Valuating and Selling a Software, SaaS or IT business

Valuating and Selling a Software, SaaS or IT business

We are frequently seeing tech startups selling for significantly inflated valuations. A great example of this was the acquisition of WhatsApp by Facebook in 2014. WhatsApp was acquired for $22 billion despite, at the time, recording an operating loss of $138 billion. This was because the acquirer saw a unique opportunity to grow its social communications platform and, based on projected user growth, saw strong potential synergies for the acquisition. The term ‘Unicorn’ is used to describe these types of companies, those with extreme growth potential and high valuations, but aren’t currently showing strong profitability. In these cases traditional risk analysis is thrown out the window due to future expectations; actually, in many cases, a lofty valuation makes these companies more attractive acquisitions.

Analysts often use unconventional valuation methods when considering tech startups; conventional income-based valuation approaches including capitalized earnings and discounted cash flows do not reflect intrinsic value due to uncertainty in future company cash flows and profitability. Similarly, market-based valuation approaches such as comparables and precedent transactions do not apply because the future trajectory of a company is difficult to predict. Business models often change dramatically to respond to changes in market demand; many of these companies are acquired significantly above the value that any of these methods would predict. 

These methodologies have allowed for immense growth to take place in geographies with prominent tech hubs. Prime examples are Toronto and LA where tech-related M&A has not only contributed to the growth of knowledge but the value of businesses. Both Toronto and LA pose a very similar situation as M&A has increased due to the surplus of dry powder available from the public, private and institutional investors driving M&A in both real estate and business acquisitions higher. Business Brokers such as Beacon M&A have appreciated this increase in M&A.

Key Value Drivers

Saas companies are valued based on unique, industry-specific, metrics that are used to measure things like how long the average customer will subscribe for, how much it costs to acquire a new customer and an average of how many customers are lost at the start of each billable period. Subscription-based services have been around for a long time but now they exist digitally and do not require the purchase of other goods as many subscription-based services have in the past such as country clubs etc. 

A primary metric in SaaS companies is customer churn. Churn is one of the most critiqued metrics when valuing a SasS business. Churn is the rate at which SaaS customers cancel their subscriptions which is the main source of recurring revenue for businesses. Churn is often measured against the customer acquisition rate. This is based on fundamental business principal, for a subscription-based company to grow, they must obtain more customers than they are losing.

 

Another important metric is customer acquisition cost & customer lifetime value. When measuring a SaaS product, it is important to understand the quantitative cost of acquiring a new customer is. This customer Acquisition Cost can be the cumulative price of paid search, advertising, cost of any dedicated salesperson and any other costs related to landing a new customer.

 

Customer lifetime value is used to determine the average revenue that is attributable to a typical customer which is closely tied to another critical metric. The ratio of Customer lifetime value to customer acquisition cost is typically measured against the industry benchmark of 3:1 (3 customers is = to the cost of 1 new one). The lower the ratio the better as this signifies that new customers are not expensive to the business. This has become an increasingly prevalent trend as companies with ratios of 2:1 and 1:1 are more and more common. 

Qualitative Value Drivers

Now we are going to look at how qualitative features can impact the valuation of a SaaS business. Typically when someone is looking to acquire a SaaS business they would prefer one that requires the least amount of owner involvement. This is to maximize money made for time spent. Another metric that is preferred is the structure in which subscriptions are paid for, there is almost a two-to-one increase in long-term revenue value for monthly subscriptions compared to their annual counterparts. 

 

Arguably, one of the most important quality a SaaS company can have is the secured ownership of Intellectual property such as trademarks, copyrights, and patents. These should all be registered with their respective governing bodies. Once the intellectual property is secured then the remaining qualities to be examined are:

Transferability: the software’s ability to be integrated into diverse scenarios scalability: the software’s ability to service more clients on a larger scale and sustainability: from a revenue and technical perspective, is the software code in an out of date language, can this become cloud compatible etc. These are all things to consider as they all play an integral role in determining a sale price.

 

Another important qualitative factor would be the company’s marketing tactics, more specifically, the magnitude and diversity of a company’s customer acquisition channels. Multiple acquisition channels are very attractive to buyers as these institutions are often indiscriminate as to whether these channels are organic, partnered agreements or paid, as long as they are effective.

Channels can have geographically specific parameters as well. As an example, marketing in Toronto may be different from other major cities such as LA due to differences in demographics and income. This must also be taken into consideration.

 

Additional Important Factors

Product Lifecycle and product development are things all acquirers take into account when determining the value of a SaaS company. This is because both product lifecycle management and product development are necessities in order to increase organic growth, broaden product offerings and meet the customer’s changing needs. This development costs time and capital but helps provide the company with direction. A development roadmap can provide insight into how the business intends to grow and what that growth will cost. This is valuable because it helps acquirers better understand what synergies exist and what goals can be aligned with their own.

Product life cycles may also vary by the geographical consumer channels a company sells into. These discrepancies occur as a result of differences in age demographics and levels of income. This can be seen when comparing places outside of the GTA to Toronto, due to the higher-earning individuals living in the city there is a greater magnitude of expenditure. Using targeted marketing to the right demographic, in the right region, a company can capitalize on those high-earning individuals and companies. 

Despite the numerous qualitative and quantitative factors that increase the value of SaaS companies there is still one more factor that we have yet to discuss, market conditions. The already inflated valuation method used to determine the sale price of SaaS companies is further exacerbated by current market conditions. Deal volume in the tech sector is the highest it has been in 5 years, with 9.9 Billion exchanging hands in Q4 2021 alone. This coupled with the fact that interest rates are extremely low allows for higher valuations and multiples.

On top of favorable market conditions, there is a huge incentive for large tech companies to acquire smaller niche companies that they can add to their portfolio of offerings. It is these same small companies that are often acquired for synergistic purposes should they have developed a successful and versatile product. This versatility intrinsically demands a higher multiple when being valued. Though these deals vary widely by industry and size a handful of these acquisitions took place in Toronto and California using the help of global and regional business brokers. 

Geography can also play a part in valuing a company. In regions such as Toronto and California, which are known to be major tech hubs, countries can drive up a higher price. It takes an expert to value complex SaaS companies but that is one of Beacon Mergers & Acquisitions strengths, we cover every sector and use industry-specific valuation techniques to derive the most value for our customers on every transaction.

Now, why does this matter to you? M&A has been hot in the tech sector for the last year, especially this quarter, with rising multiples and lofty valuation techniques this could be the exit opportunity you are looking for. Whether you are in Toronto or California, Beacon Mergers & Acquisitions is equipped with the expertise you need to crystalize your years of hard work in a transaction that goes above your expectations.

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