Getting the valuation right of your SaaS business can make or break a once-in-a-lifetime decision, such as a company sale or significant capital raise.
That is why understanding the current valuation practices can be beneficial for:
- Negotiating an acquisition offer: many potential buyers prefer to lowball in their first offers, so understanding the market environment can provide invaluable insight and ammo for negotiations.
- Raising capital: choosing a to-the-point valuation figure for your next round so it does not undervalue your company but also does not discourage potential investors.
- Understanding your company value: managing your wealth tied to the business and
- Taking strategic decisions that maximize company value and understanding what metrics drive SaaS valuation in the current cycle.
In this post, we look at the valuations of public SaaS companies and what has driven their impressive boom and bust cycle over the past eight years. We then analyze the valuations in M&A transactions, which provide much better guidance to the founders of mid-size SaaS companies.
Table of Contents
- Our Sample
- SaaS Stock Market Performance
- SaaS Revenue Multiples
- Valuation Drivers: Growth Rates
- Valuation Drivers: Profitability
- Valuation Drivers: Rule of 40
- Our Sample
- EV/Revenue and EV/EBITDA Multiples for SaaS Companies
- Valuation Drivers: Company Size
- SaaS vs On-Premise Software Company Valuations
- Public Markets vs M&A Transactions
What Is a SaaS Business?
SaaS (Software as a Service) businesses have experienced unprecedented expansion over the past years and now dominate the software landscape.
The rapid growth and stock market success made “SaaS” an overused buzzword, with many technology companies describing themselves as SaaS to fall into a basket adored by the investors. Therefore, before analyzing the SaaS valuation multiples, we think it is essential first to define what a SaaS company is.
There are three key boxes a SaaS company must check:
- Sells a license to use their software: The core business model should be software licensing, unlike many tech-enabled business models, such as marketplaces or FinTech that primarily generate commissions.
- Delivers in the cloud: The software should be delivered in the cloud, centrally hosted and managed by the vendor. Many software businesses that are now in the process of transitioning to the cloud, yet still derive most of their revenue from on-premise software, are not considered SaaS businesses in our analysis.
- Delivers “as a service”: The customers should pay for the software on a subscription, pay-per-use or pay-per-transaction basis and always have access to the most recent version of the software.
Public Market SaaS Valuations
In our analysis, we look at the most liquid SaaS companies listed on top stock exchanges:
- Companies listed on NASDAQ or NYSE
- $1B+ market cap as of 13.01.2023
We tried to err on the side of including fewer companies, and focus solely on pure-play SaaS businesses, thus excluding companies that:
- Generate the majority part of the revenue from on-premise software: SAP, Palantir, etc.
- Generate the majority of the revenue from the resale of 3rd party services: Twilio, Vonage, etc.
We start with a sample of 27 companies in 2015, which grows to 73 companies by the end of 2022, as more companies went public.
SaaS Stock Market Performance
SaaS companies have experienced an unprecedented run since 2015. While the post-COVID monetary stimulus provided the final move up, we see that the bulk of the appreciation happened during a period of stable growth in 2015-2020.
Our proprietary Aventis SaaS Index (consisting of 73 SaaS companies) peaked at more than 650 points (100 = January 1st, 2015) in early 2021, with the top marked by a meme stock mania and SPAC boom. This was also a period of peak IPO activity.
The Federal Reserve put an end to the bull market in early 2022, starting to raise interest rates aggressively.
As most SaaS companies we analyzed are currently unprofitable, they were the ones to feel the pinch as the future cash flows suddenly became worth much less. Since its peak, Aventis SaaS Index declined by 63% from its high.
With the investor sentiment falling, the IPO market virtually froze, with no major SaaS listings since November 2021.
SaaS Revenue Multiples
EV/Revenue is the most common multiple used for SaaS valuation. Most companies are not profitable as they actively invest in growth, so the profit multiples are not applicable. At the same time, the revenue multiple divided by the target future profit margin can give a ballpark estimate of the future EBITDA multiple. For example, a company trading at 5.0x Revenue that expects to reach a 30% EBITDA margin implies a future 16.7x EV/EBITDA.
