What are the top valuation models used by VCs?

You’ve decided it’s time to raise money for your SaaS company.

As a founder, it can be intimidating if it’s your first time. It means chatting with investors, doing pitches and learning about fundraising.

It also means you’ll have to value your company. As a company with recurring monthly revenue, how do you calculate your valuation? Which one is mostly likely to get support from VCs?

There are three main valuation models used by VCs. We’ll be looking at each separate one, as well as the main metrics you want to be keeping an eye on.

How SaaS companies get valued

SaaS companies are valued differently to other companies such as an eCommerce store or a brick and mortar shop. That’s because revenue is recurring, costs are lower and what matters is customer retention (although this also depends on the type of SaaS company).

The truth is, there is no consensus on what is the right way to value a SaaS company — which is why there are three instead:

1. SDE

SDE stands for Seller Discretionary Earnings, and is one of the most popular ways to value a SaaS company.

With the SDE approach, the valuation is essentially the amount of money that is left after deducting the cost of goods sold and operating expenses. The owner can then add their salary and dividends back to the profit number to get the final SDE number.

So essential, SDE is: SDE = revenue - cost of goods sold - operating expenses + owner compensation.

Usually, this model works for SaaS companies that are owned by sole owner operators, and have less than $5 million in annual revenue.

2. EBITDA

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization and as the title says, it stands for earnings of your SaaS company before removing certain expenses.

This type of valuation works best when the ownership of the company is fragmented, and the company has several heads of staff or departments. This model tends to reflect earning power more accurately and works well for companies where revenue is higher than $5 million.

3. Revenue based

The main issue with the EBITDA and SDE models is that they are not the best way to measure potential future earnings. One of the main advantages of the SaaS model is that its MRR can be used to forecast future revenue growth — but valuations don’t reflect that.

The revenue based model aims to solve this issue by being based solely on MRR growth rate. With this number you are essentially valued on the rate you’re growing at, which explains why some SaaS companies have huge valuations while still not making a profit.

Most companies who use this valuation will have an ARR of more than $2 million, and a 50% year on year growth rate.

A lot of companies prefer this valuation model because it takes into account future potential profit and is based on growth which means that valuations are often higher. However, it does mean you want a healthy growth rate if you want to raise money using this model.

What metrics VCs use

In addition to MRR and ARR, the most important SaaS metrics are: Churn , LTV and CAC.

CAC

CAC stands for cost per acquisition, and is essentially the cost of marketing and sales to get one customer. A low CAC helps you grow.

What’s an ideal CAC? This does depend on the industry and business, so there really is no magic number. The most important is to be aware of the CAC as this is a crucial metric to understand the health of the business.

LTV

LTV stands for the Lifetime Value of a Customer. It’s the total amount of money you can expect to get from every new customer that signs up for a SaaS product. The higher the LTV, the more valuable each new customer is. That’s why a high LTV is a key indicator as to whether the business is sustainable.

Another metric that investors look at is the LTV by CAC ratio, which is a good indicator of whether your SaaS company is profitable. A health ratio is usually around 3 and 4, allowing for moments when the LTV goes down or the CAC goes up.

Churn

Churn is considered the most important metric of all, since it measures how long it takes before a customer decides to stop using your software.

Your churn number is the percentage of customers who cancelled a subscription, versus the remaining paying customers. It’s usually calculated on an annual level, and is highly valued by investors because it essentially helps forecast revenue month by month.

What’s a normal amount of churn? This will depend from SaaS company to company. For example, if you sell to enterprises, churn will be lower - usually under 10%. However, if it’s a self-service consumer software, churn as high as 50% could be acceptable. In general, a low churn with a low CAC is key to allowing recurring revenues to grow.

Why it’s important to have high revenue

When you first decide to raise money for your SaaS company, you’ll also want to make sure your company is in order and the numbers are looking good.

Many SaaS companies look for ways to boost their valuation by issuing discounts, but this doesn’t solve the problem in the long run as it sacrifices revenue. Discounted accounts or even discounted annual plans are a bad idea; investors usually don’t like ARR because it is unpredictable and not a good measure of growth.

MRR is the golden metric and the key to getting a higher valuation. However, discounting can hurt in the long run since it decreases revenue, attracts low quality customers and therefore hurts valuation.

If you’re looking to get a high valuation and raise more money, then you want to be focusing on activities that help you increase revenue, rather than decrease it.

That’s why we believe in a method of raising money that doesn’t require discounting: non-dilutive financing. With non-dilutive financing, you can essentially turn your MRR into ARR without sacrificing revenue or decreasing your overall valuation.

Not sure which valuation works best for your SaaS company? As you can see, it mostly depends on your revenue and structure of your company. If you’re looking for a way to raise money that doesn’t require debt or dilution, get in touch with Levenue to learn more about non-dilutive fund raising.

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