Calculating a private SaaS company’s valuation can be tricky, but one formula using just four metrics can help you estimate the value of your SaaS business.
Tools like profit and revenue-multiples can be useful to estimate valuations of private companies – most SaaS startup businesses are valued within a multiple range from 4x to 6x – but not all revenue is created equally. Companies with the same, or similar, revenues within the SaaS sector can in fact differ from each other in significant ways, according to their stage, business model and ability to retain customers. A model exists to combine four key dimensions that describe a business, each represented by a metric:
1. Size of the business – represented by Annual Recurring Revenue, 2. Momentum – represented by Growth Rate, 3. Quality of its product or service – represented by Net Revenue Retention, and 4. Profitability – represented by Gross Margin.
Metric 1 Annual Recurring Revenue
This is the predictable revenue from subscriptions normalised per calendar year. When calculating this metric, it’s important that only recurring income is taken into account. One-time payments such as income from services or payment processing fee should not be included.
Metric 2 Growth Rate
This is massively important, especially for early stage companies. Growth is arguably the main thing investors will be looking for up until Series A/B, after which the focus should shift towards profitability.
It is important to not neglect sustainability and profitability in favour of growth, but nonetheless, companies looking for premium valuations should show strong and consistent growth rates. Top SaaS businesses now public like Twilio or Slack often double their revenues over their first years of trading. After scaling, growth rate typically decreases, but a revenue increase over 50% is still typically required for revenue multiples higher than 5x.
Metric 3 Net Revenue Retention
Net Revenue Retention represents how revenue would change if no additional sales were made. It is calculated as follows, where ARR is Annual Recurring Revenue: ARR at beginning of period + Upgrades – Downgrades – Churn —————————————————————————————— ARR at the beginning of period
This is normally a good quality indicator for a SaaS company’s offer: if the added value of customers upgrading more than compensates for the value lost to those downgrading or cancelling, it means the product basically sells itself, and investors love that!
Metric 4 Gross Margin
Gross margin is all the revenue that’s left once the cost of goods sold (hosting, licenses, support and account management...) has been repaid. It is directly correlated with a company’s valuation because it indicates how much of the revenue can be used to fuel growth or – in the best case scenario – pay dividends.
This has probably been the most talked about metric after WeWork‘s and Uber’s respective flops. In these two cases, in fact, profit margins weren’t large enough to justify all the cash burning involved in fuelling growth. Investors are now extremely wary about companies like these, and most agree that gross margin will become increasingly important in the eyes of potential investors. It is likely the most important SaaS metric for Series A and beyond.
The Formula
Using the four metrics...
Once we have these four metrics, a rule of thumb says we just need to multiply three of them all together – and by a coefficient of 10 – in order to estimate a SaaS company’s valuation: Valuation = 10 × Annual Recurring Revenue × Growth Rate × Net Revenue Retention So, for example, a SaaS business with £10m in annual recurring revenue growing 50% (multiply by 0.5) per year with a really good net revenue retention of 110% (multiply by 1.1) will be worth approximately 5.5x revenue: about £55m. This estimate then needs to finally be adjusted by gross margin. SaaS gross margins range between 60% and 90% or more. 75% can be considered average: it’s what public SaaS businesses like Dropbox or Docusign have. Therefore, a gross margin upwards of 80% calls for a proportionate premium on the above estimate.
Caveats to consider...
The beauty of this formula is that while it takes into account some of the key performance metrics investors look for, it’s still incredibly simple. It’s more suitable for early stage businesses, since growth rate has the potential to double or slice in half the multiple. A company doubling its revenues year-over-year might as well be worth a 10x multiple.
However, growth rates above 50% are extremely uncommon among established businesses. In fact, when we tested this formula for public companies such as Dropbox, Salesforce and Docusign, the result was about half of their current market capitalisation. Public companies have much lower risk than start-ups, which explains the premium. Additionally, growth becomes a less important metric as the company grows, and other metrics such as CAC/LTV or operating profits should be used instead to work out a multiple. Back to private, early-stage companies.
There are many more factors that should be taken into account when calculating a valuation: the quality of the managing team, the value of intellectual property, the cost-of-acquisition to lifetime-value ratio and payback period.
Many founders and investors like to use revenue or profit multiples, because they’re easy shortcuts to work out a valuation estimate without the need for too much data. However, it’s important to show how these multiples are calculated and what are the performance factors that influence them.
This way, both buyers and sellers can get a clearer idea of how the valuation was derived and have more confidence in the metric.