Updated July 13, 2022
The Software-as-a-Service (SaaS) model has fundamentally altered how enterprise software was delivered and maintained, its cost structure, and most importantly, how it was paid for. Until the 2000s, software companies developed software and sold it to enterprises often with a substantial installation fee and an annual maintenance fee. The customers received upgrades from time to time. The software vendor incurred significant overhead to maintain tight version control and upgrade paths. The emergence of cloud computing changed everything. Enterprises accessed only the latest version over the internet which the vendors continuously updated. Costly installation and upgrades were eliminated. Costs significantly decreased making SaaS vendors highly profitable. The most significant change was to eliminate licence, installation and support fees in favour of a smaller but continuous monthly fee. SaaS vendors incurred significant losses initially until the accumulation of continuous monthly payments overcame initial costs. The cumulative revenue from SaaS monthly subscriptions over time significantly exceeds the revenues from the licence plus service model.
The subscription pricing model required the industry to develop new ways to value SaaS companies with their initial heavy losses. The industry agreed to use the Revenue Multiple model approach.
The process involves:
1) Identifying a revenue stream, (either trailing 12 months (TTM), current run rate, or Forward 12 months (FTM)). Current run rate is used most often.
2) Multiplying it by a multiple which captures all of the performance factors of the SaaS company and the judgement of the valuator
To determine the multiple, start with the current SaaS public company multiple, and then adjust it up or down by each factor that may impact the future cash flows of the company.
The challenge comes in determining the public company revenue multiple. The numbers are so highly volatile as to make the process somewhat suspect. See companion article: SaaS Valuation Multiples – How High Can They Go? To avoid stepping into this morass, we will assume that a SaaS public company revenue multiple has already been determined.
We will carry on from that point with the standard methodology. We will examine and quantify the many factors that inform the SaaS revenue multiple, often with comparison to the traditional on-premise enterprise software business model.
Please refer to the graph “Adjustments to SaaS Public Company Multiples” near the end of this article.
- Public versus Private
The first adjustment is to convert the public company SaaS multiple to a private multiple. Private companies trade at a discount to public companies because there is a limited market for private company equity. One author recommends subtracting 1.3 from the public company multiple to calculate the private company multiple. SaaS Capital, a prominent lender to SaaS companies, has researched SaaS valuations extensively. Until 2022, they recommended discounting the public company SaaS multiple by 28%. Given the volatility since the pandemic they believe that the discount has widened to 50%. See the Valuation Multiple graph below.
- Growth rate:
Growth rate is the single most important variable in determining the revenue multiple. Because SaaS revenues are sticky, the faster the growth, the higher the recurring revenue stream will be, and the more profitable the company. However, the size of the company is also important. The graph below shows that the average growth rates depend on the size of the company. (It appeared in “Determining the Worth of Your SaaS Company in Best Tech Magazine, but the link is no longer active.
Companies which generate higher or lower growth rates than their peers are rewarded or penalized. If your SaaS company is growing at twice the peer rate; the multiple would increase by 50% of the baseline private company multiple. For example, a $7M company growing at 60% (double the peer growth rate of 30%) would be given a premium of half the private company multiple. If the private company multiple is 5.0x, the premium would be 2.5x.
This rule of thumb may have been practical in 2016 when the multiple was 6x. With the recent inflation of public company multiples into the double digits, I am skeptical that a 50% premium is achievable in 2022.
Conversely, a company growing slower than its peers will have a much smaller multiple.
Other valuators use a linear approach: starting at a growth rate of 10% and a valuation multiple of 2x, increase the multiple by 1 for every 10% increase in growth rate. A growth rate of 100% would generate a multiple of 11x. In the buoyant financial markets in Q1 2022, this multiple might be acceptable.
Gross Margin: Not all revenue is the same. The multiple also reflects how profitable the growth is. Software companies get high revenue multiples because they earn high gross margins.
Typical gross margins for software companies are about 80%. As depicted in the graph, SaaS companies exceeding 85% in gross margin earn a premium while those generating less than 75% are penalized.
