How To Calculate A Private SaaS Valuation Using 4 Key Metrics

2 February 2020

Calculating a private SaaS company’s valuation can be tricky, but one formula using just four metrics can help you estimate of the value of a SaaS business.

advice : Tech and Valuation

As we wrote in a blog a while ago, valuation multiples for SaaS companies have been on the rise for quite some times now. And despite facing a minor correction at the end of last year, they are still at all-time highs.

Of course, this is based on public companies’ valuations or, at best, M&A transactions where a lot of information has been disclosed. Tools like profit and revenue-multiples can be useful to estimate valuations of private companies – last year, for example, the revenue multiple for SaaS companies being acquired averaged 4.3x – but “not all revenue is created equally”, says David Cummings, serial entrepreneur and investor, on his blog.

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. The model proposed by Cummings aims to combine four dimensions that describe a business, each represented by a metric:

  • The size of the business – represented by Annual Recurring Revenue,
  • its momentum – represented by Growth Rate,
  • the quality of its product or service – represented by Net Revenue Retention, and
  • its profitability – represented by Gross Margin.

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.

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.

We wrote extensively about the importance of not neglecting 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 required for revenue multiples higher than 5x.

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!

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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. We previously highlighted it as the most important SaaS metric for Series A and beyond.

The formula

According to David Cummings, 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% year with a really good net revenue retention (say 110%) will be worth approximately 5.5x revenue: about £55m.

This estimate needs to 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.

The caveats

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 probably more suitable for early stage business, 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 explain the premium. Additionally, growth becomes less important of a 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 to 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, they can get a clearer idea of where to focus and improve in order to build a more sustainable – and valuable – businesses.

The information available on this page is of a general nature and is not intended to provide specific advice to any individuals or entities. We work hard to ensure this information is accurate at the time of publishing, although there is no guarantee that such information is accurate at the time you read this. We recommend individuals and companies seek professional advice on their circumstances and matters.