Valuing SaaS-Technology Company’s

Got a call from a potential client in October seeking to get help to value their SaaS- Technology business, where they had been approached by an overseas investor expressing an interest in the company.

Anyway, the conversation and the journey went something along the lines… as follows….

Valuing a SaaS-Technology company is different from traditional valuation methods due to the unique nature of the industry sector. Several key variations separate SaaS-Technology companies from other businesses, due to high growth rates; negative earnings at the early stage and significant intangible assets missing in the financial statements, such as patents, customer data, copyrights and others under IAS 38.

How to Value

Traditionally, valuation methods have been divided into income-based (a discounted cash flow analysis based on financial projections); market-based (benchmarking to comparable public companies and precedent transactions); and asset-based (estimating the fair value of the company’s assets and liabilities).

Most these companies have very few tangible assets, where years of investment in technology are written off and development as an intangible (based on proof of concept- beta) are rarely reflected on the balance sheet. This is one of the reasons why an income-based and market-based approach are more suitable for technology company valuations.

Discounted Cash Flow (DCF) in SaaS-Technology company valuations

Discounted cash flow valuation is a business valuation technique that estimates a company’s value based on its expected future cash flows. The expected future cash flows are modelled based on the financial projections for the company, which include assumptions about revenue growth, operating expenses, CAPEX,  working capital and tax. Detailed financial results are usually modelled for 3 to 5 years, after which a stable cash flow growth rate is assumed.

The discount rate used in the valuation is typically the cost of capital for the asset, which reflects the riskiness of the cash flows. It can also be a hurdle return rate for the investor performing the valuation. It is higher for tech companies than traditional businesses and exceptionally high for riskier early-stage businesses.

Present value of the projected cash flows is then determined by discounting them at the discount rate. A sensitivity analysis that estimates the valuation depending on the changes in critical assumptions is commonly used to see how robust the valuation is. With numerous assumptions and detailed calculations, DCF valuation is considered the most precise, as it is deeply rooted in financial mathematics. Yet the number of inputs, method used and difficulty in interpreting makes this method awkward in tech company valuation.

Most startups are operating in highly uncertain environments, so predicting revenue and earnings far into the future is often tricky. At the same time, slight changes to the terminal growth rate and discount rate significantly affect the final value, rendering the method a finger in the air exercise.

The model can, however, be helpful for mature technology companies with stable growth and predictable profitability. Investors still prefer a more straightforward multiples method and will express the DCF valuation result as a multiple of annual recurring revenue or EBITDA.

Moreover, DCF is a useful tool to understand the drivers of the valuation by flexing the revenue growth rate, profitability or other assumptions may give a good indicator of what levers affect the valuation the most.

Annual Recurring Revenue (ARR) or Earnings multiples

The most common method for valuing technology companies is using a multiple of annual recurring revenue or earnings.

Revenue multiple is used when the earnings multiple cannot be calculated, as there are no earnings. It is prevalent for technology companies, such as SaaS businesses that invest aggressively in customer acquisition and growth. While not related to cash flows, using revenue multiple can still be a useful benchmark when an earnings multiple cannot be applied. ARR buyers are willing to pay higher multiples of ARR as they see the value of recurring revenue and increasingly private equity firms are migrating toward this category of valuation. 

Earnings multiples are used for mature tech companies with a history of positive earnings. The earnings multiples method is, in effect, a simplification of the DCF valuation method, as the higher value of the multiple corresponds to lower risk and higher growth of the company.

A commonly used valuation multiples for technology companies is EV/EBITDA.

EV (Enterprise Value) is a comprehensive measure of company valuations that includes both equity and net debt. This enables to value a company’s operations irrespective of how the company is financed (be it net debt and/ or equity).

EBITDA stands for Earnings before interest, taxes, depreciation, and amortisation and is considered a good proxy for the company’s pre-tax cash flow. For calculating multiples, it is advisable to ensure EBITDA is normalised, where exceptional items are ignored and other one-off items, including the owner’s costs to show the true earnings potential of the company.