If the gross margin is less than 80%, some valuators won’t use a multiple on revenue. Instead, they will use a gross margin multiple equal to the revenue multiple times 1.25.
At 80% gross margin, the valuation is unaffected: GM = Rev*0.8 and GM multiple = 5*1.25. Valuation = (Rev*0.8) * (5*1.25) = Rev * 5, as before.
Below 80% gross margin the SaaS company valuation decreases. At 50% gross margins: GM = Rev*0.5. Valuation = (Rev*0.5) * (5*1.25) = Rev * 3.1, much less, as expected.
Revenue Predictability: Conventional on-premise, enterprise software companies earn a smaller revenue multiple than SaaS companies, because each enterprise sale is a one-off, and little of the revenue is recurring. The typical enterprise software company sells software on a license plus installation plus annual maintenance basis. The license and installation revenue are one-off transactions.
By comparison, SaaS companies which sell on a subscription basis have locked their customers into a recurring payment stream and are more resistant to business cycles. SaaS companies earn higher multiples than license + maintenance enterprise software companies because their revenue streams are more predictable.
Sustainable Competitive Advantages: Companies that can better defend their revenue stream from competition earn higher multiples. Some examples:
- Customer sales cycles and inertia: large utilities and governments have long sales cycles. It is difficult to land the sale, but once you have, the customers are unlikely to undertake it again for a competitor. Revenues from these sales are highly predictable.
- Intellectual Property protection: It is becoming more common for software companies to seek patent protection on their innovations. Companies that can protect their key algorithms have more predictable revenues and higher revenue multiples.
- Complex code: Companies that have invested heavily in developing a complex code base have a development lead time advantage over their competitors, leading to a higher SaaS valuation. Indeed, many software companies are sold primarily because their unique code gives them a time to market advantage that acquirers are willing to pay for.
- Technical and industry knowledge: A software company with an established reputation and deep contacts in its industry has a strong competitive advantage because as long as they continue to perform, their customers have no reason to switch to a competitor.
Total Addressable Market: Companies targeting a large market opportunity won’t reach market saturation for years. If they have sustainable advantages, they may not encounter competition for a long period. Generally, an available market exceeding $1 billion is sufficient. Companies with markets greater than $10 Billion will enjoy a higher multiple, but markets less than $1 billion may result in a lower revenue multiple.
Customer Concentration: If the software company is overly dependent on a few large customers, it will be heavily penalized in its multiple, because the loss of any of them would materially affect the business. Many private equity acquirers will not entertain an acquisition of a company with high customer concentration because of the revenue risk. SaaS companies typically sell into the Small and Medium Enterprise market with many customers and don’t suffer from a customer concentration problem.
Partner Concentration: The same concern applies on the supplier side. If a company is dependent on relations with a few large partners or suppliers, a change in terms, or a change in business direction, could easily sideswipe the business. Some travel, eCommerce and data analytics companies are critically dependent on data from large partners.
This will reduce their valuation and multiple and may cause a potential buyer to walk away. This is a risk for both enterprise and SaaS companies.
Network Effects: Social media sites become more valuable as more people use them because it becomes easier to connect with more like-minded people without significant incremental expense by the company. The site becomes more valuable to advertisers with more population to address. Companies with demonstrated network effects achieve superior multiples. However, true network effects are difficult to achieve. The few companies that have achieved this are household names: LinkedIn, Facebook, etc. A new company would need to find a narrow niche of followers not well-served by the giants, which is unlikely.
Performance Indicators Specific to SaaS companies
There are two key performance indicators for SaaS companies:
- LTV / CAC: Long Term Value (LTV) is the average expected revenue of a customer which is calculated as:
LTV = MAR*GM% / Churn: MAR is the Monthly Average Revenue per customer. GM% is the average gross margin in %. Churn is the rate at which customers terminate the service, measured as the number of terminating customers per month divided by the average number of customers during the month.
(Note: churn is calculated on the number of customers. If the revenue profile is significantly different among customers, or the customers MAR changes over time, it is better to use a Revenue Churn calculation).
