When looking at saas startup valuation, private market multiples have changed drastically in the last two years. For many founders, that means no longer just focusing on top-line revenue growth or simply pitching their product without properly defending how much it costs.
Gone are the days when investors would provide a universal sales multiple for a business simply because they received a pitch deck. Instead, they now have a defined list of criteria that includes retention rates, gross margin percentages, and how efficiently capital is currently being used to grow and scale.
The following guide will provide a detailed breakdown of saas startup valuation and how buyers and investors evaluate and determine the actual value of software businesses, using recent transactions and market benchmarks at the private equity level.
Why Software Businesses Avoid a Single Valuation Number
Despite what founders believe, there is no one-size-fits-all for calculating the actual valuation of a software business. Many founders believe that they can arrive at a "universal" sales multiple by taking their total revenues. However, the actual valuation of a company depends on the specific circumstances surrounding each transaction, how good the revenue is, and where the business is in terms of maturity.
When an investor purchases a minority interest in a startup (seed round) versus when they purchase an established business (mature), they will likely utilize completely different formulas to calculate value.
The present market is heavily weighted towards a company's ability to efficiently deploy capital and retain customers. Although higher revenue growth still warrants premium pricing, it is only warranted if backed up by strong gross margins and healthy cohorts.
In other words, if your company relies heavily on the use of expensive human capital or service costs to support its software sales growth, investors will discount the ultimate selling price to reflect that. Establishing this baseline is the starting point for developing a solid financial model and supporting the defensibility of that model.
SaaS Startup Valuation: What Determines a Company's Price
Valuation of SaaS startups in the marketplace typically involves valuing a company based on multiples of its annual recurring revenue (ARR). The most commonly used approach is to simply multiply a SaaS startup's ARR by a revenue multiple to arrive at a saas startup valuation.
The challenge with this is that there isn't an industry standard for revenue multiples. Revenue multiples for SaaS startups tend to fluctuate depending on several variables, such as risk profiles and growth rates, associated with each specific business.
To illustrate how variable SaaS startup revenue multiples can be, Founderpath collected private market data from over six-thousand founders to determine what revenue multiples (3x to 25x+) align with different growth rate brackets.
The Difference Between Enterprise and Equity Value
The single most misunderstood aspect of startup valuations is that enterprise value is not synonymous with the equity value of a startup. Rather, they are distinct and separate concepts, both of which must be carefully evaluated by a business owner when determining the potential sale price of a startup.
At the close of a transaction, a business owner will receive an equity (or market) value, which typically is the actual dollar amount received upon the sale of the business. In contrast, the enterprise value of a company's stock includes all the assets of the company (including cash), and the buyer assumes all liabilities associated with the business.
Equity value is calculated by taking the enterprise value, adding cash held by the company, and deducting any outstanding debt.
Thus, for example, a business with an enterprise value of $10 million and debt of $3 million would have an equity value of $7 million, which the shareholders would divide. This distinction should be considered when reviewing a term sheet or acquisition offer.
Public Versus Private Markets
Many founders read about public software companies trading at such large multiples that it’s safe to assume that their private company should be priced similarly. However, the data clearly demonstrates otherwise.
First, public companies provide investors with instant liquidity, whereas private companies do not. Research from SaaS Capital reported that while public software companies were trading at about 6.3x ARR in late 2019, private software companies had a much lower range of 4x to 5x.
Secondly, public stocks’ prices are immediately responsive to interest rate changes and news regarding the economy. Publicly traded companies are always responding immediately to market conditions. While private companies will typically adjust their valuations as well, they will do so over a longer time frame.
Therefore, trying to price a private startup using a public equity index will almost always create a delay in the final decision to close on the deal.
SaaS Startup Valuation During an Acquisition
One primary reason why the numbers associated with valuations seem confusing to many companies online is that they are mixing venture capital rounds (dilutive capital) with sales to buyers of companies (cash acquisitions). These two events are distinct from one another.
The venture capital round reflects the price the investor pays for their interest. Meanwhile, the purchase of a company reflects the value of a company’s future cash flows, future buyer synergies, the depth of financial research, and the terms of the purchase agreement.
You cannot determine the valuation of a company based on the venture capital multiple.
Ownership Rules for Venture Capital Rounds
When venture capitalists invest in a company, they buy a portion of ownership in the company with the expectation that the company will grow significantly larger than it is today. Due to the historically high failure standard of early-stage companies, venture capitalists require aggressive terms.
Potential failures, future dilution, and the variability of liquidations are factored into the pricing of ventures and their valuations at the time of investment.
