How To Price A SaaS Business

How To Price a SaaS Business

So you’re ready to sell your SaaS business. You probably don’t have the means to make it grow and are having trouble securing the necessary funding. Perhaps you just realized that your only SaaS product doesn’t lend itself to becoming a full-scale business. Or maybe you’re one of those entrepreneurs who just wanted to prove that they could solve a problem through software and pulled it off, but you don’t want to be bothered with actually running a business. Whatever the reason, if you’re looking to sell your SaaS business, it’s important to price it correctly. You want to ensure you get a fair market value for your company, but you also don’t want to set the price too high and scare away potential buyers.

We already wrote a post about how to sell a SaaS business. In it, we covered everything from why you would want to sell it, how to measure value, and where to sell it, to how to position your SaaS business as an easy sell. We also wrote another post on how to price online businesses. However, since the price point is one of the most critical aspects of selling a business, especially a SaaS business, we wanted to provide a more in-depth guide on how to price your company.

Aspects to consider when pricing a SaaS business

When it comes to pricing a SaaS business, there are several key elements that you need to take into account. These are related to your company’s present and future value, how much your business’s tangible and intangible assets are worth, and how much money the company’s making. All these factors are essential for investors that want to assess how good an investment your business is.

  1. The value of the software
  2. The value of the customer base
  3. Cost of Goods Sold
  4. The pricing model and strategy
  5. The level of recurring revenue
  6. The seller’s discretionary earnings (SDE)
  7. The industry’s price-to-earnings ratio or earnings multiplier
  8. The business’s location

Let’s take a more detailed look at each of these elements to see how they can help you price your SaaS business correctly.

1. The value of the software

When you’re selling a software-as-a-service business, the software is obviously an important part of the deal, and it’s something you’ll need to factor into the sale price. Factors that determine the value of the software are how well it’s coded, how in-demand the software is in the market, whether there are any intellectual property rights attached to it, and so on.

When valuing software, there are two main methods: top-down and bottom-up.

  • The top-down method is when you start with the total addressable market (TAM) or serviceable available market (SAM) and then estimate what portion of that market your software can realistically capture.
  • The bottom-up method, on the other hand, is when you look at all the individual factors that contribute to the value of your software and then come up with a total number. This is a much more thorough and accurate way to value software, but it’s also more time-consuming.

You’ll need to get an expert opinion on the matter to establish an accurate value for your software. However, the bottom-up method is probably the way to go if you want to get a ballpark estimate.

2. The value of the customer base

Another important aspect to consider when pricing a SaaS business is the value of the customer base. Since SaaS businesses rely on subscriptions to generate revenue, the customer base is a crucial asset. The size of the customer base, the average monthly recurring revenue (MRR) per customer, the churn rate, and the customer lifetime value (CLTV) are all important factors to consider when valuing a SaaS business’s customer base.

Regarding the size of the customer base, you have to look at the total number of customers and the number of active paying customers. This is because some SaaS businesses have a lot of free trial users that never convert into paying customers or inactive users that don’t use the service.

You can estimate the value of your customer base by multiplying the total number of customers you currently have by the average customer’s lifetime value.

In turn, the customer lifetime value (CLTV) is the average amount of revenue a customer will generate for your company over their relationship with you. To calculate CLTV, you’ll need to know the average revenue per user and the customer churn rate.

You can easily calculate the first by dividing the total revenue generated during a given period by the total number of users during the same period. The customer churn rate is the ratio between the number of churned or leaving customers for the period and the total number of users at the beginning of the period.

Once you have these two numbers, you can calculate the customer lifetime value with this formula:

CLV = (ARPU / Churn Rate)

Consequently, the value of your customer base will be

Customer base value = CLV * Total # of Customers = (ARPU / Churn Rate)* Total # of Customers

For example, suppose you’re running a crypto exchange platform with 1,000 users who stay with the company for one year on average. During that year, each user generates an average Monthly Recurring Revenue of $5, or $60/year. Your estimated churn rate is 20%.

In this case, the value of your customer base will be:

Customer base value = (($5/user/month * 12 months/year * 1 year)/(20%))*(1,000 users)

Customer base value = $375,000.

While this is an important metric, it’s also vital to note that it doesn’t consider the costs of running the business to generate that revenue. That’s where the next element comes into play.

