its multiples and fail to recognize the impact of market conditions, the competitive landscape, the quality or scalability of your product, or the quality of your management team, the valuation will be inaccurate.

Why?

All of these can affect your ability to generate revenue in the future. Moreover, they can impact your overheads, which are not considered in this valuation model, and cut into the profile margins.

Overestimating your growth rates

Overestimating your growth rates may not seem like a big deal. After all, you may be able to get yourself a better deal.

However, it may bite you in the long run.

First, it can create unrealistic expectations from investors, and once they fail to materialize in the future, securing the subsequent rounds of funding may not be easy as you will lose their trust.

What’s more, overestimating the growth rates can make you blind to the challenges and issues that need to be rectified to support further growth, like a leaky funnel.

How can SaaS businesses improve their valuations?

Let’s wrap up the article with ideas on how to increase your SaaS company value legitimately and without artificially overinflating its valuation.

Reduce the churn rate across the customer journey

Customer churn is one of the key factors affecting valuations, so reducing it is the obvious thing to do.

For starters, you need to find out where in the customer journey your customers churn and why.

To do so, leverage product analytics and back the quantitative data with qualitative customer feedback.

Next, use the insights to design in-app experiences that will keep users engaged and help them realize the product value:

• Personalized onboarding flows that drive user activation and feature adoption.
• Contextual prompts that guide and reengage at-risk users.
• Automated notifications and emails to prevent involuntary churn.

Improve your customers’ experiences

In-app messages and guidance are also great for optimizing the customer experience, which improves customer satisfaction and is closely linked to retention and loyalty.

How do you identify opportunities to improve the customer experience?

Collect user feedback regularly via in-app surveys.

In the surveys, include open-ended questions which allow users to explain why they feel about the product in a particular way and suggest improvements.

In addition to pop-up surveys, collect passive feedback and customer requests via a feedback widget.

Optimize your pricing strategy

Your pricing strategy is another factor that can increase or decrease your company’s value.

First, make sure to review prices regularly to account for inflation. Charging higher prices can also position your product as a premium offering but can deter prospective customers.

Lowering prices may attract more customers, but it’s a downward spiral and it may deflate your company value in the long term.

The actual prices are just the tip of the iceberg.

If you’re using the freemium model to help users experience the product value, make sure the free plan doesn’t satisfy all their needs because they won’t upgrade. Also, consider the strain on your product infrastructure and support teams.

If, on the other hand, you have a free trial, experiment with various lengths to accelerate conversions forward.

Follow a scalable revenue growth strategy

The success of the SaaS business model depends on expanding your revenue without increasing the customer acquisition cost.

How to do it?

First, explore account expansion opportunities through upsells and cross-sells. As your customers are already using your product and deriving value, it’s easier to convince them to spend more on additional functionality, products, or services.

Second, leverage organic ways to attract new customers. The freemium or free trial model is a good start, as it creates a low barrier to entry, but don’t stop there.

Your satisfied customers are probably already promoting your product via WOM, which is the most efficient way to attract new users. Take it one step further and set up a referral program, like the Dropbox one.

Another idea: boost product virality by enabling prospective customers to experience product value before they even sign up for the product, as Loom or Calendly do.

Focus on product differentiation and market positioning

A solid differentiation and positioning strategy will help you better address market gaps and stand out from the competition. This may enhance your company’s valuation.

You can do it by:

• Adopting a customer-centric approach to product development to accommodate user needs and preferences.
• Innovating continuously to deliver unique functionality.
• Prioritizing product quality and dependability.
• Offering top-notch customer support, both high- and low-touch.
• Identifying your unique selling points and amplifying them via marketing campaigns.

Protect your intellectual property

As you invest in your product innovation, protect your intellectual property to prevent competitors from using your assets in their products.

This could be in the form of patenting and trademarking your product and assets to prevent your competitors from exploiting the fruits of your hard work. In your employment contracts, include clauses that will stop staff from transferring the know-how to competitors.

Yes, this may seem like an unnecessary complication when you’re moving fast and breaking things, but the sooner you look after this aspect of your business, the smaller the potential damage in the future.

Adopt sound documentation and reporting practices

Robust documentation is essential for business transferability. As the product is developing and internal processes are getting more complex, make sure to document everything.

Otherwise, the company’s value will depend on the individuals in the know and could be difficult to maintain once they leave or once you sell the company.

The same applies to reporting.

Developing efficient reporting practices ensures all stakeholders have access to the necessary data. This includes potential investors or buyers as well as the authorities.

Conclusion

Regardless of your short- or long-term objectives, obtaining an accurate valuation of your SaaS company is critical.

The most popular valuation method for SaaS start-ups is using revenue multiples, but the approach has its limitations as it doesn’t consider other important factors and metrics.

If you’d like to learn how Userpilot can help you drive sustainable growth and the metrics that matter for a successful valuation, book the demo!