All companies are not created equal. Even businesses within the same industry, with similar products and clients, can differ dramatically in terms of profitability, growth, and long-term viability.
What Is EBITDA?
One of the first steps in valuing a SaaS business often involves taking a look at a company's EBITDA. EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization, is a fancy term for cash flow. EBITDA is relatively straightforward to calculate. You take a company's net income, which is revenue minus cost, and then add back extraneous factors such as interest, taxes, depreciation, and amortization.
As a financial metric, EBITDA can be used to compare companies against each other and industry averages.
It has become the most commonly used metric across the investment community to evaluate a company’s ability to create cash flow from its operations.
Investors will often use EBITDA as a metric to determine the price they are willing to pay for a given asset or company. As a result, the determination of EBITDA and ultimately, the long-term sustainability and growth of EBITDA are often highly discussed items during an acquisition.
Common Misconceptions About How to Calculate EBITDA
One of the biggest mistakes we see Founders make is a tendency to be very liberal with how they calculate EBITDA. As companies position themselves for acquisition, they may attempt to try and add back expenses that are true operating costs to show a higher EBITDA. This can result in an artificially high EBITDA and create a significant disconnect between the Buyer and the Seller.
Buyers will be focused on evaluating what the EBITDA or cash flow of the business will look like once they own it. Therefore, when measuring EBITDA they will often look at expected recurring and non-recurring costs.
Recurring costs are those that are expected to be on-going after the sale of the business. Some examples of these include:
- Employee costs
- AWS costs
- Rent, etc.
Non-recurring costs are those that are not expected to be on-going after the sale of the business. These can include items such:
- A lawsuit settlement
- Costs for an employee who was let go or quit prior to the sale date, etc.
Buyers will often be willing to add back non-recurring costs in their EBITDA calculation when evaluating a business since those costs are not expected to exist once they own the business.
Beyond EBITDA: The Rule of 40
EBITDA plays a key factor in the determination of another important valuation metric in the SaaS community, Rule of 40.
The Rule of 40 analyzes the health of a SaaS business by focusing on two metrics:
- Revenue growth: the increase (or decrease) in a company's sales from one period to the next)
- EBITDA margin: a measure of a company's operating profit as a percentage of its revenue - calculated by dividing EBITDA by revenue
The Rule of 40 is calculated by adding revenue growth and EBITDA margin. By combining revenue growth with EBITDA margin, a company can calculate a valuation score that measures the financial health of your company.
Typically, as long as a company hits a combined score that's higher than 40, it is considered healthy and is an attractive business from an acquisition perspective.
Inherent in the Rule of 40 score is the tradeoff between revenue growth and EBITDA. If a Founder makes the conscious decision to reinvest in their business by spending more on sales and marketing or hiring additional staff, these investments may drive a higher revenue growth rate but delay a pathway to positive cash flow or EBITDA. Vice-a-versa, another Founder may choose to spend less on sales and marketing dollars in order to drive a higher EBITDA margin for their business.
This begs the question - which is more important - revenue growth or EBITDA margin?
The answer depends on where your company is at in terms of its lifecycle and position in the market. If your company is fortunate to be in a market where there is lots of whitespace opportunity for new business, you may make the decision to forgo EBITDA in order to invest in resources that will take share in the market and create revenue growth. On the opposite side of the spectrum, your company may reside in a more saturated market where there isn’t as much opportunity for new business. In this case, your company may be positioning itself for higher profit or EBITDA given its in more of a steady state mode with regard to growth.
How We Use EBITDA to Value a Company
At ASG, we like to see companies with a healthy balance of revenue growth and EBITDA margin, with a preference towards scalable revenue growth. What is “scalable revenue growth?” It means that as the business continues to grow, the incremental costs for each new customer goes down.
For example, if a business has $2.0M in revenue with $.5M in EBITDA, it has a 25% EBITDA margin. However, if the business is able to scale such that for the next $1.0M of incremental revenue they can generate a 50% margin on that $1.0M, well then the company becomes a $3M revenue business with $1.0M in EBITDA, and a 33% EBITDA margin.
This scaling effect is an indication of a healthy business and one that will generate meaningful EBITDA and EBITDA margin over time driving up their rule of 40 score. This type of business will typically generate the highest value in terms of purchase price as well. Therefore, it is important that you position your organization in a way that demonstrates how the business will scale over time.
EBITDA Is Only One Piece of the SaaS Valuation Puzzle
As with any given metric, you can’t look at it in isolation if you want to understand the full performance of your business. EBITDA is an important metric Buyers will use to measure the health of your business. Your ability to drive EBITDA growth through incremental revenue growth is also a key investor criteria.
However, these are not the only metrics a Buyer will look at when deciding whether to buy your business. There are other key Saas valuation metrics that will be evaluated. These include the Rule of 40, Revenue Retention, Customer retention, etc.
The key takeaway we hope you have from this post is that Buyers will want to understand your company’s EBITDA both now and in the future when valuing your SaaS business.This will be a key conversation you have with any Buyer. If you can clearly and fairly articulate your company’s EBITDA both in the short-term and long-term - you will set yourself up for the highest level of success when you decide the time is right to sell your SaaS business.