5 Metrics That Matter for SaaS Company Valuations
SaaS or software-as-a-service companies are highly valued in modern IT and other industries. However, sometimes these valuations can be way off base, or they might be far too optimistic for what a company should be valued for.
It can be tough for sellers to know how valuable their SaaS companies are, just like it can be difficult for investors and buyers to know whether they are making a wise purchase based on faulty or overvalued metrics. Search for SaaS Businesses for sale on Flippa.
Today, let’s break down five major metrics currently driving SaaS company valuations. We’ll also discuss additional metrics to consider so you can more accurately value a SaaS business, whether you’re a seller, buyer, or long-term investor.
Net Dollar Retention
The net dollar retention is how much of a company’s annual recurring revenue or ARR is retained and grown over 12 months. It includes both churn rate and down sells, making it a very robust and well-rounded metric to focus on.
In short, NDR tells an investor just how much money a company can keep for expansion, future growth, or other progressive ideas. It automatically cuts out money used for regular maintenance, debts, and other costs that must be paid from revenue.
It’s a key metric for SaaS businesses throughout their life spans up to the initial public offering since it directly measures how successful its business model is. In general, net dollar retention ratings over 100% are considered good, and anything over 120% is phenomenal. Therefore, many investors will prioritize acquiring assets that produce high net dollar retention ratings.
Customer Retention
Similarly important is customer retention. The higher the customer retention rate a SaaS business can boast, the more people it retains after acquiring them as customers through marketing campaigns or other means. Most customer retention metrics measure retention over a 12-month timeframe.
Customer retention is particularly important for SaaS companies because most of their revenue comes from ongoing subscriptions or services, not one-time purchases. Therefore, a SaaS company with a bad customer retention rate is not likely a great investment and will yield a poor selling price for owners until this value is improved.
The most successful SaaS companies often have high customer retention as these customers believe that the product is necessary for their success. Such companies have to spend less acquiring new customers over time, saving them money in the long run.
Rule of 40
Investors and SaaS company owners alike often fixate on the Rule of 40, a proxy used to understand how well a SaaS performs. It measures revenue growth and profitability.
Furthermore, the Rule of 40 looks at how well a company trades off growth for profit or vice versa. If a company grows 100% year-over-year, for example, and generates 50% EBITDA margins, that’s a completely different SaaS business from a company that grows 15% year-over-year and has -50% margins.
The Rule of 40 metric allows investors to determine whether growth substantiates overall profits and estimate the earnings potential for a given SaaS business in the long term.
ARR
Investors should also examine the ARR or annual recurring revenue for a SaaS business. Most software companies have higher values than service businesses because they are much easier to scale and more likely to generate future revenue since they use recurring revenue models.
High ARR is great for companies because it shows that the SaaS business is “defensible” in that it won’t easily be dislodged from a top spot by a competitor. It also indicates a low-risk profile for investors. Generally, the higher the ARR, the better it is for company owners or investors looking for an excellent long-term asset they can hold and sell once it has gained even more value.
Growth Rate
Lastly, investors and SaaS company owners often fixate on the growth rate, one of the most important factors to consider when buying or selling a company. Growth rate broadly represents how rapidly a company’s software or services are adopted, plus incorporates their total market share capture.
Put even more simply, the growth rate is broadly equivalent to the validation or true value of a company. A SaaS business with a skyrocketing growth rate is likely to be profitable, at least in the short term. Additionally, a high growth rate often predicts good future success over the long term. Sellers will often highlight the growth rate when trying to get a great purchase price for their companies.
As you can see, each of these metrics is important in its own way. That said, investors should not look at just these five metrics when determining whether a SaaS business is valued accurately.
Other Key Metrics to Consider When Valuing a SaaS Company
There are many other key metrics to consider when valuing a SaaS company, whether you want to purchase it for a quick trade or invest in it for long-term returns. Here are some additional metrics you can use to ensure accurate SaaS company valuations.
Churn Rate
Firstly, any investor should consider the churn rate for a SaaS company before signing on any dotted line. Churn rate is used in many of the metrics above, and it’s a major valuation driver since it touches on other important factors that affect future potential cash flows for a business.
In a nutshell, the churn rate tells you how quickly a company burns through its customers. The higher the churn rate, the more time and money a company will need to acquire new customers year-over-year. In contrast, a lower churn rate means that acquired customers are more likely to stick with the software or services provided by a SaaS company for years to come.
Customer Lifetime Value
Also, consider the customer lifetime value or CLV of a SaaS before deciding whether to invest. Customer lifetime value measures the average revenue a business can earn from a customer over the full course of the relationship (how long they pay for the software/service).
