When talking to SaaS entrepreneurs, inevitably the topic of valuations come up. Right now, public SaaS companies are trading at all-time highs, so entrepreneurs expect those valuations to apply to their startups. While the valuations of public and private SaaS companies have a direct correlation, it’s important to understand that not all SaaS revenue is created equally, regardless of public or private markets, thus valuations as a function of revenue vary wildly.
As expected, premium SaaS valuations are driven by premium SaaS metrics. Here are a few of the most important ones:
- Annual Recurring Revenue – The annual run-rate is the most talked about SaaS metric. Ensure that it’s contracted, recurring revenue as different from other revenue sources like services revenue and payment processing revenue.
- Gross Margin – The money left after the cost of goods sold are taken out. SaaS company gross margins vary dramatically from the low 60s to the high 90s. Anything below 60% gross margins isn’t SaaS (startups masquerade as SaaS but often aren’t). A SaaS company with 90% gross margins is 50% better than a SaaS company with 60% gross margin, and correspondingly much more valuable per dollar of revenue.
- Growth Rate – The year-over-year growth rate reflects the potential to continue growing fast, and ultimately achieve a much greater scale in the business. Investors pay a huge premium for high growth.
- Net Renewal Rate (also Net Revenue Retention) – The gross renewal rate plus upsells and cross-sells represents how the annual recurring revenue will change assuming no new sales. Investors pay a huge premium for high net renewal rates.
Directionally, the simplest formula for SaaS valuations is as follows:
- 10 x
- Annual recurring revenue x
- Growth rate x
- Net renewal rate =
Here’s a quick example:
- 10 x
- $5 million in annual recurring revenue x
- 50% growth rate x
- 105% net renewal rate =
- 10 x $5,000,000 x .5 x 1.05 = $26,250,000
So, a $5M SaaS company with good growth and good net renewal rates would be worth a bit more than five times annual run rate.
To make it more complete, you’d add in gross margin and elements to reflect more nuanced variables like the potential size of the market (e.g. a valuation premium for bigger markets).
One SaaS company might be worth 15x run-rate (due to high growth rate and high net renewal rate) while the next one might be worth 2x run-rate (due to no growth and high churn).
Premium SaaS metrics are required for premium valuations. Look at the entire picture, not just annual recurring revenue.