SaaS Valuation Myths

“How do you evaluate SaaS companies?”

A question that I am asked in almost every conversation with founders.

I know the answer founders want to hear: Multiples of ARR.
And I also know what they don't want to hear: Multiples of EBITDA.

The truth is that your business and its figures determine how it is valued, not the buyer.

Let's take a quick look at why ARR multiples were introduced in the first place.

It is in the nature of the SaaS model that companies need to make large upfront investments to acquire customers, but recoup the profits from these investments over a long period of time.

(Looking to shorten this period? Check last week’s article about CAC Payback)

The faster you grow (i.e. the faster you acquire new customers), the worse your cash flow will look like in the short term. However, recurring revenue and strong KPIs will ensure it pays off in the long run.

As you can see, current earnings may not be the best measure to compare fast-growing SaaS companies and their potential to make money in the long run.

That’s one of the reasons why ARR multiples were introduced and have become a widely used valuation metric in the tech and investment community.

However, the fact that it has been adopted by the entire SaaS market has led to many founders being misled.

For small, profitable SaaS companies that aren't growing as quickly, this stark contrast doesn't exist - which is why investors are more inclined to use historical and current profits to estimate future earnings potential.

If your business generates an ARR of << $5M and is growing << 50% year-over-year, it likely falls into this category.

In this segment, profits have been and will remain an important part of the equation. Whether you like it or not.

To understand why, it helps to look at who acquires such companies.

In recent years, the proportion of private equity transactions in the entire SaaS sector has increased. You can assume that it is even higher in the micro cap space.

Strategic acquisitions for steep ARR multiples happen, but they are super rare. Small SaaS companies are most often acquired by:

1. Small / medium-sized PE funds,

2. Serial acquirers like saas.group,

3. Larger PE firms as tuck-ins for existing platforms.

They all have one thing in common: The pursuit of a positive ROI (rule of thumb: 3x investment in 5y).

Deals are usually structured as leveraged buyouts, i.e. buyers use a significant amount of debt to finance transactions (more on that here).

To repay this debt - plus interest! - profits matter. Even more so now that the ZIRP is over and interest rates are higher again.

➡️ Target with little to no profits = deal becomes more expensive from day 1.

If they cannot use profits that run against debt repayment rates, the pressure to grow and flip the business for a higher price increases significantly.

A risk that many don't want to take. Possible scenarios:

1. Potential acquirer says no straight away,

2. You get a bad offer with risk factored in,

3. You get a mediocre offer and acquirer ensures margin improvements post-transaction (which often includes staff reductions),

4. Acquirer doesn’t find enough savings potential and walks away from the deal.

Ultimately, EBITDA (or SDE, see differences here) as a proxy for profitability plays a much larger role among investors and buyers in the micro-cap SaaS space than many founders realize.

Common multiples range between 5-10x and can go up to 15x+, depending on numerous factors. See guidance from a reputable M&A broker in the space below.

Btw, this is from a recent article (Jan 2024), not from 2010. In my experience, these multiples typically correspond to 1-4x ARR.

I hope this helps some founders to set the appropriate course and possibly address inefficiencies before kicking off an exit process.

This particularly applies to many VC-backed companies that have been forced to reach break-even status, which has caused growth to suffer. The Rule of 40 is a good benchmark here.

You can also ignore all of this, but it will significantly limit the number of possible exit channels.

🎙️Co-hosting a webinar with Nuoptima on “How to Exit Your SaaS” later today (March 7) if you wanna join! 👉 Sign-up Link