How Much is Your SaaS Company Worth?

November 11, 2021

What You Need to Know About Valuations

It’s understandable that every SaaS business wants the highest valuation. And in a world where Zoom trades around 40x revenue, it’s easy for founders to get a bit carried away, believing that their business deserves the same multiple.

We like to think we know a thing or two about how SaaS companies can be valued. After all, Element spun out of Scaleworks and offers founder-friendly debt finance to growing software companies. These companies often look to term loans to raise capital because they value their stock more than others are willing to pay for it . So, we thought it would be helpful to give our perspective on SaaS valuations and what founders might want to be aware of.

(Lowering) Great Expectations

Life, as many a parent has told a child, often isn’t fair. This adage holds true for SaaS/software company valuations but also most other industries as well.  Small businesses typically receive some sort of haircut versus their larger peers for two reasons: size and liquidity.

• Size does matter – Larger companies have many safety qualities for investors which small companies do not have. They have economies of scale, access to cheaper capital, talent, market access, etc.

• Likewise, private companies tend to receive an illiquidity discount, because their shares can’t be swiftly sold for cash. Exiting a privately-held company takes time and can be challenging.

Long story short, it may not be fair, but Zoom and their mega-cap tech ilk will almost always command higher multiples than small but mighty SaaS companies.

Now for Some Good News

As important as it is to temper founder expectations, the reality of SaaS valuations is still quite positive. Privately-held growing SaaS companies are usually valued somewhere between 2-10x annual recurring revenue, which is something that most industries could only dream of. Indeed, for mature private businesses in other sectors, a multiple of 5-15x EBITDA is not uncommon.

Digging a Bit Deeper

As a firm that provides growth finance, we spend a lot of time evaluating SaaS companies’ operations and finances. In this regard, we consider a number of metrics when deciding whether to offer a term loan. How a company performs on these questions can have a meaningful impact on their ultimate valuation.

The Rule of 40: This is a well-known tool, combining EBITDA percentage earned in a year plus revenue growth. The percentage growth in sales combined with the percentage growth in EBITDA should be 40% or higher. For example, a company growing at 45% annually, and whose EBITDA is increasing by 5%, would score 50 using the Rule of 40. This Rule of 40 should be taken with a grain of salt. At Element, we weight the growth rate higher than profitability.

In Saas, growth is the most important metric and burning cash in the pursuit of growth is a widely accepted way to run a business. So, as long as a company isn’t burning cash at an alarming rate, we’re happy to lend to them if revenues are accelerating. However, we also factor in scale: A larger business has positive implications for financial stability and suggests that the product isn’t an overnight success at risk of disappearing tomorrow.

The Customers are Always Right: As part of our diligence process, we look at the quality of a SaaS company’s customers. Our analysis looks at the number of customers a business has, the growth and expansion in this customer, as well as revenue concentration among the top purchasers. Digging a little deeper into the analytics of a company can give you valuable insights into the customer base, usage, open rates, daily clicks, and reports downloaded. All of these metrics detail how the customer uses a product, which drives decisions about how to cross-sell. From a risk perspective, this information also shows how “sticky” a product is.

Crucially, we also evaluate customer retention and gross churn. The latter measures the percentage of the installed base that leave on a monthly or annual basis. A higher gross churn figure indicates that the product isn’t sticky, and a company has trouble retaining clients. This is obviously a worrying sign. Equity investors often focus more on retention, as they are looking at the upside. But us lenders have to protect the downside!

Gross margins: This one is pretty self-explanatory. SaaS businesses with high gross margins are the most attractive, all else being equal. One caveat, though: Companies can calculate their gross margins differently, with some excluding the cost of employees who are necessary to service customers. We look for a figure of 75-85%, and make the necessary adjustments when looking at how a company came to its own gross margin calculation. Anyone with a gross margin of 98% either has the world's best business or is not calculating it properly.

Lifetime value/CAC Ratio: Virtually every SaaS company has to spend money to make money. But it’s important to take a hard look at the extent to which sales and marketing dollars are translating into revenue. Businesses can do this  by estimating the lifetime value of a customer, and dividing that figure by the Customer Acquisition Cost (COST). Scoring 3 or higher is ideal.

Zooming Back Out

We opened this post by talking about valuations in general, and that’s how we’ll end it, too. As we discussed in our previous article, the world has been awash with money, especially since the onset of the pandemic. This has affected SaaS valuations: In the last 18 months, venture capital and private equity firms have paid increasing multiples for software companies.

Growing SaaS companies should continue to trade at a hefty premium to more established businesses. Yet we caution founders that the lofty valuations of today could give way to pricing closer to Earth if financial markets enter a period of deflation. It’s impossible to know the catalyst in advance, but markets do feel quite ‘toppy’, and many sectors might feel some of the fallout. Life, as we said, sometimes isn’t fair.

If you’d like to discuss what we are seeing in the market, talk to us.

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