A SaaS company is ultimately worth the amount a buyer and seller agree, based on their respective assessments of its future cash flows.
Different buyers may arrive at different valuations. One may identify opportunities to sell the software across a larger customer base, combine the technology with its existing operations or prevent a competitor from acquiring an important asset.
Management quality, technology, market position, brand recognition, financial performance and geographic reach can all influence buyer appetite. Competition between potential buyers, combined with effective negotiation, can then determine how much of any strategic premium the seller secures.
Polestar CF’s SaaS Valuation Dynamics whitepaper explains how core SaaS valuations are assessed and examines the three company-specific factors most likely to influence value:
The market evidence and valuation observations within the whitepaper reflect the conditions prevailing when it was produced during the Covid period.
Private SaaS businesses are often valued using a multiple of annualised recurring revenue rather than a conventional profit multiple.
This reflects the way SaaS companies develop. Profitability can take time to emerge because:
The simplified valuation formula is:
Annualised Recurring Revenue × Valuation Multiple = Company Valuation
This calculation produces an enterprise value before adjustments for cash, debt and other balance-sheet items.
Annualised recurring revenue, or ARR, represents predictable income generated from subscriptions and similar repeating revenue streams.
One-off implementation charges, consultancy income and other non-recurring service fees should not normally be included.
Because SaaS businesses can grow quickly, valuation often focuses on the most recent trading information. ARR may therefore be calculated using the latest month multiplied by 12 or the latest quarter multiplied by four, rather than relying on older statutory accounts or trailing 12-month revenue.
The multiple applied to ARR depends on several company-specific and external factors, including:
Strong SaaS valuations would commonly be supported by annual revenue growth above 30%, customer churn below 5% and gross margins generally above 80%.
A business does not necessarily need to achieve every one of these measures to use ARR as part of its valuation. However, weaker performance in one area may need to be balanced by strength elsewhere.
Not all revenue attracts the same valuation.
Recurring licence and subscription income is generally valued more highly because it provides greater visibility over future cash flow. One-off implementation, consultancy and professional-service fees are commonly valued at a lower multiple.
Buyers also examine the cost of acquiring and onboarding customers. A configurable, plug-and-play product is likely to attract more value than software requiring extensive redevelopment for every implementation.
The underlying technology architecture is also important. Multi-tenanted platforms can usually implement updates across the full customer base, while single-tenanted systems may require individual updates. Cloud-based platforms may therefore offer lower servicing and scaling costs than bespoke, on-premise solutions.
The quality of a SaaS company’s revenue is assessed through four principal measures:
Scale can significantly affect buyer and investor appetite.
The whitepaper identifies several revenue levels capable of changing the potential buyer pool:
Below these levels, buyer interest may be more restricted to domestic investors and organisations with a close strategic fit.
Financial information should also be prepared on an accruals basis. Annual subscription income should be recognised across the period to which it relates rather than recorded entirely when the cash is received.
Historic growth has a strong relationship with the valuation multiple applied to a SaaS company. Faster growth can support higher multiples, while slower growth can reduce them.
Growth rates commonly change as a business develops:
A 2019 SaaS Capital survey of the US private market estimated that average multiples required annual growth of:
Companies in the $3 million-$10 million range growing above 50% could attract an additional one to three times ARR. Businesses above $10 million of ARR with growth exceeding 50% could attract premiums of five to ten times.
These figures relate to the US private market covered by the 2019 survey. The whitepaper notes that strong UK multiples could still be achieved with slightly lower historic growth, although ARR might form only part of the valuation assessment.
Retaining customers is generally less expensive than acquiring new ones.
A strong SaaS model builds each year’s new customers onto the recurring revenue generated by the existing customer base. Even relatively modest churn can compound and materially reduce long-term revenue.
Higher churn can prompt questions about:
Stronger retention than competing businesses can reduce perceived risk, increase buyer confidence and support a valuation premium.
Buyers assess whether revenue depends too heavily on a small number of customers, sectors or sales channels.
A company may have many customers but still rely on one or two channel partners for most of its growth. This can become a concern where the channel partner, rather than the SaaS provider, controls the relationship with the end user.
Sector concentration is also relevant. During the Covid period, businesses heavily exposed to travel or hospitality faced greater scrutiny, while exposure to logistics or financial services could support greater confidence.
A buyer will consider not only the company’s present position but also how much further it can grow.
A business controlling 90% of a small niche may have a strong market position but limited room to expand without entering new markets or extending its product range.
Owners therefore need to explain:
Being the only provider in a market can create a premium if the business is ahead of competitors. It can also make the opportunity more difficult to demonstrate if no other companies have validated the market.
An external perspective can help management identify opportunities that may be overlooked while the team focuses on daily operations and immediate sales.
Overall profitability is not normally the main valuation driver for a high-growth SaaS business.
A company may reinvest heavily in sales, marketing and product development while still attracting a strong valuation. However, buyers and investors will examine the economics underlying future profitability.
Customer-acquisition cost, or CAC, helps investors understand how much capital is required to support growth.
CAC includes the marketing and sales expenditure associated with winning new customers. It can be measured against the number of customers acquired or the ARR generated.
Comparisons require care because businesses may define marketing expenditure differently. CAC can also change as the company develops. Established businesses may benefit from stronger brand awareness, while start-ups may need to invest more heavily to secure each sales opportunity.
