• Causal Engines

What is your SaaS business worth? Part I: Understanding earnings, EBITDA, and revenue multiples

For founders and investors alike, understanding the fundamentals behind business valuations is important to assess your financial standing.

Let’s talk about software multiples, where there generally are three different multiples used to value a business and each is used differently.

First, we have earnings which are what is left after management has paid all expenses and added back their salaries. This representation is most commonly used for businesses with under $2 million in annual revenue as it is very likely that they are sole owner-operators. Generally, these are referred to as SDE, or seller’s discretionary earnings with smaller businesses.

Above $2 million in annual revenue, Earnings-before-interest-taxes-depreciation-amortization (EBITDA) multiples are used for SaaS companies with a positive operating margin. As the company expands and becomes more sophisticated, often with complete management teams, EBITDA is measured as a proxy to cash flow. There are very few SaaS companies in the early stages of their growth trajectory that trade on this multiple.

However, many SaaS companies today have zero or negative EBITDA due to consistent investments in growth (sales, marketing, product development, etc.). The goal here is that these investments will increase market share to eventually explode future profits as the business matures and spends less. Consequently, earnings and EBITDA are not always appropriate for valuation.

This brings us to revenue.

The key is being aware that revenue multiples are entirely based on growth and are used for almost all sizes of SaaS companies. Without top-line growth, the software business will have extreme difficulty achieving the future profitability that the valuation represents. These businesses are awarded valuations that correspond to their ability to capture the market rather than their profitability. Therefore many firms choose to optimize recurring revenue as it is the cornerstone of future revenue growth. The most interesting point here is recurrence. Great enterprise software businesses have recurring revenues that are almost impossible to churn out of, and sometimes even net negative churn.

Regardless of the type of multiple, there are several key metrics that strongly influence the premium or discount applied to your specific business.

The line item most asked about is revenue, which leads to MRR and ARR. These measures are special because they are predictable, and their importance is highly influenced by the underlying business model. If you sell to SMBs, you most likely rely on monthly contracts whereas if you sell into the enterprise you are likely on an annual basis. Both metrics are still looked at since MRR is great for short-term planning and assessing seasonality while ARR is helpful to predict long-term growth given sufficient business history.

A critical revenue metric is churn; the percentage of your customers that cancel or do not renew subscriptions during a given time period. Software verticals with intense competition, short-term or seasonal usage are susceptible to high churn. In reality, churn rates vary by customer segment. SaaS companies targeting SMBs often have high monthly churn from 2.5%-7% due to customers going out of business. The mid-market, consisting of average annual customer revenue from $10k-$250k typically has a monthly churn of 1%-2% whereas enterprise companies with average annual customer spend being more than $250k a year have monthly churn below 1%. As the spend per customer increases, firms can invest more in customer retention and improve rates.

The best businesses have net negative churn, meaning that expansion revenue from existing customers outpaces revenue loss from plan downgrades or cancellations. A company that achieved this is Front, a customer communication platform that raised $10 million in a Series A led by Social Capital in 2016. In the prior 12 months to the fundraise, Front posted 5.4x MRR growth and 3% monthly churn resulting in net monthly churn of about -5%. The ability to institute add ons and upsell existing customers is powerful and more cost-effective than acquiring new customers. When expansion revenue exceeds churn, many SaaS businesses are granted significant premiums on their multiple.

It is worth taking customer acquisition cost (CAC) and customer lifetime value (LTV) into consideration as you look at revenue. These individual values should be optimized by targeting the right customers through the best channels, focusing on channel diversity, channel competition, and channel conversion. Investors will also look to the LTV/CAC ratio generally being greater than 3 so that the business extracts sufficient value from each additional customer.

This is just the primary foundation. Valuation is an art, not a science, and many other micro and macro factors come into play. We’ll cover these in the next part of the series.

We would like to thank Tomasz Tunguz and Thomas Smale for their inspiration.

This article is a collaboration between Archit Bhise and Sebastian Duluc.