As EBITDA is a proxy for cash attributable to both equity holders and debt holders (with interest added back), the numerator of the EBITDA multiple is Enterprise Value. The two most common sources of comparable multiples are publicly traded companies and precedent transactions.

A revenue-based valuation is advantageous if a SaaS company has just achieved product-market fit and is experiencing hyper-growth… opting for a revenue-based valuation over an EBITDA-based valuation is superior especially if profitability is uncertain.

Public comparables

It is easy to calculate the multiples implied by the investors for any company trades on a listed stock exchange using the current stock price and most recently reported Revenue or EBITDA.

To benchmark a company to a proxy public comparable, it is essential to select a proper peer group, where  companies operate in the same industry and have similar growth rates and risk profiles. The peer group will never perfect, so the practice is to include more companies in the comparison and even going as far as attributing the aggregate risk profile (asset beta) to extremely specific revenue operating/ cash generating unit segments to provide a range of multiples.

Note that publicly traded companies typically enjoy a higher valuation than their private peers, due to having audited financials and corporate governance and their shares are liquid.

Precedent transactions

M&A transactions happen among companies of all sizes. Benchmarking a company to precedent transactions would typically yield a more accurate result.

The challenge here is to collect a large enough sample of comparable transactions. The deal values in private transactions are rarely disclosed as these are often difficult to find. Therefore, you need access to large datasets of past M&A deals to build a relevant peer group. It is possible to calculate the multiples used in the precedent transactions by searching for press releases announcing the acquisitions and or paying a subscription to a specialist M&A data provider.

While all this is all good in theory, what is not reflected in the business valuation is the synergies of the potential buyer.

Synergies of the buyer

Both strategic and financial investors expect to generate value by completing a transaction.

Synergies for the strategic investor can come from various sources, not limited to improving their own technology offering, saving on development costs, acquiring a strong team, or eliminating a competitor. This is why strategic investors will usually pay a strategic premium on top of the value of cash flows.

Financial investors usually have a blueprint on how to improve the operations of the company post-acquisitions, accelerate revenue growth, improve the bottom line and finance strategic M&A. Alas, they very often do not possess the what, when, where and how to make it real, which in all fairness is not their function, but rather the company’s management.

It is essential to understand how a buyer plans to benefit from the deal and use this nugget of gold in negotiations. This is where an experienced M&A advisor with industry experience and the ability to build relationships with buyers can add significant value. Pinpointing the potential synergies is a strong negotiating argument for a higher price.

Understanding the SaaS-Technology Business

One of the greatest benefits of being involved in M&A transactions was my ability to think and act in a strategic manner, in terms of how we would run the business and what kind of dashboard we would want to see and use to navigate the waters from a position of strength and ensure the best possible price for the business sale/ exit.

Getting back to the story, I asked the client what kind KPIs they use to run the business and for them to provide me with a data set series to understand the drivers/ trends and all that good stuff. He hesitated in his reply and just said a few, so I questioned further and we deep dived and came up with additional KPI’s client should and could produce for their business².

Interestingly, on the topic of pricing the product, I asked… how they price their product/ service? In reply to this, they said, well it varies, number of users, there is a discount, you pay up front, look at demo, if you like it, then the customer can buy it, blah, blah…

To cut a long story short, I interjected and said… use the KIS approach (keep it simple) – especially when the product-market fit and customers who really need your solution are aware of the pain/ issue they have and you can offer the right solution as credible partner, whilst embracing a robust and optimal pricing model and plan.

Often when pricing models become too complex, they turn into hurdles for the customers, instead of enablers for them to buy into your product.

Competition for the deal

One of the other most critical factors for determining the company valuation and the final transaction price is the competitive dynamics of the process.

When multiple buyers are bidding for a company, it creates competitive tension that can drive up the price. Conversely, a solitary buyer knows he holds all the cards and can negotiate the price more aggressively. With no other investors to fall back, the buyers will commonly try to slow down the process to receive more information and cross-check how the company performs vs. budget over time.

