Software Valuation

Whenever software valuation or valuation of a SaaS is taken into consideration, both the investors and owners of the business have a different set of view with respect to the parameters for valuation in comparison to non-SaaS businesses. The previous year median SaaS valuation multiple ranged between 12X to 16X.

What are the reasons behind such high valuations of SaaS companies?

1. The SaaS companies have a recurring stream of income rather than one time payments.
2. The gross margins increase over a period of time and cost-to-service goes down
3. The product supplies is not finite unlike non-SaaS businesses with limited supplies
4. The customer keeps renewing the subscriptions resulting in increased sources of income
5. The data collected increases the efficiencies in the future services.

Software valuation Methods

Generally three major methodologies are adopted for software valuation according to the income received by the company. These methodologies are:

1. Seller’s Discretionary Earning (SDE)
2. Revenue based valuation
3. EBITDA

1. Seller’s Discretionary Earnings (SDE)

Seller Discretionary Earnings is the value, usually owner’s compensation, that the owner invest back into the business after deducting the expenses in the form of overheads, salaries of employees’ etc from the revenues of the company.

Following is the formula to calculate the SDEs

Revenue- [Cost of Goods sold + salaries of Employees + operating Expenses] + Compensation of Owners

Usually such kind of strategy is adopted by the owner who has just crossed the mark of 5 million dollars in Annual Recurring Revenue making the product-market fit.

2. Revenue based valuation

Another way of software valuation is through Annual Recurring Revenue (ARR) wherein the investors are willing to pay multiples of the ARR on the basis of the ARR along with the fact that the company has just crossed the mark of 5 million dollars and has become a product fit for the market.

This kind of software valuation is advisable wherein the company is in its initial stages and showing signs of hyper growth.

3. EBITDA

EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization which is actually a way to check healthy cash flows of SaaS company in the process of software valuation. The net income is taken then all the factors like interest, depreciation, taxes and amortization are added. This becomes a financial metric for calculating the industry average and helps in comparing the company performance with other companies belonging to the same market.

Net Income + Interest + Taxes + Depreciation + Amortization

The EBITDA score is again used for determining another software valuation metric i.e. Rule of 40 which takes into account the sum of revenue growth and EBITDA margin (after dividing EBITDA by revenue) to calculate the financial health of the company. The SaaS company wants to take this score over the mark of 40 which puts it in a good financial condition.

The company may wish to reinvest the positive cash flow back into business for achieving higher growth and delay the positive cash flow (EBITDA) or it may reduce the amount spent on marketing and sales and increase the EBITDA. This totally depends on the position of the company in the market. If the company projects to increase the share in blue ocean market space, then revenue growth is more prominent and low EBITDA margin is not harmful. However if the company is operating in the red ocean market space with more competition then high EBITDA margin is advisable for the company.

Therefore a healthy balance between the revenue growth and EBITDA margins taking the company to a scalable revenue growth where the incremental costs for each new customer goes down is sign for healthy business taking the score above 40 which makes the company ideal for higher valuation.

How is the multiplier decided in software valuations?

Usually in determining the multiplier, the average net profit of the last year is multiplied to the determined multiplier.

The multiplier is decided keeping in mind the apt and long term value of the business. So, the older the company bigger is the multiplier.

The multiplier is decided taking into account the revenue size of the company and attrition and retention rate.

Below 5 million dollars: usually the investors are not interested in such small cap companies with small market share. These companies attract very low multiples. So, during this stage the company must aim for more revenue share instead of achieving increasing positive cash flows and take the revenue over 5 million dollars

More than 5 million dollars:  At this stage because of the increased revenue size the investors feel that the company has found a product that satisfies a strong market demand. At this stage the multiples are still in single digit but higher than companies with revenues below 5million dollars

Between 10-100 million dollars:  This stage of growth excites investors and they are willing to offer multiples in the size of 10X to 15X taking into account the market size and future growth prospects.

Above 100 million dollars:  This stage of growth solidifies investors’ confidence and they will offer multiples between 10X to 20X or even more.

Further, another factor to be taken into consideration is whether the revenue is recurring annually or on a monthly basis. If the revenue is recurring on a monthly basis, this seems to be more attractive for investors as monthly recurring revenue indicates the strong need of the product among the customers and their strong desire to avail the same service on monthly basis.

Another important factor is the customer Attrition rate and the Retention rate. A healthy SaaS company is one where the customer attrition rate does not go above 10 percent and customer retention rate does not fall below 90 percent because the backbone of the SaaS company is the subscription based model which wants to retain its customers for better growth.

There are Other Factors too which play a great role in determining the software valuation. These include the following:

Diversification in clientele: It is important that a large chunk of the revenue should not come from a single client rather from a number of clients so that in case the client leaves the subscription, the company does not suffer many losses.

Period of Company’s operations: If the company has been in business recently then it may not attract higher valuation from the investors compared to a company which has been into business for a long term. So the longer the company has been in operations higher the amount of valuation the company attracts.

Current Industrial Trends: The company must never undervalue itself below the prevailing market trends and rightfully demand its valuations as per the existing competitive prices

Robust marketing network: A somewhat overlooked field by most of the companies. A SaaS is as good as its marketing is. If the marketing channels can generate leads organically, through SEO, affiliate programs and somehow reduce the customer accusation cost, then it can do wonders for the company.

Growing market size:  The market size of the company must be ever increasing so that the growth of the company does not get stagnated after achieving a level of growth.

Strong SOPs and Knowledge Bank:  The business should have well defined SOPs and a vast pool of technical know-how so that the company does not remain dependant on the expertise of its founders and smooth transition in leadership can take place after the exit of its founders.

Valuation of the Company’s Assets: Every important asset of the company must be properly valued including the IPRs, experienced staff etc.

Since, the companies differ on a number of parameters with respect to their size, maturity, industry etc. there cannot be a straight jacket formula to bring out a method of software valuation for every software company. Ultimately it depends on the vision and expectations of the owners and the investors and last but not the least the prevailing market conditions.