M&A Deal Points | A Deep Dive on SaaS Valuation
The variable coefficient {1}
Before turning to everyone's favorite topic - multiples - we first need to ask the question, multiple of what? The typical choices are revenue, seller discretionary earnings (SDE), and EBITDA.
REVENUE: For fast-growing SaaS companies in true startup trajectory with explosive growth but little or no profitability, revenue-based metrics like ARR are appropriate. Because revenue-based valuations are based totally on future growth, they are becoming less popular for valuing SaaS companies that are not driving meteoric revenue growth. acquire.com's January 2024 multiples report *only* discusses profitability metrics, which is a shift from past practice.
SDE: SDE is typically a profitability metric used for Main Street businesses that are operated by the owner. Essentially, SDE is everything the business puts in the owner's pocket (compensation + distributions + discretionary & non-recurring expenses). SDE is appropriate for most SaaS businesses with a purchase price of less than ≈ $2M, that are fairly owner-dependent, and that are not growing revenues greater than ≈ 50% YoY.
EBITDA: Once the business has management apart from the owner in place and a purchase price above ≈ $2M, EBITDA is likely the appropriate profitability metric.
For all but the fastest growing SaaS companies, the appropriate multiple metric is going to be one that is profitability based, and is going to be either EBITDA or SDE depending on size and the seller's role.
The range {2}
We're getting closer to the multiple, but we're not quite there yet. This post focuses on multiple ranges, as often found in indications of interest before a buyer has really had a chance to dig in on diligence.
As noted in part 1, multiples can be all over the map, from less than 1 to close to 35. Despite those outliers, a good general guideline is that:
For businesses with a purchase price of less than $2M, multiples from roughly 4-7x *SDE* are common.
For businesses with a purchase price over $2M, multiples from roughly 7-10x *EBITDA* are common.
At first glance, you may think that's totally unhelpful. That means a company doing $3M in EBITDA could be worth anywhere from $21-30M, a variation of $9M or 30% of the higher price.
So, we need to get to work and start to narrow the range. How do you do that?
By looking at the durability of the business's earnings, its growth potential, and its transferability, topics we'll delve into next.
Finding the multiple {3}
We've previously covered the appropriate metric to multiply by the multiple (revenue, SDE, or EBITDA), as well as general multiple ranges (<$2M in TEV, ≈4-7x; >$2M in TEV, ≈7-10x).
Now, let's begin to dig into the factors that locate the actual multiple within the range, starting with financials, operations, and customers:
1️⃣ FINANCIALS:
▶ Is revenue and net income stable or, better, growing? While included among other factors, note that growth is weighted extremely heavily.
▶ Are the financials trustworthy and can irregularities be explained?
▶ Will there be transfer barriers for any of the earnings streams to a new owner, either due to her expertise or relationships?
▶ Has the business taken on outside investors, and, if so, at what stage is the funding?
2️⃣ OPERATIONS:
▶ Is the business somewhat mature (more than 2-3 years old)?
▶ Is the owner technical and how much time does he or she spend on the business?
▶ What technical skills are needed to operate or manage the business?
▶ How is the team? Are they employees, contractors, or both? Has the business's IP been secured, including by having workers sign confidentiality and intellectual property assignment agreement?
▶ Is the code quality high and well documented, including annotations? Is open source code used?
▶ Where is the product in its lifestyle? Ideally, key products will not need major updates soon, or perhaps even better, updates and new features, along with supporting marketing campaigns, will already be ready for implementation just before or just after closing.
3️⃣ CUSTOMERS:
▶ Does the business serve enterprise, SMB, or individual customers?
▶ What is customer acquisition cost (CAC)?
▶ What is customer lifetime value (CLV)?
▶ What is the churn rate?
▶ How do ARR and MRR compare?
▶ When customers unsubscribe, what are the typical reasons?
Each of the factors listed (and lots of others that fall under the same umbrellas) could warrant its own book, so this list isn't meant to be exhaustive but a starting point.
Are you getting used!? {4}
Getting used is a good thing, if you’re a SaaS company!
So, what are some customer acquisition considerations?
What percentage of users come from search? Are search rankings resilient and how has traffic changed over time?
What percentage of users come from a marketplace, like an app store or other hardware-linked marketplace? How strong is the company's relationship with the marketplace and hardware salespeople (eg, does your service add functionality that allows the hardware business to be more attractive and sell more units)?
Does the business produce high-quality, valuable content like blogs, white papers, ebooks, and webinars?
What percentage of users come from referrals? Are those referral relationships durable?
Metric mania {5}
We now turn to a final factor that quantifies elements from across the other factors: SaaS metrics.
There are literally podcasts devoted to SaaS metrics (check out SaaS Metrics School) and SaaS products that are themselves devoted to collecting and reporting metrics. Any discussion of SaaS metrics here will be incomplete, but let's go over some key ones to consider for valuation purposes.
1️⃣ Monthly Recurring Revenue (MRR): The predictable revenue that the business can expect to receive every month based on its current subscribers. MRR is the preferred metric for monthly subscription plans.
2️⃣ Annual Recurring Revenue (ARR): Similar to MRR but calculated on an annual basis. ARR is the preferred metric for annual contracts.
3️⃣ Customer Lifetime Value (CLTV): An estimate of the total revenue a business can expect from a single customer.
4️⃣ Customer Acquisition Cost (CAC): The cost associated with acquiring a new customer, including marketing and sales expenses. Comparing CLTV to CAC is crucial. A CLTV/CAV of ≈ 3 is typical.
5️⃣ Churn Rate: The percentage of customers who stop using the service over a given period. A low churn rate is critical for long-term success, as customer stickiness dramatically increases revenue growth over time. Note that churn rate is highly segment specific: For the SMB market, higher churn rates are expected than in the enterprise market, where more resources are expended on both customer implementation and retention.
6️⃣ Lead Conversion Rate: This measures the effectiveness of the sales funnel by tracking the percentage of leads that become paying customers.
7️⃣ Revenue Growth Rate: This measures the rate at which the company’s revenue is increasing over a specific period.
8️⃣ Magic Number: This evaluates the efficiency of the business's sales and marketing spending in terms of 1 year's worth of revenue growth for every dollar spent on sales. A magic number of 1 is good, and indicated CAC has been recouped in 1 year.
9️⃣ Total Addressable Market (TAM): This metric represents the overall revenue opportunity available for a product or service, assuming 100% market share in the targeted market segment. The bigger the TAM, the more opportunity for growth.
🔟 The Rule of 40: Is the sum of the business's growth rate and profit margin greater than 40%?
BOTTOM LINE: Understanding and optimizing key SaaS metrics is crucial for accurately valuing your business and attracting potential buyers or investors. By focusing on these metrics, you can highlight the strengths of your business and address any weaknesses before going to market. Remember, the better you understand your numbers, the more confidently you can negotiate and secure favorable terms. Keep these metrics in mind, continuously track your performance, and leverage this data to drive strategic decisions and achieve long-term success.