Valuation multiples for SaaS companies are at an all-time high, which is largely based on public company valuations and M&A transactions. When it comes to estimating private SaaS valuations, tools like profit and revenue-multiples can be useful.
However, companies with similar revenues within the SaaS sector can still differ from each other in significant ways according to their stage, business model, and the ability to retain customers.
The following four dimensions are used to describe a business, each represented by a metric. We will use these metrics in a formula to estimate a private SaaS company valuation.
- Business Size (Annual Recurring Revenue)
- Momentum (Growth Rate)
- Quality of Products/Services (Net Revenue Retention)
- Profitability (Gross Margin)
SaaS Valuation Metric #1: Annual Recurring Revenue
Annual recurring revenue (ARR) is an essential SaaS business metric that shows how much recurring revenue you can expect every year based on its subscriber base.
Not only is it used to map out the best and most efficient path forward for your company, but it also acts as a compass to easily see the impact of the changes you’ve made on a year-over-year basis.
Here is a basic formula to calculate ARR:
ARR = (Overall subscription cost per year + recurring revenue from add-ons or upgrades) – revenue lost from cancellations
Note that any expansion revenue (add-ons and upgrades) do affect the annual subscription price of the customer. However, one-time options or fees should not be included in this calculation.
If your pricing strategy is built on monthly recurring revenue (MRR), you can calculate the ARR by multiplying MRR by 12.
SaaS Valuation Metric #2: Growth Rate
The growth rate is the single most significant determinant of a company’s valuation multiple, especially for early and growth-stage companies seeking early-stage equity rounds, venture debt, or revenue-based financing.
However, keep in mind that measuring your SaaS company’s growth is only relevant when compared to a group of similarly-sized businesses.
The chart below shows average and median growth, broken down by annual recurring revenue.
Image from SaaS Capital
SaaS Valuation Metric #3: Net Revenue Retention
Net Revenue Retention represents how revenue would change if no additional sales were made.
This metric is used to indicate the quality of a SaaS company’s offer.
If the added value of customers upgrading more than compensates for the value lost to those downgrading or canceling, this means the product basically sells itself.
Here is the basic formula to calculate Net Revenue Retention:
Net Revenue Retention = [ARR at beginning of period + Upgrades – Downgrades – Churn] / ARR at beginning of period
SaaS Valuation Metric #4: Gross Margin
Gross margin describes the company’s top line earnings. It is correlated with a company’s valuation because it indicates how much of the revenue can be used to fuel growth, or in some cases, pay dividends.
Here is the basic formula to calculate Gross Margin:
Gross Margin = [Revenue – Cost of Goods Sold] / Revenue
The Valuation Formula
Once you calculate these four metrics, you can plug them into the following formula to estimate a SaaS company’s valuation:
Valuation = 10 x Annual Recurring Revenue x Growth Rate x Net Revenue Retention
Let’s say a SaaS company is generating $5M in annual recurring revenue and is growing at 60% per year with a net revenue retention rate of 120%.
The valuation comes out to $36M, around 6.2x.
From there, this estimate needs to be adjusted by gross margin. SaaS growth margins can range anywhere from 60-90% or more, averaging around 75%.
Therefore, you can add a proportionate premium on the estimate above if your company is generating around 80% or more.
Things to Keep in Mind
While this formula does take into account key performance metrics investors look for, it is extremely simple.
This estimate is more suitable for early-stage companies since growth rate can dramatically change the multiple.
As the company grows, growth becomes less important of a metric, and other metrics (e.g. CAC:LTV ratio, operating profits) should be used instead.
Other factors that can be taken into account when calculating a valuation can include:
- Quality of the Management Team
- Value of Intellectual Property
- CAC:LTV Ratio
- Payback Period
Using revenue or profit multiples are an easy way to estimate a valuation without needing too much data. However, it is important to show how these multiples are calculated and the performance metrics that influence them.
With this in mind, you can get a clearer picture of what areas to focus on and what to improve in order to build a more sustainable and valuable business.