KEY ARTICLE TAKEAWAYS
Understand why SaaS companies earn higher valuations than project-oriented companies
Learn which specific factors make SaaS companies more valuable than their peers
Learn how to calculate key SaaS ratios
Why do SaaS companies sell for higher multiples of EBITDA?
Investors like certainty. They want to know that the cash flow they expect from an investment will be delivered. If cash flows are erratic or unpredictable, they will be less valuable to an investor and the company will be less valuable as a result.
The business model of a SaaS company helps create more certainty in its future cash flows. SaaS customers subscribe for a specified period of time (could be a month, quarter, year or longer) in order to have access to the software being sold as a service.
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As more customers subscribe, a SaaS company’s revenues hopefully grow consistently over time. Unlike a project-oriented business which has to sell new business every day to replace the project revenues it just completed, the SaaS provider adds more revenues on top of its existing revenues over time (with some exceptions).
This is a very attractive business model for investors because the cash flows from SaaS companies are much more predictable than for companies who have to sell new business every day just to maintain existing revenue levels. A company that fails to sell new projects to replace the ones it just completed will shrink in revenues and earnings.
Because SaaS cash flow is much more predictable, it is more valuable, and SaaS companies earn some of the highest multiples of revenues and EBITDA we see in the middle market (we have closed SaaS deals in excess of 10 times revenues and 30 times EBITDA – multiples unheard of in project-oriented businesses).
Why do SaaS companies sell for higher multiples of EBITDA?
When evaluating SaaS companies against one another, there are several key metrics that determine which ones will sell for the highest multiples of revenues or EBITDA.
The first key metrics is the ratio of the cost to acquire a customer to the lifetime value of that customer. This ratio is commonly referred to as LTV/CAC (Lifetime Value/ Customer Acquisition Cost).
LTV takes the average gross margins generated by a customer in a year multiplied by the average duration of a customer’s relationship with the company. This tells you the estimated gross margin dollars a customer will generate over the duration of their lifetime as a customer.
CAC takes all sales, marketing and unreimbursed new customer implementation costs for a year and divides those by the number of new customers acquired in the year. This tells you how much it costs to acquire a new customer.
A lower LTV/CAC ratio means it is more expensive to acquire a new customer relative to the margin that customer will generate for the company. Investors like to see this ratio be greater than 4. For example, if it costs $100 to acquire a new customer, that customer should be expected to generate at least $400 in gross margin over their lifetime as a customer.
We have seen companies with an LTV/CAC ratio over 15x, and they sell for the highest valuations. We have also seen companies with an LTV/CAC ratio under 2, and these companies can struggle to get a deal done.
Revenue growth rate
Higher revenue growth rates will make a SaaS company more valuable as it signals higher expected cash flows in the future. In addition, very rapid revenue growth might be required for a company to cement its position in the market as competitors undertake a land grab to sign up customers.
One key metric for determining revenue growth is to look at monthly recurring revenue (“MRR”). MRR is the amount of revenue being generated each month that is expected to recur the next month. Investors expect MRR to continue to grow each and every month – the higher the growth, the better.
Revenue churn rate
Revenue churn rate is the rate at which customers are canceling their subscriptions or purchases. Revenue churn rate is calculated by dividing the total dollar amount of revenues generated in the prior year from customers who have terminated their relationship with the company by the total revenues generated by the company in the prior year.
Some investors will also look at “net revenue churn,” which adds any increase in revenue from existing customers (from price hikes, purchase of additional products or services, etc.) to the amount of revenue lost from terminated customers, and then divides that amount by total revenues for the prior year. Net revenue churn will be a lower churn rate than revenue churn overall.
Investors are most attracted to companies that have positive net revenue churn (meaning existing customer purchases increased overall, even accounting for terminated customers), and generally do not like to see churn rates of more than 5% per year.
High revenue churn rates mean the company must work that much harder to maintain and grow revenues. High revenue churn also tends to decrease the LTV of a customer.
Incremental gross margin percentage
Incremental gross margin percentage can be calculated by dividing the gross margin dollars generated by a new customer in its first year by the revenue dollars generated by that customer in the first year. Investors like to see incremental gross margins of over 80%.
If incremental gross margin percentages are significantly less than 80%, it will be harder to scale quickly without additional capital. High gross margins make it possible to use incremental cash flow to reinvest in customer acquisition, leading to higher growth rates. High gross margins are also a good indicator of how differentiated a company’s product is to its customers.
We have written a 9-page white paper that goes into detail on each of these calculations, as well as the importance of accounting for revenues and expenses correctly. Please let us know if you would like a copy. Likewise, if you would like to discuss how to best position your SaaS company for going to market, please feel free to reach out to us at [email protected].
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