Valuation model for software companies

However, there is no magic number when it comes to CAC because each SaaS business is going to be different. To make an apples-to-apples comparison we first need to incorporate an additional metric — Customer Lifetime Value LTV.

LTV is the average amount of revenue that is earned from a customer throughout the time they are paying for the service. The higher the LTV is the more valuable each new customer is to the business. Once again, the number will vary depending on the business model, market, competition and a multitude of other factors. In order to truly get the most use out of these two metrics we must compare them to each other.

In doing so, we will get a ratio that will quickly tell if a business is making more revenue per customer than it is spending to acquire that customer. This allows us to measure the return on investment of marketing efforts and determine if the growth strategy is working. This will allow for enough cushion to account for a dip in the LTV or an increase in the CAC and still be able to generate a healthy gross profit margin. In small- and mid-market, self-funded SaaS businesses, the temptation is to sell reduced priced annual plans to increase top-line revenue and improve cash flow to reinvest into growth.

While in many situations this is necessary, from a valuation perspective it will hold the business back. The same goes for selling lifetime plans — these are a big no-no when it comes to increasing the value of a SaaS business. This is often the opposite of what an owner of a SaaS business will look to do, especially when looking for growth capital. Even if it slows growth, focusing on selling monthly plans is key to achieving higher valuations.

Data from deals completed by FE indicate that MRR is valued around two times higher than equivalent revenue from lifetime plans, so this can often outweigh the benefits of the short-term cash flow boost. SaaS products with a higher ratio of annual plans would see a lower valuation as the revenues are less predictable.

Aside from the SaaS metrics just touched on, there are various other important factors that need to be considered in the valuation process. Acknowledging the higher rate of churn that small- and mid-market, SME-facing, SaaS businesses experience, customer acquisition is understandably a focal point for evaluating the longevity of these businesses.

The customer acquisition channels of a SaaS business are thus of great importance to investors, who tend to evaluate these in terms of concentration, competition and conversion.

In our experience, a premium SaaS business will acquire customers from a multitude of channels, be it organic search, affiliate, paid or otherwise. Having a diversity of channels not only reduces the dependency on one channel but also proves its monetization in multiple ways. SaaS businesses that have successful organic and paid channels benefit from this premium with investors. Naturally, many small- and mid-market SaaS businesses build their customer acquisition from content marketing before exploring paid and affiliate channels.

It can be a worthwhile experiment to trial the months ahead of an exit to see whether they yield positive ROI. The defensiveness of each acquisition channel is of interest to investors when evaluating their strength. If the business has a strong backlink profile and ranks well for a high number of relevant keywords this is considered a strong, defendable platform for organic customer acquisition.

Conversely, if the business is engaged in price-wars in paid search with competitors, this is understandably considered a weaker acquisition channel. Small- and mid-market SaaS business trying to outbid in that niche will suffer a short-lived PPC lifecycle. The ultimate appraisal of customer acquisition channels are the associated conversion and cost attached to each.

Here the conversion-to-trial ratio and conversion-to-paid ratio are carefully eyed by investors, as well as the associated CAC. To summarize, a premium SaaS business is one that has multiple customer acquisition channels with high defensiveness and solid conversion metrics for each. Eventually all software needs development to keep up with customer requirements or to grow the business further. While every SaaS business is unique in its development requirements, when the business comes to market, it is generally best practice to have the product in a high point of its development life-cycle, or in other words, not requiring a major update any time soon.

This gives the new owner some runway ahead of any major development and provides some comfort that the current management has not simply given up on the business and is passing over ownership at a time when the product needs care and attention.

In the diagram above, it is the equivalent of selling at point A, where the software is maturing, and point B where the software has aged too much and is in need of development to promote further sales. As mentioned briefly, the amount of owner involvement in the business and particularly the nature of the work can be a sensitive valuation factor for SaaS businesses.

At first this might seem counter-intuitive to a SaaS entrepreneur. More technical input from the owner i. All of the above could be true, but an investor still needs to either be able to do the same work themselves or pay for someone else usually at a high cost. Factoring this into the SDE will ultimately lower the valuation.

One might be tempted to instead pursue investors that can readily resume the same responsibilities themselves i. SaaS businesses that therefore have the burden of development work on reliably outsourced contractors will benefit from a perceived easier transfer of ownership and a greater pool of investors as a result. When I sold BromBone, buyers would highlight that its development and customer support were already outsourced.

The only role they needed to replace was my marketing outreach, which meant it was an easier business to take on. Eventually we sold to a non-technical buyer for a great valuation. Competition in the niche is of great interest to investors when evaluating a SaaS business. Clearly the level of competition is important to understand for any business acquisition, but this is especially true in the SaaS space. In SaaS it becomes of acute interest because of the generally higher number of VC-funded players in the industry and the high development costs associated with the business model.