3. Cost of Goods Sold

The cost of goods sold (COGS) is another critical factor to consider when pricing a SaaS business. This includes all the direct costs of producing and delivering the software to the customer.

COGS can be divided into two main categories: direct costs and indirect costs.

  • Direct costs are those directly related to the production of the software, such as salaries for the developers who create it, the wages of the people who maintain the software and provide customer service for that software, cost of marketing directly associated with that particular product, etc.
  • Indirect costs are those not directly related to the software but necessary for its production, such as office expenses, internet service, accounting fees, legal fees, hosting services, etc.

The primary use we give COGS is to calculate the gross margin, which is the difference between the revenue generated and the COGS.

Gross Margin = Revenue – Cost of Goods Sold

For example, if your SaaS company has a total revenue of $1 million and the total COGS is $500,000, then your gross margin would be:

Gross Margin = $1,000,000 – $500,000 = $500,000

Considering the cost of goods sold is important for buyers because it gives them an idea of how much it costs the company to generate profit.

4. Your business’s pricing model

In the SaaS space, you can use many different pricing models to price your product. From subscription to tiered pricing and from per-feature to freemium, there are many options to choose from, and each has its own set of pros and cons that make it ideal for each business model. The combination of your customer base with the pricing model you’re using to generate revenue can be a source of value for interested investors.

Furthermore, an investor may also want to assess your pricing strategy to see how your company is generating the revenue it’s receiving. A poorly thought-out pricing model and strategy represent a significant risk for the potential buyer. However, it can also mean an opportunity to increase revenue once they purchase your SaaS company.

Either way, if you want your SaaS business to be as attractive as possible for potential buyers, it’s important to have a well-thought-out pricing strategy that is in line with your business model and can generate the revenue you’re looking for.

5. The level of recurring revenue

Recurring revenue is the portion of a customer’s payments that come in regularly, typically monthly or annually. For example, if you have a customer who pays you $100/month for your software, that customer generates $1,200 of recurring revenue over the course of a year.

The higher your recurring revenue, the more valuable your business is, and the higher the price tag you can put on your business.

6. The seller’s discretionary earnings (SDE)

The seller’s discretionary earnings (SDE) is a metric used to assess a business’s profitability. It’s calculated by taking a company’s net income and adding back in any expenses considered discretionary, such as the owner’s salary, personal expenses, etc.

The SDE is important for buyers because it gives them an idea of how much profit the business is actually generating. It’s also vital for sellers because it’s an objective metric they can use when negotiating the price of their business. A higher SDE means the business makes more money for the current owner.

7. The industry’s price-to-earnings ratio or earnings multiplier

The SDE or seller’s discretionary earnings isn’t important just because it gives an idea of how much profit the company generates. It’s also important because we can use it to provide an unbiased estimate of what a SaaS business is worth. This is done thanks to the price-to-earnings ratio, a.k.a. earnings multiplier.

The price-to-earnings ratio is a metric investors use to determine whether or not a company’s stock price is high or whether the company is undervalued. This is because it measures the company’s current share price in relation to its earnings per share.

By comparing the earnings multiplier to the one for other companies in the industry (or with the industry average), we can get an idea of whether your business is performing well compared to other players.

But more important is that you can use the industry’s price-to-earnings ratio or earnings multiplier to estimate the value of your SaaS business by multiplying it by the company’s SDE.

For example, let’s say the average P/E ratio for your SaaS business is 4, and your company has an SDE of $100,000. This would mean that your company is worth $400,000 (4 x 100,000) if you want to price it according to the average company in the industry.

8. Your business’s location

The location of your headquarters can significantly impact the price of your company and how attractive it is to investors. For example, a SaaS crypto company based in India will most likely fetch a lower price than a similar company based in Silicon Valley, even if the first one has a better source code. While this may be unfair, there are several reasons for this. Big tech hubs like Silicon Valley are considered the mecca for tech startups, and investors are willing to pay a premium for companies based there.

Additionally, wages and living costs in some developing countries are much lower than in industrialized countries, so developers and entrepreneurs are almost always willing to accept a lower price.

The bottom line

Now that you understand the different factors that go into pricing a SaaS business, you’re better positioned to set an asking price that is both fair to you and attractive to buyers. Keep in mind the importance of recurring revenue, the seller’s discretionary earnings, and the industry’s price-to-earnings ratio when setting your price. It’ll be a win-win for everyone once you sell your business.

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