As a result of the potential for a high valuation to have strings attached, such as a guaranteed return if the company sells before the date of maturity, the investment caps placed upon a high valuation serve to determine the ownership percentage of the investor when the investment is made.
High valuations serve as a guide to the ownership percentage to be established. The amount to be paid in cash upon a sale of the company prior to maturity is a determination of the cash that an investor can expect to receive upon their exit from the venture.
How Buyers Look at Profitability During a Sale
The sale price of a company is based on its current cash flow, not its potential future cash flow. In order to price a company fairly, the buyer must determine how much cash the company generates and how well its products align with the buyer's current sales process.
According to a report by the Software Equity Group (SEG), 42% of all software transactions last year were made by strategic buyers. The balance of software transactions was made by private equity buyers.
Buyers of software pay different prices for different software categories. For example, financial software was valued at 5.3 times median revenue, while supply chain management software was valued at 6.7 times median revenue.
In other words, the buyer of software will be doing the math to determine how fast the cash being paid for the purchase of the software will be recaptured. The value creation of an investment depends upon how well the investor can leverage the metrics obtained from the growth of a business.
For example, the value of a company's revenue is dependent upon the quality of its revenue. Revenue generated by a company with lower quality metrics will command lower valuations than the same revenue generated by a company with high quality metrics.
Why the Quality of Your Growth Matters
When examining saas startup valuation, revenue can be created differently. In the case of two different companies, both with $5 million in annual recurring revenue (ARR), each company may receive completely different offers from potential acquirers.
This is because the market will examine only the metrics associated with the growth of that revenue and the future scalability of that revenue.
Net Revenue Retention: The Growth Engine
One of the most significant metrics to establish the quality of a company's revenue is net revenue retention (NRR). NRR is a measure of how much your existing customer base continues to spend over time, net of churned (lost) customers.
According to SaaS Capital's research, a company with an improved NRR will experience the most significant increase in total company growth. Increasing the NRR from the range of 90% to 100% to the range of 100% to 110% can increase overall growth rates by five points.
Companies with an NRR greater than 120% are typically able to achieve significant multiples on their equity valuations, while companies with an NRR below 90% will likely endure drastic reductions in their equity multiples. If your existing customers leave, prospective acquirers will believe that your future customers will also leave.
Profitability and the Rule of 40
In a company's growth phase, traditional investors look at how a company's growth will impact future profitability. This is where the Rule of 40 applies. To determine the company's Rule of 40, you take the revenue growth percentage plus the profit margin percentage. An ideal score would be 40 or more.
However, many modern investors prefer to evaluate companies according to the Rule of X. Under this formula, you assign a weight of two to the revenue growth, compared to one for the profit margin.
For example, a company with a 25% revenue growth and a negative 10% profit margin would score 15 under the Rule of 40. Under the Rule of X, it would score 40. This demonstrates that growth can be more important than strict profitability, so long as the business is managing its cash burn appropriately.
Gross Margins and Revenue Mix
A high revenue multiple will be reserved for companies that offer their products through a pure software platform. The scalability of software solutions allows businesses to grow faster without incurring a large amount of added costs for adding new users.
Why Human Services Lower Your Valuation
The following two conclusions summarize how the investor should assess whether a company is taking advantage of its gross margin:
When evaluating a SaaS company, investors should closely consider the gross margin figure (above 80%) as evidence of a company that primarily generates revenue through the sale of software.
On the other hand, if a company has a gross margin below 60%, more than likely it is generating revenue via human labor (consultants) or by charging significant manual setup fees.
Because of this fact, investors will be less inclined to assign a multiple of these service revenues into their valuation calculation. Instead, they will reduce the valuation multiple for service revenues, thereby resulting in a lower overall company valuation.
Real-Life Examples of SaaS Startup Valuation
To better visualize how the real-world market determines a saas startup valuation and how to assess where companies fit into this real-world market, we will look at concrete examples.
One approach for understanding how SaaS companies' respective multiples are impacted by such valuation methods as gross margins could be evaluated as follows: a SaaS company's value was substantially decreased by due diligence that identified an operational risk.
A Typical Base Multiple Scenario
Assume we have a sample SaaS firm generating annual recurring revenue (ARR) of $3 million and growing at an explosive 80% per year, with a 115% net revenue retention rate and a 75% gross margin.
If we were to simulate a typical SaaS market, we would consider this SaaS firm's gross margin of 75% and apply a 9x revenue multiple, yielding an enterprise value of approximately $27 million.