Buyers assess the time and cost required to take a customer from contract signing to full implementation.
An automated and configurable onboarding process can support scalability. Extensive custom development for each customer increases cost, delays implementation and may reduce value.
One-off installation charges are generally treated as consultancy income because they do not provide the same recurring return. However, customised software may still attract a consulting buyer capable of benefiting from both the technology and additional service revenue.
High gross margins indicate that a SaaS company can deliver additional revenue without a corresponding increase in direct costs.
Margins can be reduced where the platform relies on third-party data, cloud hosting or licensed elements of the technology stack.
Different revenue streams should therefore be separated and presented with their associated costs. This is particularly important where a software platform processes transactions and retains only a small fee. Recording the full transaction value as revenue could create the appearance of a low-margin model when the retained fee is actually highly profitable.
Polestar’s private-company survey produced:
This was broadly consistent with the 73% average gross margin recorded for public companies within the SaaS Capital Index.
Buyers consider the future investment required to maintain and scale the technology, regardless of whether development costs are capitalised or expensed.
A developed, cloud-based, multi-tenanted platform can require less investment to scale than a single-tenanted, on-premise product.
Some continuing development will always be necessary. However, a platform where the principal development work has already been completed can be more valuable than one requiring substantial redevelopment before it can support further growth.
Profitability can compensate for weaker performance elsewhere.
If revenue growth is below the level normally expected from a SaaS business, strong profit and cash generation can provide reassurance.
Cash generation can also allow the company to finance its own growth and retain control over the timing of an investment or sale. A business under less pressure to raise money may have more time to improve operations and a stronger negotiating position.
Technology companies outperformed wider equity markets during the period covered by the whitepaper. This reflected both rapid revenue growth and increasing global demand for automation and digital services.
Covid accelerated existing digital-transformation trends as businesses adopted remote-working technology and reconsidered their longer-term IT requirements.
Within Polestar’s AIM Technology index:
Valuations also differed between Systems Software, Application Software and E-commerce. Multi-tenanted Systems Software commonly attracted a premium over single-tenanted Application Software.
Public-market valuations provide useful context, but they cannot be applied directly to smaller private businesses.
Differences include scale, liquidity, access to capital and the quality of available performance data. At the time covered by the whitepaper, US private SaaS businesses traded at an average discount of approximately 28% to listed equivalents.
Several trends were visible in the UK private market:
Vertically focused companies could offer cross-selling opportunities, relevant customer references and more efficient marketing.
Private SaaS value can be considered through a combination of three factors:
A larger company with strong growth may not need to demonstrate the same level of current profit, provided the underlying margins support future earnings.
Where scale or growth is lower, profitability becomes more important.
The strongest valuation does not necessarily require maximum performance across all three. A compelling combination of two factors may be sufficient, depending on the company and the buyer.
Once the operating valuation has been calculated, balance-sheet adjustments determine the value received by shareholders.
Businesses are generally valued on a cash-free, debt-free basis with a normal level of working capital.
Surplus assets, such as excess cash or property, may be excluded from the operating valuation and assessed separately. Debt commonly includes loans, corporation tax and overdue HMRC liabilities.
Deferred income is particularly important for ARR businesses.
It represents the proportion of cash received for subscriptions that has not yet been recognised in the profit and loss account.
The whitepaper considers deferred income to be part of normal working capital rather than genuine debt because it is continually replaced by new subscription payments and does not need to be repaid like a loan.
However, buyers commonly seek to treat deferred income as debt and deduct it from the purchase price. This treatment was seen in all but one of the transactions considered, with competition and buyer synergies contributing to the exception.
Preparation can materially affect both value and transaction certainty.
Owners should consider:
Creating competition between credible buyers or investors is also important. The company must be presented clearly, taken to the most appropriate parties and positioned in a way that encourages genuine engagement.
The three principal drivers are the quality of revenue, the scale of the market opportunity and profitability.
A private SaaS company is often valued by multiplying its annualised recurring revenue by an appropriate valuation multiple, before adjusting for cash, debt and other balance-sheet items.
ARR should include predictable subscription and recurring licence income. One-off consultancy, implementation and service fees should normally be excluded.
Recurring revenue provides greater visibility and predictability over future cash flows. It can also become highly profitable once the customer base and platform have reached scale.
The whitepaper identifies annual growth above 30% as an important expectation, with higher rates commonly required for smaller and less-established companies. The precise requirement depends on scale, market and other valuation factors.
Customer churn below 5% is identified as an important benchmark. Higher churn can reduce confidence in the durability of future revenue.
Dependence on a small number of customers, sectors or channel partners increases the risk that the loss of one relationship could materially affect revenue and growth.
Not necessarily. A high-growth business may reinvest its profits and still attract a strong valuation. However, profitability becomes more important where revenue growth or scale is lower.
Customer-acquisition cost measures the sales and marketing expenditure required to win new customers or generate new ARR. It helps investors assess how much capital is needed to support growth.
Automated and configurable onboarding supports scalability and lower costs. Extensive custom development for each customer can reduce margins and restrict growth.
Private companies generally attract lower multiples because of their smaller scale and reduced liquidity. The whitepaper cites a US private-market discount of approximately 28% to listed equivalents at the time.
Preparation should include producing reliable performance data, addressing management or technology constraints, documenting the company’s market opportunity and understanding potential balance-sheet adjustments.
