Optimizing SaaS Company Valuations
Over the course of my career, I have spoken with hundreds of CEOs about their growing technology companies and helped several of our clients close capital raises and M&A transactions. One of the questions I have been asked most is, “What is my company worth?” Here are some factors that impact valuations for SaaS companies.
When Arbor develops valuation analyses for our clients and we look at public comparables and precedent transactions, the ranges plotted often span several tens of millions of dollars. A reason why valuations fluctuate so widely is that there are several KPIs that fundamentally differentiate a particularly valuable SaaS company from an average one. These factors include growth rate, net retention rate, gross margin, payback period, total addressable market, and less quantifiable considerations such as the value of IP.
Benchmarking SaaS Valuations:
Public comparables provide a benchmark for private company valuations. The median publicly traded SaaS company, as of today, is worth approximately 6.9x its last twelve months of revenue (“LTM”). However, because private company stock is less liquid than public stock and generally more risky, it tends to trade at a discount. We agree with the assessment made in SaaS Capital’s White Paper: Company Valuation that this discount can be estimated to be 1.3x. Therefore, a median private SaaS company will trade for approximately 5.6x (6.9x – 1.3x) LTM. A question I am often then asked is, “What would make my company worth more?”
Growth rate is by far the most important metric for SaaS companies. Companies with less than $5 million in revenue can receive valuation premiums by growing more than 50% year-over-year. Companies with more than $5 million in revenue similarly may receive premiums if they are growing in excess of 35%. Depending on how large a company is and by how much a company exceeds these growth thresholds, premiums can range from 1-5x+ for a total valuation of 8-10x+ LTM. Naturally, the larger a company gets, the harder it is to retain high growth. In our experience, SaaS companies receive the higher end of the 1-5x range when they have more than $10 million in revenue and are growing 40, 50, or 60+% year-over-year.
Net Retention Rate:
Buyers pay for predictability and often offer premiums for companies they perceive as predictably losing few customers. There are a couple of reasons why this is the case. First, losing customers causes a company’s addressable market to shrink. Second, high revenue retention lends itself to enhanced cash flow predictability, which can affect the long-term value of a company. For private SaaS businesses, the median net revenue retention rate, which accounts for cross-sells, up-sells, and price increases, is 100%. For companies with net retention rates above 100%, buyers will often pay premiums of 1-2x LTM. Companies with net revenue retention rates less than 80% may receive lower valuations.
Gross margins can be a proxy for scalability and profitability. The less direct costs required to deliver the software-as-a-service, the more valuable the associated revenue becomes. The average gross margin for a private SaaS company is approximately 84%. A private SaaS company may receive a valuation uptick if its gross margin exceeds 85%. Similarly, SaaS companies with gross margins less than 75% often receive valuation penalties.
Customer Acquisition Costs and Payback Period:
Customer acquisition costs (“CAC”) and the related payback period are important metrics that any buyer will consider prior to investing in or acquiring a SaaS company. The degree of efficiency at which a company converts sales and marketing spend into new customers is an indicator of the core unit economics that drive a business. The CAC ratio is one way of measuring this efficiency. The ideal CAC ratio, which equals the lifetime value of a customer divided by the company’s CAC, is 3:1. If a company’s CAC ratio is 1:1, the company is spending too much on acquiring new customers. Similarly, if this ratio is 5:1, the company is spending too little.
Related to the CAC ratio concept is the payback period. A company’s payback period is how long it takes to recoup costs associated with acquiring new customers. Private SaaS companies with payback periods of less than a year often receive valuation premiums. Similarly, companies with payback periods of significantly more than 12 months may receive lower valuations.
Total Addressable Market:
Market size is an important consideration for investors in particular. Total addressable market or “TAM” establishes the upper limit on how much money a company can conceivably make. Investors tend to look for opportunities with addressable markets larger than $1 billion. Companies operating in smaller markets often will be valued lower, sometimes by more than 1 or 2x.
Other Important Considerations:
There are a number of other, less quantifiable considerations that affect SaaS company valuations. Being the leader of a space, owning valuable IP, or having an especially strong management team, for example, each can lead to higher valuations. Furthermore, in our experience, strategic acquirers often debate whether they should “buy or build.” That is, should they buy a company with existing technological capabilities or build a similar technology themselves? We’ve sold companies in the past for which this dynamic impacted valuation significantly. In a certain instance, we were able to successfully show a buyer that if it were to have internally developed a certain technology instead of acquiring our client’s, the process would have taken too long and the buyer would have missed a large market opportunity. After this conversation, the buyer increased their offer by more than $65 million (several turns of revenue).
In summary, SaaS company valuations (and valuations for middle-market technology companies in general) are very subjective, but by improving certain metrics, such as growth rate, net retention rate, gross margin, and payback period, you can improve your company’s valuations in advance of a capital raise or M&A process.
If you would like to have a conversation about your specific situation, please feel free to reach out to me directly at email@example.com.
Ben Laufer is an Advisor for Arbor Advisors. Over the course of his career, he has worked on over $30 billion in aggregate transaction value, including several transactions for SaaS companies.