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Software-as-a-Service (SaaS) is a recent business model that wouldn’t exist without the internet. Businesses using this model are hosting their software solutions online on a server and users pay the rent to use the software for a specified time period.

Or you can use the more complex definition by Gartner which defines software as a service (SaaS) as software that is owned, delivered and managed remotely by one or more providers. The provider delivers software based on one set of common code and data definitions that is consumed in a one-to-many model by all contracted customers at anytime on a pay-for-use basis or as a subscription based on use metrics. Some examples of well known companies using SaaS business model:

Google Suite
Google suite includes a lot of cloud-based solutions, like email for business, google drive a file storage solution on the cloud and many others. Users tend to pay monthly fees to use Google’s technology.

Slack is a cloud based messaging solution. Mostly used for teams for their internal communication. There seem to be a lot of communities forming on slack as well.

Microsoft Office 365
A well known product package created by Microsoft which consists of: Word, Excel, Powerpoint and others. It is also reachable in the cloud (online) for a price.

Adobe photoshop
As well as other companies Adobe has moved their creative suite solutions to the cloud. Making it accessible for a wider range of users since the monthly price is more affordable than paying a one huge license fee

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Which valuation method to use when valuing a SaaS business?

Large businesses (>5M annual net profit) usually use EBITDA valuation model to determine the value of their business. EBITDA  stands for Earnings Before Interest, Taxes, Depreciation, and Amortization – essentially, it’s the pure net profit of a business.

Like EBITDA, business owners calculate SDE which stands for Seller’s Discretionary Earnings to determine the true value of their business for a new owner, so your SDE will include expenses like the income you report to the IRS (tax offices in your country), non-cash expenses – whatever revenue your business actually generates. Unlike EBITDA, though, you’ll also add back in the owner’s salary and owner’s benefits into your SDE calculation. Small businesses typically use SDE, since small business owners often expense personal benefits.

To calculate your business’s SDE: Start with your pre-tax, pre-interest earnings. Then, you’ll add back in any purchases that aren’t essential to operations, like vehicles or travel, that you report as business expenses. Employee outings, charitable donations, one-time purchases, and your own salary can all be included in your SDE. Finally, any current debts or future payments, called liabilities, are subtracted from the net income.

A simplified method to calculate SDE:

SDE= Total Income – Cost of goods sold – Operating expenses + Owner compensations

Now that you have a base level of understanding the valuation methods used to value a SaaS business. Take a look at the example income statement below. This will serve as an example to help you understand the concepts described above.

Currently, there is an ongoing debate on whether a multiple of revenue or earnings should be applied to the business and, correspondingly, what that multiple should actually be.

ABC Mailing SaaS, LLC has decided to find out the value of their business. The company has one owner, who takes a salary of $120,000 per year and works full-time in the business (A). He is currently running his family’s $1800/yr. cell phone plan through the company, as well as around $5,000 in personal fuel charges (E & F). This year, the owner had to replace $10,000 worth of equipment (D).

ABC Mailing SaaS, LLC Income Statement
Year: 20XX

SDE example income statement
SDE example income statement. Source: Midstreet

The final value of your business is calculated using an SDE multiple. There is a different SDE multiple for every industry. The higher your SDE multiple, the more your business is worth.

What SDE multiple to use?

Once you have calculated your SDE for the last twelve months, you need to identify a reasonable multiple. For smaller SaaS business it’s within the range of 2.5 to 6. So which end of the spectrum does your SaaS business fall?

To reasonably asses the multiple you have to look at variables that make the most influence.

1.Age of the business

The age of the business mostly show the risk involved in the transaction for the new buyer. So essentially if the business is in operation for 1 year is very young and has a little of historical data to show for. If the business is 3 years old the new owner can start to predict future profits and sees such acquisition as less risky.

2. Growth and stability

The bread and butter of SaaS businesses are monthly and annual recurring revenues MRR & ARR accordingly. If your MRR/ARR metrics ar constantly going upward you can expect to use a higher multiple when valuing your company.

3. Owner reliability

Buyers of internet business expect little involvement and passive income. It’s not necessary the case all the time but generally people want a lifestyle business. Unless this is a strategic acquisition and your new company will be used to grow already an established business. Either way. The less time involvement is necessary for the new owner the higher multiple you can use.  

4. Churn,Lifetime value (LTV), Customer acquisition costs (CAC)

Any SaaS business owner should should be looking at their customer acquisition costs (CAC), conversion rate, pricing strategy, churn rate, lifetime value (LTV). The new owner will also look at these metrics to try and establish the health of your product.

To understand the averages and what a SaaS company should aim for in their Churn rate we are following the analysis of Tomasz Tunguz from Redpoint VC:

“In practice, churn rates vary by customer segment. Startups serving SMBs tend to operate with higher monthly churn, somewhere between 2.5% and 5%+, because SMBs go out of business with greater frequency and tend to be acquired and managed through less retentive channels, e.g. self-service. In the mid-market, which I’d define by average customer revenue of between $10k and $250k loosely speaking, the churn rates I’ve seen are between 1% and 2% per month. Enterprise companies, those with customers paying more than $250k per year are typically closer to 1%. As the spend per customer grows, startups can afford to invest significantly more in retaining the customer, hence the improving rates.”

Tomasz Tunguz, Redpoint VC

To calculate your churn rate you can use this simple equation:

Formula to calculate SaaS Churn Rate

To calculate your Customer acquisition costs use the formula below:

Formula to calculate SaaS CAC rate

To find out more about Lifetime value, look at the infographic below which was prepared by Kissmetrics. If it is too small to read for you please click here.

Now you know how to value your SaaS business. It’s always a good idea to have an understanding of how to value your company even if you’re planning to speak with a broker. Having this knowledge you will feel more comfortable and prepared to sell you business for a realistic valuation. For an accurate valuation we advise you to speak to one of our brokers. We will not only evaluate your business but also advise you of how to increase the valuation to your ideal number.

Are you interested in selling your SaaS business?