The rationale for applying this multiple is based on the firm's rapid growth rate and a strong customer retention rate. Thus, the company should continue growing its revenue based on retained customers without the assistance of a significant amount of new customers.
How Business Risks Lower the Price
Continuing from the above example, assume the company is still generating $3 million in ARR. However, this time, the company is experiencing a very different internal growth engine (i.e., its growth rate has dropped to just 20%).
Revenue retention is down to below 100%, therefore the customer base is dwindling each year. The buyer also sees that there is a very large customer concentration risk: one customer is contributing to 25% of the company's overall revenue.
Therefore, these risks will lead to the multiple being significantly lower. The buyer can expect to only offer a multiple of 4 times, thus reducing the enterprise value to $12 million.
If this one large customer were to cancel their contract, this would effectively kill the business model and the buyer would be left holding a failed business.
The Founder's Checklist for a Sale
Once an offer is made, everything listed on the term sheet will be contingent on the buyer or investor verifying that each and every data point is correct. If the internal numbers do not match the numbers that were presented on the pitch deck, the buyer will immediately cut the valuation.
Organizing Your Financials for a Buyer
Founders need to have their financials completely organized before they approach buyers. Buyers do not want to see estimates; they want to see the actual raw, undeniable proof of ability to perform over an extended period of time.
The customer revenue bridge is a detailed, month-by-month account of the company's revenue growth, along with the number of new customers acquired, the number of existing customers that expanded, the number of customers that contracted, and the total amount of lost revenue.
The customer cohort table is hard evidence that proves how long a typical "old" customer remains active and how their spending patterns change over time.
The customer concentration report clearly breaks down all of the company's revenue into distinct segments according to the size of the customer's purchase, thus proving that no single customer has the potential to control the financial success of the entire company.
The definition of gross profit margin includes the separate and distinct software-related costs for the company, costs associated with cloud services, support service costs, and one-time setup costs.
The Value of Accurate Revenue and Cohort Proof
One of the quickest ways to have a lost opportunity is to not understand the difference between contracted revenue and recognized revenue. The founder may sign a large contract for $100,000 and immediately add it to their ARR. But if that contract includes a termination clause or the client has a poor payment history, the company will remove the total from the ARR calculation.
The investors will place great scrutiny on churn rate data. Having an overall retention of 110% looks good, but if that retention is being supported solely by one major customer increasing in value and a multitude of small customers leaving, the investor will quickly see through that facade.
Retention in all ranges of customer size is what will lead to a high multiple.
The Current Market Reality
Investors have matured past the days of blind optimism in the private marketplace. The days of obtaining premium multiples solely based on vision and the most aggressive promotional efforts of revenue are long gone.
The multiples given today are reserved for companies that have established operational discipline. Companies that are maintaining clean gross margins, demonstrating that their product is effective through net retention, and closely managing customer acquisition costs are the only entities achieving the highest levels of valuation.
The current trend in the world of M&A has emphasized the importance of understanding how to value companies based on cash flow, risk, and proven unit economics. It has also shown that fundamentally sound valuations cannot be achieved if high-growth companies continue receiving low M&A offers.
Questions to Ask During a Sale
Why do high-growth companies continue to receive low M&A offers?
Top-line growth doesn't mean anything if it is done at the expense of cash reserves. For example, a company growing 70% but spending excessively on marketing and human resources with a poor payback period will be perceived as having "rented" growth rather than "owned" growth by potential acquirers.
Likewise, if the growth is driven by low-margin professional services instead of actual software subscription services, the acquiring company will adjust the multiple to remove that low-value revenue from the multiple altogether.
How does high customer concentration negatively affect a company's sale price?
An acquirer will value a company based on the expected future cash flows from the customer base. Therefore, if a startup has one or two large clients that represent 30% of the company's total revenue, the overall value of the business will be subject to and reliant on those contracts.
If an acquirer purchases the business and one of the large clients decides to change vendors, the value of the acquired company will decline significantly overnight. To mitigate this type of risk, acquirers will apply a significant discount to the total valuation of the startup based on the risk of losing that large client.
When will a startup's founders suffer financially as a result of raising a venture round?
All dollars raised through venture capital will come with legal obligations. The most notable of these obligations are liquidation preferences, which will guarantee that investors will receive their investment back first in a liquidation or sale transaction.
When a founder raises a large amount of money at a large valuation, all proceeds from future asset sales will be allocated first to the investors. This means that if the market declines and the founder is forced to sell the company for less than the previous valuation, the investors will take all of the proceeds from the sale, and the founder will receive little to nothing from the sale.