EV/Revenue multiple for our sample of SaaS companies was growing slowly for most of the period of 2015 to 2020. The multiple expansion partly drove the increases in share prices, but the companies in parallel grew their revenue.
The big valuation jump-started in April 2020, when the median EV/Revenue multiple increased from a COVID bottom of 9.8x to almost 20.0x, with companies in the 1st percentile valued at above 30.0x. The highest multiple recorded in our sample was Asana, which closed at an incredible 89.0x LTM Revenue on November 9, 2021.
After lingering around 18.0-19.0x for most of 2021, the median revenue multiple started its rapid descent in early 2022, just as monetary policy tightened. By the beginning of 2023, the median revenue multiple declined to 6.7x.
The rise and fall of revenue multiples can be explained by the changing dynamics between the two most important factors determining the valuation: growth and profitability. We take a closer look at both in the following sections.
Valuation Drivers: Growth
Revenue growth has always been a crucial SaaS metric.
With the new business model allowing for better product stickiness and a lower churn rate, the calculation has been simple. If customer lifetime value (LTV) is larger than customer acquisition cost (CAC), keep investing in new customer acquisition. The profitability will follow at scale, so the short-term profits are irrelevant, and growth is key.
As in any new industry, the growth rate starts high and then declines as it becomes difficult to grow revenue from a larger base. By Q3 2020, a median SaaS company’s revenue growth slowed to 20% YoY and was on a clear downward path (see chart below).
The growth rates partly explain the massive increase in the revenue multiples in 2020-2021. As companies were digitizing amid COVID, the median growth rate jumped by 11 percentage points to 31%. This immediately fed through to the revenue multiple, which is sensitive to the growth rate, especially when interest rates are low.
Yet the jump seems short-lived as the growth rate returns to the long-term trajectory. Given the higher revenue base and the upcoming slowdown, growth can fall even below 15%. The collapse in growth rates is one of the most important fundamental factors contributing to the decline in multiples.
Valuation Drivers: Profitability
The other part of the SaaS company valuation equation is profitability, as it is the cash flow that essentially matters for a company’s valuation. From 2015 to 2019 SaaS companies were on track to profitability, with improving EBITDA and net income margins. Yet, the improvements in profitability stagnated after 2019 and even declined slightly as early-stage, loss-making companies entered our index. For most of the past three years, a median public SaaS company operated with an 8-14% net loss. At the same time, as interest rates stayed close to zero, immediate cash flow generation was less important.
As a result, the higher interest rates were a large blow to public SaaS companies’ valuations. As the yields on short-term Treasuries grew to over 4%, valuation multiples for companies with significant losses declined the fastest.
With the change in the economic environment, SaaS businesses are now adapting to the new paradigm. Many have laid off staff, implemented a hiring freeze, decreased investments, and aggressively cut operating expenses.
The most exposed companies have high burn rates compared to their cash balance. With the IPO market frozen and debt getting increasingly expensive, many businesses need to get to break-even as soon as possible to stay afloat.
As of Q3 2022, in our sample of 73 firms only 16 were profitable on a Net Income level and 21 were profitable on an EBITDA level. Those profitable ones had a median revenue multiple of 7.8x, compared with 6.7x for unprofitable companies.
For example, one of the profitable businesses, Descartes, a vendor of SaaS logistics software, traded at 11.9x revenue, while generating a healthy 40% EBITDA margin. The company was relatively immune from the tech sell-off, with its share price declining only 15% from the peak in November 2021.
Valuation Drivers: Rule of 40
The Rule of 40 is calculated as a sum of the company’s growth rate and profitability. As the argument goes, SaaS companies can easily choose between revenue and growth, so fast growth compensates for low profitability and vice versa. In any case, a healthy SaaS company is supposed to score above 40 on this metric.
As of January 2023, revenue growth decelerated for most companies, but the increase in profit margin did not compensate for this slowdown. Only several companies exceeded the Rule of 40 with a comfortable margin (e.g., Adobe, Descartes, and EngageSmart).
While a valuable rule of thumb to assess a company’s operational efficiency, Rule of 40 also correlated with SaaS business valuation. We see a slight upward-sloping trendline, suggesting a 10% increase in the Rule of 40 score corresponds to about 1.0x growth in revenue multiple.
