How 5 Pillar Metrics of SaaS Influence Valuation
- Which SaaS metrics buyers and investors consider when determining valuation
- How the subjectivity of a transaction influences valuation
Founders are invariably curious about how much their company is worth, so the topic of valuation comes up in nearly every discussion we have with client founders.
While arriving at a valuation goes far beyond any financial or metric-based analysis, buyers and investors do take into account core SaaS metrics to form a foundation for their valuations.
As a founder you may hate to see your business reduced to a handful of metrics—after all, you’re building a business, not a spreadsheet. Nevertheless, certain core SaaS metrics serve as the vital signs for any SaaS business and provide a like-for-like comparison for any banker, buyer, or investor evaluating your company (so long as you calculate them properly).
Based on our broad base of experience advising 75+ software and internet founders across varying industries and transaction structures, the most important KPIs influencing a SaaS company’s valuation multiple are the following:
- Recurring revenue growth rate
- Gross margin
- Market size
- Sales efficiency (LTV:CAC, etc.)
Below is a quick synopsis of why buyers care about these metrics. If as a founder you’re not tracking or not paying attention to any of these metrics, you may want to take a second look.
Your company’s ability to retain customers and revenue from year to year speaks volumes about the predictability of future revenue and also influences other metrics like revenue growth rate, gross margin, and sales efficiency. Retention is also a strong indicator of product-market fit.
Though good retention rates depend on the space you’re working in (including industry and target customer size), buyers will always reward higher than average retention rates.
Recurring revenue growth rate
Since a valuation represents a company’s ability to generate revenue into the future, the rate of revenue growth from year to year plays an important role in valuation. As such, selling into growth is a great strategy for improving your multiple.
The rate of growth for recurring revenue is particularly important, as buyers/investors prefer contractual revenue that is easy to predict, as opposed to transactional revenue.
Gross margin in software can easily exceed 80%, placing this business model into a class of its own. When a SaaS company has a high gross margin even early in its existence, buyers interpret that metric as an opportunity for profitability at scale, which is highly attractive. In addition, a high margin business is easier to grow since excess earnings can be funneled back into growth.
Note that the lower gross margin, the more likely the company is to be valued based on EBITDA vs. revenue, which can materially impact valuation.
Even if your company does well in all other areas of business, your market size needs to be large enough for the buyer or investor to capitalize on good performance and grow the business further. As such, buyers/investors place higher valuations on companies with a larger total addressable market (TAM).
Market size is particularly important to investors who need to grow the business enough within a relatively short time frame (a "hold" period that normally lasts 3-5 years) to generate their return.
Sales efficiency (LTV:CAC, etc.)
Buyers/investors take interest in sales efficiency because they want to see how good your sales & marketing engine is at creating value for your company. If you have a track record of acquiring customers at a much lower cost than the lifetime value of those customers, your company will receive a higher valuation.
Sales efficiency also speaks to how difficult future growth will come. The closer the costs are to value generated, the sooner returns will begin to diminish.
A Note About Scale
The size of your company will have a strong bearing on how buyers/investors interpret each of the above metrics. For example, 60% growth in a $2M ARR business will not have an equal influence on valuation as 60% growth in a $10M ARR business. The same goes for other metrics like retention and sales efficiency which become progressively harder to improve the more your company grows.
The Subjectivity of Valuation
Performing well or poorly with a given metric will certainly push valuation up or down for any given buyer. But something to note is that buyers/investors aren’t all working off the same valuation model. Even though buyers in a transaction are all looking at the same data, you’d be amazed how broad the range of valuations is.
While buyers/investors might have similar benchmarks of comparison for these metrics, interestingly they don’t value them the same. And though these metrics might establish a baseline for valuation, many intangible factors will have a big influence on the final outcome.
Considering the subjectivity of valuation, there are a few actions you can take to tip that subjectivity in your favor:
- Build a broad and varied list of qualified buyers
- Run a competitive process
- Position your metrics in the context of your business case
- Drive upside by leveraging the intangibles of the business
Build a broad and varied list of qualified buyers
The more qualified buyers you include in a process, the more likely you are to find the buyer who subjectively values your company higher than the competition. This doesn’t mean you shoot the deal out to a thousand buyers, but that you keep your options open in terms of buyer background and transaction structure so that you’re more likely to find the right buyer.
When building a buyer list, you should broaden your horizons beyond the buyers reaching out to you, as these outbounders may not be fully interested or qualified to transact. In many cases, though not always, the outbounders are value shoppers trying to preempt a process and buy your company at a discount.
Run a competitive process
When many buyers are making offers on different terms, you can leverage the strengths of one buyer in negotiations with other buyers. In a competitive process, buyers have to put their best foot forward in terms of valuation and terms in order to win the bid.
By itself, having more buyers in the transaction process will make it more competitive. But you can increase competition even more by how you structure the process and interact with the various parties.
Position your metrics in the context of your business case
Out of context, the barebones metrics might send the wrong message to buyers. As such, communicating the context of your metrics can help buyers make a more fair interpretation of your KPIs.
While buyers/investors will place significant stock in the barebones metrics, much of the excitement around a transaction comes from the story you can tell about the future of your company. Positioned in the right light, many weaknesses become opportunities where the buyer/investor can optimize performance and realize a return.
Drive upside by leveraging the intangibles of the business
Not every benefit of a transaction between parties is easily quantifiable but still pertinent to matters of valuation. Emphasizing mutually beneficial albeit intangible synergies can go a long way to increase interest and commitment to closing a deal at a premium valuation.
Improving Valuation by Hiring an Investment Bank
As a founder, you might be able to realize a good outcome by running a transaction on your own. But simply knowing and presenting your metrics isn’t enough to achieve a great outcome.
Understanding the implications of each metric, how buyers interpret these metrics, and how to leverage these elements throughout a competitive process is core to what we do as an investment bank.
Learn more about what some of our past clients think about selling their business through an investment bank.