Why 99% of SaaS CEOs Are Wrong About Metrics
If you listened exclusively to the VC community, this article would be pretty short, as almost all of them would tell you that the only thing that matters for a SaaS company’s valuation is revenue growth, at all costs. However, for the vast majority of mid-cap SaaS companies, this is not the only relevant driver.
In our experience, there are several factors that we believe drive mid-market SaaS valuations, which are:
2. Revenue growth
3. % SaaS
4. EBITDA margins
5. Churn and Customer Acquisition Costs
6. Total Addressable Market (TAM)
Let’s look at each of these categories in more detail.
One very important metric for buyers is the overall scale of the business. We see several step-jumps in valuation as a result of scale and they usually occur at $3m, $5m, $10m and $25m of software revenues (excluding services and implementation). Below $3m of revenue, it is very difficult to get the attention of many buyers – as they might argue that traction of product / market fit really hasn’t been validated at below these levels. We find less buyers passing up a business doing $5m+ of revenue and scale issues rarely come up for companies with more than $10m of revenues.
This correlation can be seen in the following chart that shows as revenue increases, so do valuation multiples paid in M&A transactions.
So the traditional VC metric of revenue growth is important, but it is just one factor that goes into overall SaaS valuations. For example, you might be growing revenues at over 100% but if your revenues are only $100k, jumping to $200k is likely not that interesting for most buyers.
Believe it or not, but there is a great deal of variability between SaaS companies in terms of the amount of their revenues that are purely recurring revenues and revenues that are not. Many SaaS companies have revenues coming from implementation and services (non-recurring). While many others have legacy revenues from perpetual licenses and maintenance contracts. It is true that buyers are very focused on pure SaaS revenues and will pay a premium for these.
EBITDA is more important than many sellers think. This is especially true with the entry of Private Equity (PE) firms into the software space. While these PE firms aren’t looking to pay 6-8x EBITDA for a software company, they are looking to make sure that the company has strong prospects of generating cashflow. Most of the time PE money is being given to their portfolio companies to acquire and as such, they are looking at what Proforma or Adjusted EBITDA can be once that take over the company and achieve revenue and cost synergies. Strategic buyers are also looking at things with this same lens. This analysis becomes increasingly difficult to do for companies that are losing money or breakeven EBITDA.
Surprisingly there is an even stronger correlation of revenue multiples to EBITDA margins than there is to revenue multiples and scale – this can be seen in the following chart.
Churn and Customer Acquisition Costs
Churn and Customer Acquisition Costs (or CAC) are very important metrics for the average SaaS company. Churn is important because it is much cheaper to keep existing customers than to replace them with new ones. But there is an interplay here with CAC because the more expensive it is to acquire a new customer the more detrimental high churn can be. As such, churn is less of an issue if the CAC is low. Churn is also an interesting metric to look at when analyzing customer sentiment and overall happiness with the software solution. So we find many buyers scrutinizing churn and CAC to determine the likely impact on the business.
Total Addressable Market (TAM)
This is a metric that comes up a lot in our discussions. Buyers want to know that the addressable market is much larger than the current base and therefore there is room to grow for many years to come.
So, while revenue growth is important, it is just one factor that we see buyers using in their valuation approach.