Software as a Service (SaaS) is an exciting industry based on the software licensing business model and packed with unlimited opportunities. SaaS business owners should know how Saas metrics for business valuation can enhance the market values of their companies.
How Do SaaS Business Valuations Work?
Business owners do not usually understand how prospective investors value companies. Several factors, such as revenue multiples, come into play before an investor decides whether to invest.
Average Revenue Multiples vs. Recurring Revenue Multiples
A revenue multiple is a ratio that helps measure the value of a business or the equity on its gross revenue or net sales. Revenue multiples are more reliable than earnings multiples because they are less volatile. Also, unlike the book value and earnings ratio, revenue multiples are available for young firms and troubled companies.
However, SaaS companies have high recurring revenues, making the frequent revenue multiples better suited for their valuation.
The annual recurring revenue (ARR) metric helps predict the recurring revenue generated from a company’s subscription customers within a year. Monthly recurring revenue (MRR) serves the same purpose but for a month. MRR identifies the company’s short-term growth, and ARR gives the long-term view of the business’ progress.
A critical metric for SaaS company owners and prospective buyers, ARR helps management evaluate its overall health and assess its long-term strategies. Its stability and predictability make it a good metric for measuring company growth. Management can then compare the ARRs of past years and determine if their business decisions resulted in business growth.
Factors Influencing Business Valuation of SaaS Companies
Standard factors that influence all businesses include:
Operating history. Investors look at a business to gauge its profitability. It also helps them estimate the company’s prospects.
Earnings history. Historic income trends matter greatly in business valuation. A rise in income over recent years positively impacts valuation; a downward income trend may devalue the business.
Owner’s responsibilities and management team. Small companies usually depend on business owners to oversee multiple critical functional areas. From the investor’s perspective, this reliance upon the owner increases risk and reduces business value. They want the target company to have a stable and reliable management team. Business owners should employ and empower responsible employees to reduce the company’s dependence upon them.
Growth potential. Valuation also depends on the company’s growth prospects within its industry and also as a unique business. Having a business model with high growth potential and being in an industry witnessing increasing growth trends positively impacts business value.
Customer concentration. Customer concentration significantly impacts business valuation. A business dependent on a few key clients is risky from the investor’s perspective and scores low on value. A company with a diverse client base is more valuable.
Apart from the factors that influence all businesses, consider how the SaaS metrics impact the valuation of SaaS companies:
ARR (annual recurring revenue). ARR (annual recurring revenue) evaluates only subscription-based revenue and excludes one-time payments, like income from services or payment processing fees. It helps SaaS business owners identify the extent of their subscription model’s success. ARR also lends itself to forecasting revenue and easily incorporates complex calculations to project future revenues.
MRR (monthly recurring revenue). SaaS companies become market-fit quicker and start scaling faster than other business models, especially since their business is not seasonal. Therefore, investors can rely on monthly recurring revenue, which gives in-depth performance details and indicates if the company is a good acquisition target. Month-over-month growth figures help an investor get a better look at the business.
Customer churn. This SaaS metric measures the period during which the customer uses the software before discontinuing it. The annual churn rate is the percentage of customers that have canceled subscriptions during the year versus the customers that have not. Customer churn helps business owners forecast their revenue month-over-month.
Customer lifetime value (CLV) and customer acquisition cost (CAC). Customer lifetime value (CLV) and customer acquisition cost (CAC) are two essential metrics in SaaS. CAC refers to the cost of marketing needed to acquire a new customer. It is easier for the SaaS business to grow if the CAC is low. CLV is the revenue expected from every new customer. To beat the churn and sustain the business for the long term, your CAC should be low, and CLV should be high.
Increasing Value of Your SaaS Company
The following contribute to increasing the value of your SaaS business and help you obtain your desired exit.
Improve software consistently. For your software to remain relevant to customers even after a few years of use, you must add value to it with enhancements, new features, etc. This increases the CLV of your subscription model.
Understand your competitive position. Keep track of your competitors: their R&D initiatives, growth strategies, pricing policies, etc. Stay current with the latest industry trends, customer expectations, and the changing landscape. Use this insight to formulate and execute strategies to counter competition and stay relevant for your customers. Improve customer engagement and offer better services to retain your existing customers and attract new customers.
Up-sell strategies. With upselling, you try to persuade an existing customer to buy additional services or a more expensive tier of service. Effective upselling techniques may considerably boost your revenues while retaining your customers. Consider the happiness tactic when approaching your customers for upselling, and you show them how the service you are offering is more powerful and valuable for them.
Focus on ARR/MRR. The difference between ARR and MRR is that, while ARR provides a macro perspective of the SaaS company’s recurring revenue, MRR looks at it on a micro-scale. ARR can also be calculated as 12X MRR. While you adopt strategies to increase your ARR quickly by extensively promoting yearly plans, keep an eye on the MRR levels. Investors often look at the MRR to know if company growth is stable.
Balance growth with profitability. Balance the growth of your SaaS business with profitability by running more efficient systems and operations. This may include decreasing overhead costs, cutting unnecessary staff, or investing in efficient and effective processes. Improved operational efficiency leads to improved margins. Margin is the gap between the sales price of your product and the cost to make it. It is better to have this gap bigger. Also, do not forget to focus on the sustainability of your SaaS business. Put in place optimized, efficient growth levers that are free from any issues. The growth levers that investors look for include optimized pricing churn reduction, lead generation, etc.
Investors are looking for a profit engine with good growth prospects, so it’s essential to think about increasing your SaaS company’s value. Understanding the SaaS metrics, factors that drive SaaS valuation, and ways to improve your company’s value will help you achieve your desired exit, even if your company is a start-up.
Connect with Quantive to discover the right value-creation strategies for your unique business and receive expert guidance at every step.