We know that Software-as-a-Service (SaaS) companies with a higher growth rate are much more valuable than other SaaS companies with a lower growth rate, all things equal, based on research of publicly traded companies. When looking at the value of a business internally for the purpose of raising money or selling the business, it’s an interesting exercise to quantify just how valuable growth is to the overall valuation of the business.
Now, making the assumption that gross margins are in the 70% – 80% range, renewal rates are in the 80% – 90% range, and that there’s nothing else abnormal about the business from a SaaS perspective, here’s the proposed formula:
Valuation = (2*ARR) + (ARR*(1+(GRM*GR)))
ARR = Annual Recurring Revenue
GRM = Growth Rate Multiplier = 2.5
GR = Growth Rate
So, if growth rate is 0 (e.g. the company isn’t growing), the company is worth two times revenue, which makes sense. Assume a business with 75% gross margins can have profit margins of 33% if it doesn’t invest heavily in sales in marketing. Take the 33% profit margins and multiple by six to roughly approximate the six times EBITDA valuation assigned to an arbitrary business (the common value of a private company is usually 4x – 6x profits). With .33 (for 33%) times six, you get a business value of two times revenue (e.g. .33 * 6 = 2).
Here are some more examples with growth rates:
- $300,000 annual recurring revenue
100% growth rate
Valuation = (2 * 300,000) + (300,000 * (1 + (2.5 * 1) = 600,000 + 1,050,000 = $1.65 million - $1,000,000 annual recurring revenue
50% growth rate
Valuation = (2 * 1) + (1 * (1 + (2.5 * .5) = 2 + 2.5 = $4.5 million - $1,000,000 annual recurring revenue
200% growth rate
Valuation = (2 * 1) + (1 * (1 + (2.5 * 2) = 2 + 8 = $8 million - $5,000,000 annual recurring revenue
100% growth rate
Valuation = (2 * 5) + (5 * (1 + (2.5 * 1) = 2 + 8 = $27.5 million
Of course, these are the theoretical valuations for a strategic buyer or an investor with preferred shares. For a shareholder with common shares, there would be a 50% discount for lack of liquidity and other issues related to not having control. In the end, growth rates drive SaaS valuations and (2*ARR) + (ARR*(1+(GRM*GR))) is an example to think through a valuation.
What else? What are your thoughts on quantifying the SaaS valuation growth rate multiplier into a simplistic formula?
David Cummings on Startups 
I think this is about 30-50% market if it’s a {Very} Hot SaaS company. Otherwise, it’s spot on.
Thanks Jason. I agree, the very hot SaaS companies in the public markets are trading at twice this formula and I know of several private SaaS cos that got pre-money valuations significantly higher than this formula.
David I’d be curious to know how the formula changes based on the renewal rate not being 80-90%.
Here’s a related post from Dave Kellogg, with a focus on the publics.
http://kellblog.com/2013/06/05/what-drives-saas-company-valuation-growth/
Discount Kellogg’s formula by 50%, and you’ll end up with something very similar to David’s. These formulas are great guides for entrepreneurs with an eye to exit.
Here’s an incredibly distracting and fun exercise (or frustrating, depending on your rate of growth):
Add this formula to whatever model you use to track historic and forecasted performance, and plot the line. You’ll see during which periods you’re lifting valuation the fastest, or when you might have been growing revenue but the rate of growth wasn’t fast enough to keep lifting valuation.
Hey David – correct me if I am wrong, but using your equation, if you plug in zero for the growth rate the resulting valuation would be 3x ARR. This would mean you are paying for 9 years of profits at a 33% EBITDA margin which is not consistent with the typical timeline of an investor. Is this a formula error? Also, where does the GRM of 2.5 come from? My colleague and I are working on SaaS valuation methodologies and thought your post was interesting. Thanks.
I would think a SaaS company would have much higher than 33% EBITDA once they are up and running.
Author does say “So, if growth rate is 0 (e.g. the company isn’t growing), the company is worth two times revenue, which makes sense. ” This statement is incorrect as you have pointed out, as the result of 0% growth rate is in fact 3 x ARR.
Hey David. Could you maybe provide some examples of SaaS companies where this formula has been used? Will it be helpful for me to raise VC funding for my firm if I use this formula for valuation? Also what is your rationale behind taking GRM to be 2.5?
David, great blog …. i think i understood it. Anyway great share.
Same questions as above…why 2.5 GRM, and in what circumstances could it change?
This post is awesome thanks for providing an actual formula with examples! I noticed there are not any places online where you can enter in your own metrics. So I took your formula and let you input your own values… http://stath.es/saas-calc
I hope you enjoy, feel free to let me know any adjustments, I will be constantly trying to improve.
Great post! Here’s another article I found useful for early stage valuation estimations http://www.growsaas.com/blog/2016/1/10/what-is-your-startup-actually-worth
As Greg Stathes saas-calc is no longer functioning I’ve built a live SaaS Valuation calculator: http://saasvaluation.leaddoubler.com
You can simply that formula to Valuation = ARR * (3+GRM*GR)
it looks like the relationship between valuation and growth is almost linear, which is justified imho, given the forward-looking nature of valuation as such and widely used revenue multiples. Gross margins however do matter as well. Somewhere (Feld?) i saw a metric called “Rule 40” that basically sets a benchmark 40% for the sum of growth and gross margin percentages. Accounting for both growth and profitability may be a challenge, not to mention watching markets. To save some work hours, I just made a small tool for myself that helps to do quick valuations. It employs current market valuations and accounts for both, company growth and gross margin: http://monyca.vc/. It’s quite accurate so thought it’s worth sharing with others
“So, if growth rate is 0 (e.g. the company isn’t growing), the company is worth two times revenue, which makes sense. ”
Doesn’t match the formula if growth rate is 0 multiple is 3 not 2?
Valuation = (2*ARR) + (ARR*(1+(GRM*GR)))
Valuation = ARR * (3 + GRM*GR)
GRM = 2.5
Valuation = ARR * (3 + 2.5*GR)
IF GR = 0
Valuation = ARR * 3
Formula doesn’t match explanation
Can you walk through what the formula represents?
David,
From your experience, what is the impact of growth coming from retention vs new customer acquisition. You comment on retention needing to be at 80-90% but is a company has high NRR likely to be valued significantly more than a company growing at the same rate but with relatively low NRR?
Hi David. Love your post. Do you not look at EBITDA when valuing these companies? If so, how does EBITDA come into play? Also, how are you getting 2.5 for the GRM?
Is this still up to date? how to think about the GRM in the current market and depending on the sector the company is in? (a not so hot sector vs cyber security for instance: any rule of thumb?)
Thanks