06 Aug Critical Metrics for Valuing SaaS Businesses
Software companies are attractive to many buyers and investors. Software companies with the Software-as-a-Service (SaaS) business model are especially attractive. Their financial appeal comes from their recurring revenue, high margins, growth and scalability.
If you have a healthy, growing software business, there are strategic and financial buyers that may be interested in acquiring or investing in your business. They will look at critical metrics in the areas of revenue/profitability, customer base/growth, and market size to analyze investment opportunities.
Revenue and profitability are critical measures of a company’s success. Company valuations are generally computed as a multiple of revenue or EBITDA (earnings before interest, taxes, depreciation, and amortization). Optimizing revenue and EBITDA is essential for obtaining a good valuation.
There are a number of different ways that investors evaluate the strength and sustainability of your SaaS revenue:
- Monthly recurring revenues (MRR) – Does the company have consistent revenue and consistent cashflow or is revenue “lumpy”, e.g. seasonal?
- Annual recurring revenues (ARR)– Does the company show a good revenue growth trend?
- Revenue concentration – What percentage of revenue comes from the largest customer? The top 10 customers? Is revenue and success too dependent on a handful of customers?
Your company’s valuation will be heavily influenced by the percentage of your revenue that is recurring and SaaS companies generally receive higher valuations than traditional software businesses. There is also a stairstep effect on valuation; buyers will pay higher multiples for companies with larger total revenue and larger recurring revenue percentages.
Profitability is equally important. Healthy SaaS companies generally realize EBITDA of at least 20% of revenue once they achieve scale (overcome startup expenses). Best-in-class SaaS companies can realize EBITDA of 40% or more of revenue.
Customer Base and Growth
Investors want to see a strong customer base. Customers validate the desirability of products and services. Happy customers provide recurring revenue and establish the foundation for continued growth.
- Number of Customers – the number of customers is a measure of the maturity of a company and also an indication of the risk the company has for sustaining profitability and growth
- Customer Growth – How many new customers do you add each month? Each year?
- Revenue Growth – An important company-specific metric is revenue growth rate. In order to achieve a higher valuation, your company must be growing faster than other similar-sized SaaS companies. As you get bigger, it’s harder to maintain the same growth rate so the “growth premium” will vary by company size. Very small SaaS companies may grow their annual revenue by 40-60% or more. As they get bigger, their growth will often slow to 30% or less. Salesforce, the largest SaaS company with over $14 billion annual revenue, is still growing faster than 20% per year.
- Customer Acquisition Cost (CAC) – How much does it cost you to acquire a customer? CAC should include all marketing and sales costs, including all program and marketing spend, salaries, commissions, bonuses, and overhead associated with generating new leads and converting them into customers.
- CAC Payback – The time it takes to recoup the CAC from the revenue and margin produced by the customer.
- Churn – How many customers do you lose each month? Each year? Why do you lose customers? Customer churn measures how many customers you lost in a given period. Revenue churn calculates how much recurring revenue was lost (not all customers spend the same amount).
- Life-Time Value LTV – The total expected revenue from each customer during the life of their relationship with the company. Note: it may be difficult to estimate LTV for companies with very low churn rates.
For a software company to keep growing, it needs to add new customers at a rate faster than its churn rate. As points of comparison, the median annual churn rate for small SaaS companies with less than $10M in revenue is about 20%. Best-in-class SaaS companies have annual churn of less than 7%.
A simple rule of thumb for SaaS is that the CAC Payback should be no greater than one year, or the business model is probably not sustainable. This is seen in many startups and struggling SaaS companies. Best-in-class companies have a CAC Payback of 6 to 12 months, and less than six months for some outliers.
Larger companies that sell enterprise software typically have field sales forces and higher customer acquisition costs of $1+ to generate a single dollar of new customer revenue. This higher CAC is offset by greater stickiness (lower churn) and a higher LTV of enterprise customers. By contrast, smaller software companies rely on less expensive Internet sales strategies with acquisition costs of $0.50 or less per dollar of new revenue, but they may experience higher churn. The best SaaS businesses have an LTV to CAC ratio that is higher than 3, and the very best may go as high as 7 or 8.
A company’s growth potential is determined by the size of the market in which it operates. Achieving market potential requires investment and good decision making, but if the size of the potential market is small then investments will likely have to be limited.
- Total Addressable Market (TAM) – The entire market segment expressed as a dollar figure of money spent by customers for a category of products and services.
- Serviceable Available Market (SAM) – The subset of the TAM that the company could reasonably service, given its focus and constraints.
- Target Market – The subset of the SAM where the company currently operates, including customer type, geographic boundaries, and product/service delivered.
- Market Share – The percentage of the Target Market that the company’s customers comprise. Typically, a company’s total customers as a percentage of total potential customers in the Target market (or total revenue as a percentage of total potential revenue in the Target Market).
Being able to describe your TAM is important so that your buyer or investor understands what your growth potential is. Most investors would prefer to invest in a growing company with a large TAM than in a large company with a small TAM.