The annual churn rate is also considered as a factor in valuation. A rate of 5% – 7% is considered acceptable, so churn less than 5% add to the SaaS multiple whereas a rate higher than 7% would penalize the multiple.
CAC: The average Cost to Acquire a Customer. This includes all sales and marketing costs: salaries, commissions, and program expenditures. Sum these costs over a quarter and divide by the number of customers acquired during that quarter.
The higher the gross margin and the lower the churn, the higher the long-term value of the average customer.
The LTV must be balanced against the Cost of Acquiring the Customer. The industry has centered on the following ratio:
LTV / CAC > 3
A successful SaaS company needs to earn, over the life of a customer, at least 3 times the cost of acquiring the customer.
- Payback period: Suppose that the cost to acquire a customer is $6000 and the monthly average gross margin is $500. It will take 12 months to recover the CAC. The industry has agreed that to be successful, a company needs:
Payback < 12 months
Very successful companies can generate a pay back in 5 – 7 months.
Rule of 40. There is another popular metric for evaluation the performance of a SaaS company. The Rule of 40 generates a single number to quickly determine whether a SaaS company is achieving the right balance between profit and growth:
Year-over-year growth in Annualized Revenue + EBITDA% >= 40%
For example, suppose a SaaS company generated annualized revenue of $12M over the previous 12 months (Trailing Twelve Months, TTM) and $9M in the prior comparable period, its ARR growth rate is 33.3%. If it generated EBITDA of $1M TTM, its EBITDA margin would be 1/12 = 8.3%. The sum is 33.3% + 8.3% = 41.6%. This exceeds 40%, so the company is performing well.
In the startup phase, all of the effort is focused on growth, and none on profitability. Startup SaaS companies are better measured using the LTV/CAC ratio described above. Conversely, mature SaaS companies should be profitable enough to generate EBITDA margins in excess of 40%, so the Rule of 40 is again not useful.
The Rule of 40 metric is most useful for SaaS companies in the rapid growth phase where the company needs to continue to grow quickly while generating profits.
Summary of Factors Affecting the SaaS Multiple: The graph below is modified slightly from a version which appeared in Best Tech Magazine (which is no longer available on the web). It summarizes the myriad of performance factors that inform the revenue multiple used to determine the valuation of enterprise and SaaS software companies. The biggest impact, both on the upside and downside, is the growth rate.
I have left the private company discount at 28%. In mid-2022, the public company multiples appear to be decreasing quickly and within months should be in the range where a 28% discount is more reasonable than 50%.
The Rule of 40 metric is not explicitly included in this chart as the growth rate and gross margin items effectively capture the growth/profitability trade-off that the Rule of 40 is meant to illuminate.
SaaS Capital Approach: As noted above, SaaS Capital, a leading lender to SaaS companies has invested significant effort in improving the calculation of private company SaaS revenue multiples. The methodology detailed above and captured in the chart requires the identification of the factors affecting the future revenue stream, and then using judgement to quantify the effect on the multiple, both plus and minus. By contrast, SaaS Capital uses a total objective, data-driven approach which obviates the assessment of multiple factors. Using statistical analysis on 91 purely SaaS revenue public companies, they isolated three factors which can estimate the private SaaS revenue multiple:
- The SaaS Capital Index – the current average public company SaaS model as described above.
- The growth rate in the Annual Recurring Revenue using the current revenue run rate.
- The Net Revenue Retention – a new term resembling Churn, discussed above.
Using statistical methods SaaS Capital developed the following formula to estimate the revenue multiple for any private SaaS company[i]:
Valuation Multiple = -3.2 + (0.32 * SCI) + (8.26 * ARR Growth Rate) + (2.62 * NRR Rate)
While difficult to explain, this formula has the advantage of removing all subjectivity and it is easier to use than the multi-step process above. A sensitivity analysis on the factors in the formula indicate that changes in the ARR Growth Rate have the biggest impact, confirming again that growth rate is the most significant factor in valuing SaaS companies.
SaaS Capital has calculated that the Multiples derived using this formula are within 30% of those observed in their practice.