SaaS Valuation Trends to Know

SaaS Valuation trends have never been so important. As time goes by, more and more people are investing in SaaS. What was looked at as a very small segment of the technology market, it is has now become one of the most sought-after sectors in which to invest in. In fact, it is estimated that both private and public cloud services spending will triple from 2013 to 2017. Also, according to statistics made by Software Equity Group, sales of SaaS will be 25% of all sales in the software industry before 2020. This facts make it very luring for SaaS companies themselves, investors, and other interested parties to be updated regarding valuation for these companies which will allow businesses to value themselves the right way as well as allow investors to profit from investing in strong and solid companies.

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SaaS Valuation Trends to Know

The SaaS Business Model

In order to understand SaaS valuation trends, we have to first look into the basics of the SaaS Business Model. Unlike traditional software companies which charge a fee for a lifetime use of their software, SaaS sells its software by offering monthly subscription fees for its use to its customers. The customers don’t have to worry about updating it since this this is automatically done by the SaaS which is one of the reasons why more people are buying this type of product. Users can also access the software from any device and don’t have to buy licenses for each device they use, making it cheaper for them in many cases.

The cash-flow of traditional software business models consists of high payments at the beginning periods due to license sales, while the cash-flow of SaaS businesses consists of high investing in customer acquisition which leads to loss on the earlier periods and then consistent positive returns every month due to the subscriptions paid. That being said, the most important factors for SaaS success is customer acquisition and retention in order to cash in profits after the break-even period has been reached.

What are Experts Looking for When Valuing SaaS Companies?

In traditional business valuation, the two most important factors are the present value and the internal rate of return, both of which explain how profitable and viable the company is taking into account the initial investment plus the future expected cash-flows.

Due to the nature of SaaS companies, the trend has been to value it according to metrics about its customers and how willing they are to keep paying for the product on a monthly basis which is the financial basis from which the whole concept of SaaS is founded on. Therefore, valuation of these companies are based on the following indicators:

1) Revenue Growth

Contrary to traditional valuation, valuation of SaaS companies shows us that the profit itself isn’t important when calculating the value of the company. The reason why revenue growth is so important is because it means that after the break-even period, the company will have a sharp increase in earnings due to the large number of its customer base. For instance, a company that invests a small sum of money to acquire a few customers will be at a small loss at the first periods or months and after the break-even point, the profit will be equally small yet positive. On the other hand, a company that invests large sums of money in acquiring customers will see that in its first period, it will have a larger loss than the first company, but as soon as it breaks even, its revenue will have a sharp increase.

2) Churn

Churn is the percentage of customers that stop paying for the subscription each month. As we said before, the success of a SaaS companies depends to a great extent in repeated purchases from its current customers. In fact, if customers go away before the break-even period (month) is reached, the company will be left with a loss instead of a profit. Therefore, the lower the churn of a SaaS company is, meaning, the fewer its customers stop paying the monthly fee, the more value the company will have. It is estimated that a churn higher than 2% indicates that the company is not in good shape.

3) Customer Acquisition Costs

This indicator is calculated by adding marketing expenses and sum of sales of a specific quarter and then dividing this number by the amount of new customers on that quarter. This way, the company can assess how much it has to spend in order to bring a new customer in.  However, this indicator shouldn’t be used alone, but it should be used with the customer lifetime value indicator.

4) Customer Lifetime Value

This indicator is one of the most important as it will allow us to know how much money the average customer brings into the company and allows us to compare it with the customer acquisition costs. The customer lifetime value is estimated by multiplying the gross margin times the average monthly recurring revenue, everything divided by the customer churn rate.

These indicators should be used all together to reach the SaaS valuation as they will allow us to calculate the premium of any specific SaaS company when compared with the benchmark indicators for that particular industry. In general, a SaaS value depends on having high revenue growth, low churn, and low customer acquisition costs to customer lifetime value ratio.

Conclusion

SaaS valuation is radically different from the traditional valuation of other technology companies. This is due mainly to the nature of the business model that SaaS have which is constantly changing and vary depending on factors such as customer payback periods and renewal rates as opposed to a the usual perpetual license business models of traditional software companies. Therefore, the most important SaaS valuation trends revolve around revenue growth, churn, or ratio of customers lost monthly vs total customers, customer acquisition cost, and customer lifetime value all of which are aimed at defining how much money will the company make from each customer and how likely is for customers in that company to make repeated purchases, meaning, keep paying the monthly subscription.

 

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Omri Erel
Omri is the Head of Demand Generation, as well as the Lead Author & Editor of the SaaSAddict Blog. Omri established the SaaSAddict blog to create a source for news and discussion about some of the issues, challenges, news, and ideas relating to SaaS and cloud migration.
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