July 12, 2019 Selling your SaaS business
How to Value a SaaS Business
Taking the time to understand what moves the needle in the value of your business will positively impact the way you run it.
In my role as Co-Founder and Head of Corporate Development at ASG, my job is to identify and execute acquisitions of bootstrapped SaaS companies. I’ve had the privilege of working with a few thousand Founders over the years and the most common question I hear is “What is my company worth?”
Regardless of whether you’re considering a sale or simply curious how you stack up against competitors, knowing how to value your SaaS business empowers you to make better decisions about your company’s future (and your own). To help, we’re breaking down how we approach valuation at ASG and dispelling common Founder misconceptions.
The 3 most common misconceptions about valuing your SaaS business
- Comparing yourself to a recently sold competitor. Context is key. The buyer could have a range of motives that allowed them to value higher or lower than expected (i.e. strategic acquisition in a space, the business has the largest client in the industry, etc.)
- Comparing yourself to the public market. Size matters. Salesforce and Oracle have revenue in the billions. Comparing yourself to companies at this kind of scale doesn’t set you up for realistic expectations.
- Using a valuation service firm. A valuation firm is going to value all businesses virtually the same, no matter the industry. Software businesses are inherently more valuable because the revenue model naturally allows for recurring revenue and cost efficient growth. Valuation firms don’t take this into account. They value the discounted cash flow, not the recurring revenue, meaning you won’t get the premium bump you deserve. If you’re looking for a conservative take, this is the way to go.
These three strategies will certainly give you an initial valuation, but the range will be so broad that it’s not useful in practical conversations. It might cause you to overestimate to a place of having unrealistic expectations (first two points) or underestimate to a point of underselling your business (last point). Instead of focusing on external factors, look at how your SaaS business is performing.
Start with the Rule of 40.
The rule of 40 is a metric for assessing the health of a SaaS business and is based on two important metrics: growth rate and profit margin.
The rule of 40 is calculated by: (growth rate + profit margin) x 100. As its name so subtly implies, a good rule of 40 score is greater than or equal to 40.
When the rule of 40 first made its debut, the industry was forgiving on how you got to 40. That’s starting to change. Now, it’s important to have a healthy balance of both growth and profit to maximize the value. A business can have substantial growth, but without the cash to continue, it’s not as sustainable or enduring as it may seem.
The rule of 40 is a quick starting point to assess your business, but the true value of a SaaS business is about so much more.
When we assess the value of a SaaS business, we look at 6 key factors.
- Revenue – the annual recurring revenue (ARR) of your business.
- Growth rate – Percentage at which revenue was added this year over last year. For example, if your company went from 10 to 11, you would take the New Value – Initial Value and divide by the Initial Value. (11-10)/10 = 10%
- EBITDA – Earnings Before Interest Taxes Depreciation Amortization calculates the profit a business generates on an annual basis. In calculating the rule of 40, the margin looks at EBITDA as a percentage of revenue.
- Customer retention – Percentage of customers that you retain based off of the prior year, not including the addition of new customers. For example, if you had 100 customers and 90 of them were still customers a year later, that would calculate out to 90% customer retention.
- Revenue retention – Percentage of recurring revenue that you retain based off of the prior year, not including the addition of recurring revenue from new customers. For example, if you had customers that generate $100 and the next year that same group of customers generated $98, that would calculate out to 98% revenue retention.
- Market size – The total revenue if one solution had 100% of the potential addressable customers in your market.
At ASG, we follow these rough guidelines for assessing mid-market SaaS businesses.
|YoY Growth rate||<20%||20-40%||40%+|
|Representative revenue multiple||2-3x||3-5x||4-6x|
*This framework is a rough guideline and does not guarantee a valuation.
A 7th, and harder to define, factor in assessing the value of a SaaS business is its intangible value. Do you have something no one else has? This isn’t just a perceived differentiator (i.e. “our technology provides a better user experience than anyone else in the market”), this is something specific and real that other businesses do not have and can not replicate. For example – a patent for a piece of technology or an exclusive contract with the single biggest customer in the space. These factors provide a defensibility for your business, adding to its value.
Understanding the value of your SaaS business is powerful. Knowing what to do about it is even better.
- If you’re not looking to sell yet – whether you’re bullish about growth, or not ready to hand over the keys, we encourage you to spend time exploring exit planning and the risks of holding on to the business too long.
- If you’re not happy with the valuation you calculated – start looking at your business and figure out what actions you can take to get there. Do you need to expand your market? Improve customer retention? Find the area where your business could benefit from strategic focus and make a plan to tackle it.
- If you have a number in mind – get comfortable sharing it upfront with potential buyers. This will help you weed through the casual buyers quickly and ensure you’re not wasting time if the two parties are too far apart.
- If you’re considering a sale of your business – the next step is knowing what’s most important to you (liquidity, flexibility of role, your people, your legacy, etc) and then do some research on your options – PE, VC, and ASG (our personal favorite). Balance the desire for the payout you want with finding the right partner to build upon your legacy – both matter.
Taking the time to understand what moves the needle in the value of your business will positively impact the way you run it, regardless of when you decide to sell.