The valuation for SaaS businesses with proprietary software is often higher than for traditional IT businesses, and there are good reasons for that.
SaaS businesses often have recurring revenue streams (recurring revenues). The business model is often based on software contracts that are concluded for a longer period. In practice, we see periods of up to 36 months for a software subscription, for which monthly payments are made. After the 36-month period, the contract is often tacitly renewed, often for a period of 12 months. This is in contrast to somewhat more traditional software business models, where an indefinite license is purchased for a one-time fee and an annual maintenance fee is charged in addition. The advantage to the customer of a SaaS contract is that the monthly fee for the software product is lower than the one-time purchase price for the software license in the traditional model. This benefits the company's liquidity. For the software vendor, the advantage of a SaaS business model is that the long term of a SaaS contract often generates more revenue than a one-time software sale. In addition, because of the long period it is entered into for, the subscription model brings a certain predictability of revenue, which in turn makes business owners happy.
In information technology, valuations are higher than many other industries. This can be explained by the industry's growth rate, which in some parts of the market exceeds 15% per year. Returns are also higher on average than in other sectors, especially for software businesses. In addition, the market is also characterized by short life cycles of businesses and business models, which quickly leads to consolidation in a particular sub-segment. Right now, for example, there is consolidation going on in the market for managed services businesses. These are companies that take the management of your IT environment out of your hands. This segment is attracting interest from investors.
High valuations
Among the outer category in terms of valuations are SaaS (Software as a Service) businesses. These are companies that provide software on a subscription basis. Often these solutions are hosted by the software vendor itself or by a strategic partner. The idea behind these higher valuations is that the businesses that operate based on this business model can grow faster than other businesses, resulting in higher returns on invested capital.
Subscription model
The way a SaaS business' software is contracted can affect its valuation. A business model based on multi-year contracts and monthly subscription revenue (also known as MRR = Monthly Recurring Revenu) generally yields a higher valuation than the traditional model with one-time license payments and a maintenance fee. However, converting a traditional software licensing model to a SaaS licensing model is no easy task. It usually requires a lot of liquidity that not every company can muster. Fortunately, there are specialized investors who have jumped into this gap and can bridge the so-called "SaaS gap."
Another aspect that can lead to higher valuations lies in the ability to build a cash machine with well-targeted marketing campaigns. For that, we need to dive into the metrics that are considered important by connoisseurs of a SaaS business, among others; Customer Acquisition Costs (CAC) and Customer Life Time Value (CLTV).
CAC
The CAC provides insight into the costs involved in bringing in customers. This includes direct spending on marketing, for example, but it also includes indirect spending on staff or hiring for marketing purposes. It's actually a good thing for any business to measure this variable and then examine how it could be optimized by being able to acquire more customers with less money, but with SaaS businesses this measure is particularly well followed.
A business model based on subscription revenue generally yields a higher valuation than the traditional model
CLTV
The CLTV additionally provides insight into a customer's revenues over the life of the business relationship. In the simple version of the CLTV, we calculate the average revenue per customer over the average period that a customer is served by the company. Then we multiply that number by the average percentage margin. Again, this is a KPI that every business should measure, but one that also receives special attention from investors in SaaS businesses.
Dividing the CLTV by the CAC provides insight into a client's level of profitability. Investors often look for a minimum of three times the amount invested to acquire the customer as a return (Ergo; CLTV/CAC > 3).
The CLTV / CAC ratio is in flux. In the company's early years, this ratio usually won't be above three, but gradually over its lifetime the ratio will improve, for example through focused programs such as Member get Member, where a user of a product is rewarded for bringing in a new user. The greater the user numbers become, the greater the number of newly introduced customers who are referred by other customers. In addition, SaaS companies also learn how to use marketing more effectively. For example, they learn which SEO campaigns are more effective than others and by constantly adjusting the variables, the best mix of tools can be found to spend marketing budgets efficiently and, as a result, the CLTV / CAC ratio gradually improves.
A high level of recurring revenue and a CLTV/CAC ratio that is above three contributes to the valuation for your software company in general and your SaaS company in particular!
Revenue multiples
Whereas in the "normal" valuation of IT businesses we often see multiples over Ebitda, with SaaS businesses it is more common to pay multiples over revenue. The range is between a factor of 2 at the low end to a factor of 8 at the high end (with exceptions). These are valuations that capture the imagination of every entrepreneur!