SaaS Valuations in M&A Transactions
In our analysis of the M&A transactions, we looked at 959 software deals since 2015 and marked the ones where the target company can be considered operating in a SaaS business model.
Over the past eight years, 327 SaaS transactions had a disclosed revenue multiple, and 130 transactions had a disclosed EBITDA valuation multiple.
EV/Revenue and EV/EBITDA Multiples for SaaS Companies
Despite all the gyrations of the public markets, revenue multiples in M&A transactions stayed stable. At the same time, EBITDA multiples rose significantly, suggesting investors pay the same revenue multiple for companies that over time had a decrease in profitability. This corresponds with the analysis of public companies where there is a slight downward trend in profitability since 2018.
In 2015-2020, a median SaaS company was valued at around 5.2x Revenue. Of course, there were significant differences between companies, with a quarter of the companies being sold at valuations above 9.7x Revenue.
While the 2020-2021 period brought about a massive boom in the public markets, the median valuation multiple in M&A deals grew only slightly from 5.8x to 6.4x. In 2022, it declined back to 5.7x, in line with the figures from 2018-2020.
The year 2020 has seen a high figure for the 3rd quartile, suggesting the multiples in the top 25% of the deals jumped significantly. However, most deals were still happening at more rational valuations.
Although rarely used and disclosed for SaaS company valuations, EBITDA multiples stayed above 20.0x since 2019 for businesses that generated positive EBITDA and the median even grew to 29.1x by 2022.
Many SaaS metrics account for the significant differences in company valuations. Highly valued SaaS firms usually operate in a larger total addressable market, have low churn and high net revenue retention, and efficiently use customer acquisition channels. However, the most important factor that can predict company valuations is the deal size which we describe below.
Valuation Drivers: Company Size
Deal size is one of the most important determinants of the valuation multiple. In our sample, the median revenue multiple is twice as high for deal sizes in the $50-100M basket, as compared to the $20-50M basket.
We think there are a number of factors contributing to this large difference:
- Many larger M&A transactions involve targets from the public market, so the buyers need to pay a premium to the price to delist the company from the stock exchange.
- A lot of larger deals are highly strategic for the buyers, so they tend to pay a premium for potential synergies with their product: e.g., recent acquisitions of Slack by Salesforce, Figma by Adobe, Mailchimp by Intuit, etc.
- Larger companies typically operate in larger total addressable markets with ample growth potential, while many smaller software businesses are local and difficult to scale (e.g., cloud accounting software in European countries).
- A larger transaction size opens up a larger base of potential investors: many top private equity funds with low cost of capital have a strict minimum investment size in their mandates.
SaaS vs On-Premise Software Company Valuations
In our analysis, we compared the valuations of businesses operating in a SaaS model with non-SaaS businesses (on-premise software, API/SDK, software components, etc.).
In 2015-2020, the valuation premium of SaaS over non-SaaS businesses was significant at more than 40%. Yet in 2021, as the valuations of non-SaaS software jumped to a median of 5.3x Revenue, the premium declined as well.
We believe the unprecedented volume of capital on the market made investors look at the less crowded segments of the software industry. The number of investors looking for deals in lucrative SaaS just didn’t match the number of strong companies there. The wave of interest in on-premise software companies may have increased the valuations in this segment as well.
In addition, on-premise software companies are gradually accelerating their cloud migration efforts and they change their pricing strategies, which makes them resemble SaaS companies more and more.
Public Markets vs M&A Transactions
While enjoying a significant overvaluation during most of the past five years, by the end of 2022, SaaS valuations in public markets declined so much, so as to almost converge with valuations in M&A transactions.
Private markets usually reflect the change in investor sentiment with a lag, so we expect valuations for private SaaS companies to potentially also decline in 2023.
About Aventis Advisors
Aventis Advisors is an M&A advisor focusing on technology and growth companies. We believe the world would be better off with fewer (but better quality) M&A deals done at the right moment for the company and its owners. Our goal is to provide honest, insight-driven advice, clearly laying out all the options for our clients – including the one to keep the status quo.
Get in touch with us to discuss how much your business could be worth and how the process looks.