One of the most common questions we get asked is how to value software-as-a-service (SaaS) businesses. Often times these companies are not currently in a phase in their life cycle where they’re generating significant cash flow and can be valued based on traditional multiple (EBITDA, Price/Earnings) methodologies. These companies generally are investing every penny made back in future growth and aren’t yet spitting off significant distributions to their owners. See our Q2 SaaS Newsletter for more on the “New SaaS Income Statement.”
Would one suggest that because there isn’t significant cash flow to show yet that these companies are worthless? Of course not! One of the largest and best known horizontal SaaS companies, salesforce.com, inc., still hasn’t reported positive net income, but has a market cap of over $47 Billion. RingCentral hasn’t shown a quarter of positive EBITDA, but has a market cap of roughly $1.6 Billion. Especially in the private market, how are SaaS businesses valued when traditional multiples fall short?
The first thing to keep in mind is that there isn’t a simple regression model that anyone can plug a few variables into and presto out pops a company’s worth. Investors and buyers look at several factors in aggregate, and utilize their analysis to come up, most frequently, with a revenue multiple that can be applied to determine the company’s value. The key factors we’ve observed buyers circling in on in all our transactions follow, and comprise the Founders SaaS Valuation Index:
- Contracted Recurring Revenue Growth – Growth can cover a multitude of “business sins” and if your business is adding recurring revenue at a rate north of 40% YOY, you are doing exceptionally well.
- Competitive Position/Brand – Software development kits (SDKs) and the internet as a distribution network have made copycatting and replicating easier than ever; having an established brand and position de-risks an investment and can help increase value.
- Marketing Spend Efficiency – Companies that have demonstrated the ability to grow impressively on frugal budgets are prime candidates for acquisition or investment by larger companies. These acquirers can pump previously unavailable cash into the sales and marketing budgets and ideally see an exponential return on that investment.
- Gross Margins (GM) – Of course the higher the better, but GM is a metric that encompasses marketing spend efficiency as well as the efficiency with which a company provides support for customers.
- Customer Acquisition Costs (CAC) – Goes hand in hand with Marketing Spend Efficiency, but shouldn’t be viewed in a vacuum. When the lifetime value (LTV) of a customer doesn’t sync up well with the CAC, a business may find itself less attractive.
- Intellectual Property (IP) – IP can serve as a successful barrier to entry against competition, and companies that have protected their business where applicable, can benefit from doing so.
- Pricing Power – Economics addresses firms as generally either price takers or price makers. If you can make your price, and drive it into the market with people excited to pay for your software, rather than having to price at a lower level often dictated by competition, you will command a premium.
- Total Addressable Market – Would you rather own a pizza place that specializes in only anchovy pizzas, knowing that the majority of people abhor them on their pie, or one that can make one of 100,000 combinations of pizza for its customers? Large total addressable markets show runway for continued growth and command premiums
- Churn – Another metric to not view in a vacuum, sometimes churning low margin and difficult customers is a benefit, but in general more valuable companies are able to demonstrate stickiness through customer retention.
- Customer Lifetime Value – This metric correlates to churn and pricing power, among other variables. Businesses aren’t all apples to apples, a $400 LTV in a smaller addressable market is worth less than a $150 LTV in a huge market.
- Net Promoter Scores – A true test of what your customers think about you is if they would recommend you to a friend. High scores, such as those greater than 9, are highly investible businesses.
- Multi-year Contracts – Contracts increase stickiness and help boost the LTV. Clients may not like getting “locked in” to longer contracts, but it greatly eases forecasting and cash flow management, which is a big plus for investors.
- Management Team Experience – the one maxim that we convey over and over at Founders is that buyers bet on the jockey and not on the horse. An experienced management team can weather challenges and overcome risks, while greener operators may falter.
If you’re considering raising growth equity or possibly selling completely to a strategic competitor, we would love to learn more about your business and give you our experience driven guidance to what your business is worth using our Saas Valuation Index. Please don’t hesitate to reach out to Zane, Chris, or Brad, and we can quickly discuss next steps and the process.
About Founders Investment Banking
Founders Investment Banking (Founders) is a merger, acquisition & strategic advisory firm serving middle-market companies. Founders’ focus is on oil and gas, SaaS/software, industrials, internet, digital media and industrial technology companies located nationwide, as well as companies based in the Southeast across a variety of industries. Founders’ skilled professionals, proven expertise and process-based solutions help companies access growth capital, make acquisitions, and/or prepare for and execute liquidity events to achieve specific financial goals. In order to provide securities-related services discussed herein, certain principals of Founders are licensed with M&A Securities Group, Inc. or Founders M&A Advisory, LLC, both members FINRA & SiPC. M&A Securities Group and Founders are unaffiliated entities. Founders M&A Advisory is a wholly owned subsidiary of Founders. For more information, visit www.foundersib.com.