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How to value a SaaS business has typically been a grey area for business owners, advisors and accountants alike. When it comes to answering this question, the starting point is often what comparable businesses have recently sold for, in an effort to see where the business falls on the spectrum and what a likely sale price might be.
However, it soon becomes obvious that SaaS businesses sell for a wide range of prices, and have wildly different models, making it nearly impossible to get a good, accurate comparison.
Some businesses will be larger and have more employees therefore generating significantly higher revenues, while others will have been in business for longer periods of time and have a more solid history.
For example, smaller SaaS businesses that have been bootstrapped can be difficult to put a value on, especially if the business generates less than $1 million in ARR.
These smaller SaaS businesses tend to get valued using an SDE valuation model, which uses the actual profits from the business after owner’s compensation, expenses, and costs.
That means, when valuing a SaaS business, you need to examine the factors that are important to investors.
Consistent Growth Determines the Business’ Value
Whenever investors are thinking about buying a business, one of the key factors is being able to show them that the business has grown consistently since the time it was started.
The biggest areas investors look at are how you’re bringing new leads in, the number of leads you’re bringing in, the conversion rate on those leads, the packages and upgrades that you have in place, how well optimized your package pricing is, and how long you can keep a customer.
Some of the most attractive businesses will be able to show investors that they are performing in each of these areas.
If revenue is fluctuating from month, to month, the valuation could take a hit as a result. Even if the business has shown growth year over year, investors will value the business based on how well it is expected to perform in the future.
If sales go up and down, or are relying only on new, large agreements, investors could see the business as risky and devalue it. This is especially true if they are looking at buying another business that has more consistency in the month-over-month revenues.
Your Marketing Strategies
Investors are also going to dig into the marketing strategies used to grow the business - primarily, content marketing and search engine optimization strategies.
When it comes to traffic sources, very few are able to compete on the same level as content marketing and ranking highly in the organic search results. The number of leads these two strategies can bring in can be mind boggling.
For the most part, SaaS business owners won’t devote the level of effort needed to really turn up the volume on their lead generation when it comes to content marketing and SEO.
This is a massive mistake, and one that can cost big money whenever the time to sell rolls around.
If the business owner has devoted a large amount of effort to content marketing and SEO strategies, and are getting great results, those results can help justify a higher asking price during the negotiation process.
How Much Time is Required?
Another area that investors are going to look into is how much time they need to devote to the business in order to keep it growing. While most people believe that a completely hands-off business may be the most attractive, there’s actually a grey area you want to be in.
For instance, if the business requires you to put in 40-60 hours every week just to maintain it, bring on new customers, provide customer support, and continue developing the business, it may be hard to find an investor that’s willing to offer the maximum value.
Likewise, if you are taking a completely hands-off approach to the business, you may end up losing the interest of other investors. They will believe that the business is potentially being neglected, and makes the conversation for you that much more difficult.
The grey area exists between having the right number and type of people in place, so you can step back from the business when needed, while also making sure you are doing what’s necessary to keep the business moving forward and ensure it’s not being neglected.
ARPU can be Difficult to Use
Your average revenue per user, or ARPU, is a metric most SaaS owners will want to use when they’re selling their business, but it can be difficult to use in most situations.
Investors understand that your APRU’s will eventually make it into the income statements you use to value the business, but comparing one ARPU to another business’ ARPU can skew the metrics.
To give you an idea, take two different businesses. One generates lower revenues but sells directly to consumers, while another has higher revenues, but sells directly to corporations. Both of these businesses are going to have significantly different valuations.
Speed of Growth is as Important as Age
For most investors, they aren’t going to pay nearly as much attention to the age of the SaaS business, when it comes to placing a value on it, as they will when they’re looking at how quickly the business has grown and whether that growth can be sustained.
You’ll need to still back up the growth with metrics like your average churn rate, how leads convert into customers, and new growth trends you’ve identified if you want to justify a higher asking price.
You will also want to look at how dependent the business is on annualized subscriptions versus monthly subscriptions. Investors will see a payoff sooner with monthly subscriptions than they will from annualized subscriptions.
The Business Needs to be Transferable
Every one of the factors listed can help you figure out how much a SaaS business is really worth but if the business cannot be easily transferred to an investor, it simply won’t be attractive.
For example, if there is a lot of undocumented code in the software or you have agreements in place that cannot be easily transferred to the new owner, obtaining the highest asking price possible will be difficult.
Going one step further, if you’re using a payment processor that your investor can’t use, like Paypal for instance, the business could be impossible to transfer. These are areas many SaaS owners fail to address before the sales process moves forward.
How to Value a SaaS Business
In spite of the valuation challenges, SaaS businesses are bought and sold all of the time. Sometimes those businesses sell for as little as two and one-half times yearly SDE, while other times those businesses will sell for as high as four times yearly SDE.
The range may seem to vary wildly at first, but when you stop and look at how each factor plays a role in the valuation of the business, it becomes far easier to understand.
Knowing the metrics of a business and how investors view those metrics can make it easier to determine a fair price.
Jock Purtle is an expert in valuing online and digital businesses. He is the founder and CEO of DigitalExits.com.