Naturally, higher customer lifetime value is better than lower. High-quality, very valuable SaaS companies will provide irreplaceable software products. As noted above, these software products will be considered essential by their users, so they’ll be less likely to ever stop paying for them.
In contrast, a low CLV means that a company’s software products are either easily replaceable or are too inconvenient to use to be worth customers’ long-term time and subscription money.
Customer Acquisition Cost
Next, keep customer acquisition cost or CAC in mind. CAC is calculable by adding total marketing and sales costs needed to acquire one new customer. Of course, a lower customer acquisition cost is better than a higher cost since it means that a SaaS company has to spend less to acquire new subscribers or users.
However, what counts as a “good” CAC will vary from company to company. A company’s marketing budget, cost of its software or services, and other financial factors will determine whether the dollar amount is low or high.
Monthly Recurring Revenue
Of equal importance is monthly recurring revenue or MRR. Like ARR, monthly recurring revenue shows how much revenue a business brings in month after month. It’s primarily important for smaller or mid-market SaaS businesses, especially those run by small teams.
SaaS business owners may wish to prioritize the MRR metric because investors often look for high growth capital. Even though focusing on monthly recurring revenue rather than long-term or lifetime subscriptions can slow down your growth, it will help you achieve a higher valuation and, therefore, sales price for your company.
Plus, many successful SaaS businesses have a relatively high MRR to ARR ratio of about 5 to 1, meaning some SaaS software products have annual plans that are about 10% to 20% cheaper compared to monthly plans. Ultimately, you may wish to look at both MRR and ARR when determining an accurate valuation for a SaaS company.
Customer Acquisition Channels
Customer acquisition channels are particularly important for small to mid-market SaaS businesses, which usually have relatively high customer churn. Therefore, the more customer acquisition channels a SaaS business has, the easier it can draw in new customers.
For example, a SaaS business that loses between 30% and 50% of its customers each year must replace those customers rapidly to counteract those losses. A good investment and likely successful SaaS company will have:
- Many different customer acquisition channels, such as banner ads, social media, direct advertising, email ads, and more.
- A few more concentrated customer acquisition channels. These allow SaaS companies to focus their marketing efforts and target their ideal customers more accurately.
Investors should spend a good deal of time looking at customer acquisition channels to accurately predict whether a small to midsized SaaS company will be able to replace customer losses in the short to midterm.
Product Lifecycle
Any wise investor will take a good, hard look at a SaaS product’s lifecycle before making a purchase or investing. After all, any SaaS software has to be developed and improved over time to meet customer expectations or ensure business growth.
Product lifecycle can include:
- How long a given version of a software product is expected to last (or be in the market).
- How long it takes to develop new versions of a software product.
- What resources each development cycle for a software product needs, and more.
The product life cycle will also impact operating costs, projected revenue and growth, and so on. Analyzing this key performance indicator will be easier for investors who already know the software development industry. Any SaaS company looking for a buyer should have a breakdown of their product lifecycle as well.
Potential Buyers
SaaS business investors may also wish to investigate potential buyers for a company’s products. This is effectively a form of market research; no software product should be made without the company knowing someone is likely to buy it in the first place! Similarly, no investor should invest in a SaaS company without knowing that the enterprise is potentially valuable.
In many ways, discovering or determining potential buyers may show an investor that SaaS has profit potential. Plus, by identifying the potential buyers for a software product, a SaaS company will be able to:
- Market more directly and effectively to its target audience (or the people most likely to buy its product)
- Determine what the right price point for the software service is
- Know where they should focus their marketing efforts (i.e. on social media, B2B marketing channels, etc.)
Understanding potential buyers (and how many there are) is vital so a SaaS investor doesn’t waste their money on a dud company.
Public Markets
Lastly, SaaS investors should consider the public market interest for a company before offering a cash infusion. Public markets include the public stock markets, like the New York Stock Exchange, on which a SaaS company may eventually be listed.
Investors should see whether there is sufficient public market interest for a given SaaS company before investing in the enterprise. It’s an important metric since it speaks to an organization’s long-term profitability and growth potential. If a company can never be listed on the stock market and will never offer shares to investors, after all, it’s probably not a very wise investment in general!
Summary
In the end, lots of metrics drive SaaS company valuations. Different investors or buyers will naturally prioritize different metrics based on their preferences, investment history, and personal business philosophies.
On average, though, it’s wise to incorporate as many KPIs or metrics as possible when making your decision. The more accurately you value a SaaS company, the better price you’ll get as an investor and the better deal you’ll get as a seller.
