How to value a SaaS Business

What is a SaaS business?

In a traditional software business model, software was typically sold and installed onto the customers’ network – the end-user then buying a perpetual license with an up-front cost, with optional ongoing support fees.

Conversely, a SaaS company hosts the software on its server and makes the software available to customers over the internet/cloud – with the end-user paying a subscription fee on a monthly or annual basis. A key benefit to the end-user (and the supplier) is that updates and fixes are only applied to one location and are instantaneous for all customers.

SaaS businesses have grown with the expansion of the internet across the economy, with software being accessible from commercial and residential locations, and able to be used across a range of devices from desktop to mobile ‘anytime anywhere’.

SaaS companies may have operated their SaaS model from inception or commenced trading with a traditional model and migrated to a SaaS model in recent years. Indeed, a number of businesses are in the process of transitioning their software (or elements of their range) to a SaaS model and are therefore currently operating a hybrid model.

SaaS businesses typically attract a valuation premium over conventional software businesses, stemming largely from the following factors which are typically more prevalent in SaaS businesses:

• High recurring revenues;
• High, and more stable, gross margins reflecting economies of scale following the development of the software and subsequent roll-out; and
• The ability to scale is much less impacted by finite and unpredictable supply chains, production capacity and stock availability. Product development and marketing typically require access to a pool of skilled labour; however, this can be located worldwide.

The valuation premium attached to SaaS businesses implies that when preparing their business for sale, business owners should understand the current positioning of their business relative to the SaaS / “traditional” models.

What is the valuation methodology for SaaS businesses?

SaaS businesses are typically valued based on a multiple of Annual Recurring Revenue (“ARR”).

However, it is important and (often overlooked) that the ARR multiple is intrinsically linked to EBITDA generation, albeit with a greater emphasis (more so than in other sectors) on forecast medium/long term EBITDA generation. Essentially, the ARR multiple will reflect a blend of assumptions around forecast growth and EBITDA levels.

What are the key valuation drivers?

Business owners preparing for sale should therefore consider how they can improve key elements of their business model in order to maximise the ultimate valuation.

Scalability

Businesses with a readily scalable operating model are likely to attract an enhanced valuation premium. Scalability involves technological aspects such as hosting, marketing, customer support and a capability to roll-out into overseas markets to significantly, and efficiently, expand the customer base.

Intellectual property and brand

Trademarks, patents and copyrights are important to any IP based business – for SaaS companies securing the intellectual property associated with the software is essential.

Owning the rights to your IP is key. Simply put, if a competitor patents something used in your business model before you do, this may hinder your ability to operate and hence it can significantly adversely impact corporate value.

Amongst other things, patents and trademarks should be obtained for coding, products, and any other substantial assets that create a competitive advantage. Additionally, freelance and in-house developers should be asked to sign an IP assignment agreement to ensure that all IP they develop as employees and sub-contractors of the company, belong to the company.

Contracts, pricing and inflation

In general terms the longer the contract term the better, provided that the contract terms are adequate to preserve margin, in order to give a potential acquirer greater long-term earnings visibility and hence less risk in making the acquisition.

As recent macro-economic experience shows all too clearly, it is important that owners take steps to protect profitability levels through incorporating annual escalator price increases into contracts. In order to achieve this, businesses will need to clearly articulate value, for example sharing webinars on getting the most out of the latest feature release is a cost-effective way to increase value perception and build customer loyalty.

Investment in product development

Businesses which invest in product development are likely to attract a valuation premium.

It is important for business owners to consider if their products address a significant issue in their target markets. This can often require management teams to think differently, challenging conventional wisdom and build a track record of creating new solutions to stay ahead of the competition.

Target market and verticals

SaaS businesses which operate across a range of sectors are likely to be considered more diversified and attract a higher valuation premium – a diversified client base being regarded as a way of spreading and reducing the risk profile.

Product range

Multiple products and services generate ‘sticky’ customers and can enable growth through entry into new markets, and deeper market penetration in existing markets; both factors which are likely to attract a higher valuation.

Churn rates

Lower rates of customer churn accelerate ARR growth and increase resources available to the business for further investment. Churn rates will be reviewed as part of a valuation and those businesses able to demonstrate consistently low churn rates are likely to attract a higher valuation; again, as they represent a lower risk opportunity for the acquirer.

Age of the business

Well-established businesses are likely to achieve a greater valuation premium, but only to a point. For example, rapid forecast growth in a well-established business with modest historic growth is likely to be challenged by acquirors and may be discounted in a valuation.

Strong management team and workforce

The above factors are difficult to achieve and sustain without a strong management team and experienced workforce. Those businesses with a strong management team and which can access pools of skilled labour (locally or remote with appropriate flexible working arrangements) are likely to attract a higher valuation premium.

It is also important that management teams and key staff are suitably incentivised and “locked-in” through appropriate share option or other LTIP incentive arrangements.

Can MHA Moore and Smalley help me sell my business?

We have significant experience working with the owners of software and SaaS businesses to achieve their objectives and have been involved in a number of recently completed transactions.

How to value a SaaS Business – Moore & Smalley (mooreandsmalley.co.uk)