Small- and mid-market SaaS business in a highly competitive niche will tend to find itself under-funded and unable to compete with the development efforts and features of better-funded, VC-backed SaaS companies. The SaaS businesses that achieve a premium are almost always products that are prepared for growth at scale. You can add hundreds of thousands of dollars of value to a business by taking the right steps before a sale.

Naturally not all the valuation factors are addressable e. This may be driven by the need for a Private Equity firm to borrow cash flow. EBITDA stands for Earnings before interest, taxes, depreciation, and amortization and proves beneficial for companies with high profits.

This method takes into consideration different factors for more mature, developed businesses. Now that we've covered the basic valuation models, let's explore the question you're actually here for identifying your SaaS valuation multiplier.

The more established the business is or the more a business depends on larger and longer-term contracts the bigger the multiplier. B2B software companies can be valued from anywhere between 3x and 15x their annual revenue -- determined by a mixture of parameters, who is conducting the valuation, and other valuations within the industry at the same time.

But how can you determine what your SaaS multiple is? While some of the influential factors may be out of your control, here are some valuation attributes to focus on:. You want strong, reliable revenue with strong cash flow, and are typically categorized into the following segments:. Note that there are two types of revenue in a SaaS valuation. SaaS NRR is the percentage of recurring revenue retained from existing customers within a defined period of time.

This includes subscription expansion revenue, subscription downgrades, and subscription cancellations. Another way to represent customer churn, SaaS NRR gives a comprehensive view of positive and negative changes within customer retention. We recommend matching your metrics for revenue and churn to be either monthly or annually. Still, it's important to note that 'acceptable' churn rates vary depending on your customer base and market.

This means that around 5 out of every customers leave. For a SaaS business that services SMEs , your churn rates can be a bit higher, given the number of small businesses that fail every year.

Because a SaaS company relies primarily on subscription-based revenue, the customer will likely turn into a renewing customer. However, churn is a more popular metric as it often is paired with automatic renewals leading to a better valuation.

Other qualities of a company to consider are market position, company age, industry, and the assets that come with it. Do you also have transaction multiples? And multiples on European software companies? Hi Alex! Some are European software companies. And yes, they are trading multiples, not transaction multiples.

Hi David, thanks for your comment! The companies used in the analysis and their multiples are listed in the article above. Hi David! Hi Microcap: this is a really useful analysis. Thank you! Thanks for your comment, Mary! I will post an updated software company valuation list. If you want to be notified, please sign up for the mailing list. Hi Mary! I am interested in the full list of companies in the data set.

Would you please send this to me? Thank you. Hi Larry! Thanks for this valuable information! When did you take this analysis? Also, can you provide a link to your next article with the full list?

In the COCOMO model, this database of actual software development projects was used to derive the equations and cost drivers. In the SLIM model, the equations are based on the study of actual development projects, and key variables may be assigned using projects in the database with characteristics similar to those of the subject system. Both models calculate an estimate of effort to develop a software system in terms of person-months.

To estimate the cost to develop that system, the number of months should be multiplied by a current cost as of the valuation date per person-month. The cost per person-month is a comprehensive or "fully loaded" cost that includes the average base salary of the development project team members and other factors. These other factors include, but are not limited to, perquisites, payroll taxes e. This cost estimation method projects the amount of effort required to create the subject software, taking into consideration the size of the programs, the program characteristics and the resource constraint environment in which they are to be developed.

That basic model estimates the number of person-months to develop a software product as a function of the metric called "delivered source instructions. This person-month estimate includes all phases of the development from product design through integration and testing, including documentation. Delivered source instructions are source program lines of code including job control language, data declarations and format statements—but excluding programmer comment lines, unmodified utility software and, generally, non-delivered support software.

The basic COCOMO model allows for three different modes of software development, with a specific effort equation provided for each. The software development modes characterize three general environments in which software is developed: the organic, semidetached and embedded modes.

Organic projects are defined as small in terms of number of delivered source instructions under 50, and project team size. The project team has extensive experience working with related software systems. Additionally, organic projects do not require complicated algorithms. Organic projects are developed in a familiar and stable environment and are not developed under severe time constraints. Examples of organic systems are scientific models, business models and batch-type data reduction.

Embedded projects are defined as large and are characterized by tight hardware, software and operational constraints. Large project teams and complex data processing architectures and algorithms are usually involved in the embedded mode development environment. Examples of embedded systems are avionics and ambitious command-control systems. The semidetached mode in an intermediate software development environment between the organic mode and the embedded mode.