Therefore, creating a competitive environment when selling a company is essential to achieve the best possible valuation. This can be done by arranging a structured sale process, marketing the company to many potential investors, keeping tight offer submission deadlines and keeping information disclosure to a minimum.

Early-stage SaaS-Technology companies

Companies without revenues, earnings, or a business model may be difficult to value with any of the methods I have described here. Investors in such early-stage companies take equity positions based on the potential size of the market, the quality of the team and the maturity of the technology the company has developed.

SaaS-Technology company valuations are often theoretical exercises that are not approached through a scientific lens (using multiple iterations and probability) and often do not reflect reality due to their limitations and the biases of the persons conducting the valuation as a single output/ number, which may be nebulous.

Let us face it, sellers want to see a range, which is why from my experience by using Monte Carlo Simulationᵌ in M&A valuations can help predict the probability of a variety of valuation ranges when the potential for random variables is present. Including, explaining the impact of risk and uncertainty in prediction and financial models. Assigning multiple values to an uncertain variable to achieve multiple results and then using statistical analysis to obtain an estimated range is more superior.

Whilst all this is fine in practice… The true litmus test will always be to test the valuation against the market, where the ultimate answer of closing the deal will reveal how much the company is worth.

Deferred Consideration/ Earn-out Share

Putting your money where your mouth is, is what this is all about. Crossroads can be reached if both buyer and seller reach a stale mate of an agreed price.

One tactic is to consider, a deferred consideration or earn-out, where both are payment arrangements that can be used in the context of a business sale. The main difference between the two is that deferred consideration is a payment arrangement in which the buyer agrees to pay the seller a portion of the purchase price at a later date, while earn-out is a payment arrangement in which the buyer agrees to pay the seller a portion of the purchase price based on the future performance of the company being sold.

To orchestrate an earn-out requires depth and understanding of the business as previously mentioned above. If the seller is feeling particularly bold and if the buyer accepts, excess profits earn-out percentage, or gain share also worth considering in the purchase agreement.

How did we help?

As M&A advisor¹ we played an essential role in helping company owners increase the value of their business. A assessed the value of business by utilising the sophisticated valuation methodsᵌ briefly described here. Additionally, I guided company in terms of the timing of the deal from the perspective of the company’s life cycle as well as the economic cycle – where every industry and company have moments when valuations peak, for it to make sense and sell. Additionally, knowledge of the sector, pricing strategy and goals, KPI to be used, tax planning and what to look out for are all invaluable prerequisites to make an informed decision and to help close out a M&A deal.

The most considerable boost to company valuations when using a competitive bidding process, increasing the pressure on investors to bid more highly via understanding their business too. As such, M&A advisors provide a valuable service for SaaS-Technology company owners looking to get the most out of their M&A deal⁴.

Dee Singh Kothari is a senior partner in Kothari Partners

¹ Contact Kothari Partners for a free confidential discussion on how we can help.

² Monthly Unique Visitors; Product Signups; Product-Qualified Leads (PQLs); Lead Velocity Rate (LVR); Organic Vs. Paid Traffic ROI; Coefficient Viral; Conversion Rate to Customer; Average Revenue Per Account (ARPA); Customer Acquisition Cost (CAC); Monthly Recurring Revenue (MRR); Number of Support Tickets Created; Average First Response Time; Average Resolution Time; Net Promoter Score (NPS); Number of Active Users; Customer Retention Rate; Attrition/ Churn Rate; and Customer Lifetime Value (LTV).

ᵌ Ideas expressed in this article are solely of the authors. The author nor Kothari Partner’s accept any liability for the incorrect application of these ideas either used by companies, employees or other individuals alike. Contact us on how we can help with the now.

⁴ At Kothari Partners, our approach is to help our clients understand their current situation, identify the value and decide on the scope, vision and set of strategies for what they could achieve for their business. We help plan their implementation and support them and deliver the solution/ change needed, so it is properly and permanently embedded in their organisation.

We aim to help past and future clients by delivering high-quality work to their organisation, generate real efficiencies and free up time to support better business decisions. For a confidential discussion please free to contact us, via our corporate website: https://www.KothariPartners.com