What drives Saas valuation?
We often see a representation of the SaaS valuation as a multiple of the annual recurring revenue (ARR).
The SaaS software is a billed service subscribed by customers and the SaaS business model is correlated to their recurring payments.
But, what’s about this mysterious “multiple”? Why do we have so many differences between worst and better SaaS multiples?
This approach is useful for obtaining a quick estimation, but we lose the opportunity to really understand drivers that increase the valuation.
Past proof and trust in forecast
Annual Gross Profit: ARR minus COGS.
Cost of Goods Sold: For a SaaS, it could be also called “Retention Cost”. It includes support, customer success, software costs, etc…
Growth characteristics: All metrics related to SaaS growth, like acquisition metrics(ex : CAC), retention metrics (ex: churn), team performance etc…
Total Addressable Market: Size of the market addressable by your SaaS
Barrier to entry: Degree of protection against competitors, also called “unfair advantages”:How many efforts are needed to reproduce your SaaS?
The Saas valuation is related to the current Annual Gross Profit and his growth confidence.
Focus on growth characteristics
The growth depends on the performance of the customer acquisition and retention.
Major acquisition metrics are:
- the number of new customers acquired by month
- the new recurring revenue generated
- the cost of this acquisition (CAC)
Major retention metrics are: churn, upsell, downsell, and lifetime value.
The next graphic illustrates all these metrics.
A representative view of the customer lifecycle
On this graphic, the blue line shows the customer’s cash flow.
The lifecycle of a Saas customer starts with his acquisition which implies spending some money (CAC). At this moment, the cash flow is negative.
Each period of time, the customer will pay a subscription. The cash flow’s raise is equal to the amount of this subscription minus the Customer Retention Cost (CRC). The CRC includes all costs needed to retain the customer (the support, CS, software architecture, etc…).
It needs several months to recover the CAC, this period is named the payback period. In this example, the customer upsells to a more priced subscription. Consequently, the cash flow’s trend curve is better during this period.
After, the customer prefers to use a product’s offer which has a lower price: it’s a downsell.
The final event is customer departure: the Churn. It’s now possible to calculate how many revenues the customer paid from acquisition to departure: it’s the Lifetime value.
The ratio “Lifetime value/CAC” is an important indicator of the SaaS’s performance. SaaS companies with a ratio under 1 have failed to build a successful business model. A ratio superior to 3 is interesting for many investors.
Focus on acquisition dependencies
The Product Market Fit drives acquisition. Indeed, for each step of its funnel, the product value propositions should match the addressed market.
The Serviceable Obtainable Market(SOM) is related to the Product Market Fit: it’s how many customers would realistically benefit from buying the SaaS’s product and how many are reachable?
According to the budget a SaaS can spend to acquire customers, the Customer Acquisition Cost(CAC) impacts also acquisition. If a SaaS tries to convert customers beyond his SOM, the CAC will be exponential. Actually, there is also a better scope than SOM: the “ideal persona addressable”.
These limits can change as per the market maturity mainly if the SaaS proposes a disruptive product. (Read: Crossing The Chasm).
Finally and obviously, the Marketing and Sale team skills and the budget allocated to their actions will also impact the SaaS acquisition.
But, a good Product Market Fit and CAC affordable are the foundations.
Focus on retention dependencies
The Product-Market Fit drives the retention. When the customers start to really use the product, quick churn occurs if that’s means that the Product Market Fit is not enough strong.
Customer satisfaction has a global impact on retention. It can be measured by Net Promoter Score(NPS) and it can be improved when the buyer expectations match the solution provided.
Customer Retention Cost and the affordable budget will also change the retention performance. And finally, the efforts of the Marketing, Sale, CS, Support, and team skills will also be determinant.
How to increase the Saas valuation?: Increase the ARR growth.
How? The best way is to increase the Product Market Fit. I’ll propose soon a story to detail its drivers.
