The main sticking point in any M&A transaction is, of course, the price. You can’t buy or sell a company before first determining how much it’s worth.
Software and SaaS companies can be different from traditional companies in how they are valued in multiple ways, including the fact that their earnings tend to be based on recurring or contracted revenues, rather than one-off purchases.
But what kind of mechanisms can be used to figure out and illustrate the value of a software company, and what kind of factors will have an effect on it?
Types of valuations
- Seller Discretionary Earnings (SDE): SDE describes the amount of profit left over after you account for cost of goods sold (COGS)and critical operating expenses are taken off the gross revenue.
It is the way most smaller businesses are valued, typically at under $5m. It’s a good way for them to show the underlying value of the business and its ability to generate revenue.
It takes into account the ownership structure of a young company, where there is likely a single owner who draws a salary that is not necessarily correlated to market rates - SDE allows for this to be added back to the valuation.
It can be calculated using the following formula: Revenue - COGS - Operating Expenses + Owner Salary = SDE - Earnings before Interest, Tax, Depreciation, Amortization (EBITDA): Once the business grows and the leadership structure changes as more shareholders potentially come on board while more employees and management get hired, SDE is no longer enough - the valuation will need to reflect discretionary spend and expenses of the owner.
The valuation of most businesses over $5m is typically expressed through a multiple of their EBITDA, as it is perhaps the best proxy available for future revenues and a rough indicator of how long it will take the buyer to break even. If a company is being bought at an EBITDA multiple of 5x, for example, a buyer could conclude that it will take roughly five years for the company to generate the revenue to pay off the sale. - Revenue: When you’re talking about a young software or SaaS business, EBITDA can be a sub-optimal way of ascertaining a valuation. Even if they bring in a lot more than $5m in revenue, they often have to put up so much upfront expense while they are in early stages of grow that their EBITDA might be zero or even negative.
In this context, EBITDA makes for an unreliable basis for a valuation and a poor predictor of future revenue, as the contracted nature of SaaS revenues, assuming that customers stay on over time, will mean earnings are likely to grow sharply in the short to medium-term.
For this and other reasons, many buyers are looking at annual recurring revenue (ARR) as a basis to forecast future profits once the expenses normalize, and value companies with ARR multiples.
What other factors will affect the valuation?
Obviously, pure financials alone are not the only determinant of a company’s value or its future revenue forecast. The underlying drivers of those revenues also paint a picture of the company’s longer-term prospects.
- Churn: This is a very important one. The ability of a business to hold on to its customers over a long period of time will have a massive effect on how much money it will be able to bring in going forward. Churn varies from month to month - it could be 1% one month and then 20% the next - so you’ll need an annualized value for reliability.
The difference in income between a company with 5% church - which is an acceptable amount as you’ll never see a perfect churn-less enterprise - and a company with 15% churn will grow over time. Three years down the line, the difference in earnings might not be too large, but another 8 years and the company with the higher churn - all other things remaining equal - will have significantly lower revenues. - LTV/CAC Ratio: Every business needs customers, and it takes money to get them and retain them. The customer acquisition cost (CAC) describes how much it costs, in terms of sales and marketing, to gain a single customer. Obviously, you want this value to be as low as possible.
The CAC will itself be influenced by your customer acquisition channels - how many channels can you source customers from, how much competition there is in each channel, and what the respective conversion rates may be will all be of interest to investors as well.
Once you have them, the lifetime value (LTV) of the customer refers to how much value you can generate from that customer throughout the entire time you provide them services. This is a value you want to maximize.
By comparing the two and determining the LTV/CAC ratio, you can see if you are getting as much out of a customer as you are spending to bring them on board. The higher your LTV/CAC value, the better it will reflect on your valuation - most software and SaaS companies aim for a ratio of at least three, as it allows for a drop in LTV and still maintain healthy margins. - Monthly Recurring Revenue (MRR) vs Annual Recurring Revenue (ARR): The more revenue a company earns month-to-month, as opposed to year-to-year, the higher the valuation will be. Offering discounts to customers for buying an annual subscription as opposed to monthly ones may increase your cashflow and help reduce churn by locking people in, but also reduces overall revenue.
A good place to be is to have your MRR at least five times as large as your ARR. - Product and Competition: The quality of the underlying product or service you offer will, of course, factor heavily into your valuation. If the product is at a high point in its life cycle - that is to say, it won’t need an update or overhaul in the near-term - the valuation will be higher because the new owner will have some time at peak revenue to figure out where to go next with it.
Similarly, if the company does not have many competitors for its services, the valuation will definitely reflect that, as there will be less chance or a rival siphoning off customers or revenue. Having high barriers to entry and good protections over the intellectual property will mean a higher price tag.
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