Essential Valuation Factors for SaaS Business Owners

September 18, 2022
Essential Valuation Factors for SaaS Business Owners

Essential Valuation Factors for SaaS Business Owners: Revenue, Revenue Churn and Acquisition Channel

When it comes to valuing a business, some terms are more familiar than others. SDE (seller discretionary earnings), profit margins, and real estate are all common concepts in the acquisitions space, but what about the terms that apply when performing a valuation of something outside the traditional box? SaaS valuation factors differ from those used to rank non-tech businesses, and some are more difficult to nail down.

Revenue, revenue churn, and acquisition channels are three key elements to have a firm handle on when seeking a valuation for your SaaS business. In this post, we explore each factor in-depth to help you elevate your SaaS business and its valuation.

Revenue

While net profit is often the bottom line for traditional businesses, different metrics must be considered when it comes to SaaS valuations. Like any subscription service, SaaS companies derive revenue from recurring subscriber payments. While some small- and mid-market SaaS owners could be tempted to offer discounts on their subscriptions, this does lower the overall value of a revenue profile, which is something to bear in mind.

MRR

MRR, or monthly recurring revenue, is defined as the revenue a SaaS company can expect on a recurring, monthly basis. Calculating this can be tricky, which presents major risks when it comes to providing accurate valuations. The basic formula for this is to take your average revenue per user and multiply it by your total number of users. The consistent growth of MRR speaks volumes about a SaaS company’s overall value.

MRR is a critical element of any revenue profile, as these consistent payments are often sold for a higher rate than annual plans. While those who subscribe on a month-to-month basis may have an easier time leaving a plan, attracting customers on this scale is also substantially easier. In that regard, these lower-commitment clients will typically more than makeup for churn via new acquisitions. MRR is also more popular for D2C-based SaaS businesses, as individual consumers are less likely to have their budget sorted for years in advance.

ARR

For businesses with term subscription lengths based on contracts, ARR (annual recurring revenue) is another stream of revenue to consider. Though MRR is the more commonly used metric, B2B businesses that have a minimum contract term of at least one year will have a substantial ARR. There aren’t as many hard-and-fast rules regarding what to include in an ARR calculation, but it’s important to use the same formula every time to track growth. Non-recurring fees, such as sign-on or overage costs, are excluded from this metric.

Due to the long-term planning and annual budgets allotted to businesses, this type of revenue offers stability for firms marketing B2B products.

What Balance is Right?

A revenue profile with both MRR and ARR is most common, though MRR is more valuable when it comes to overall growth. Lifetime plans may seem more appealing to sell on the surface: Consistent subscribers mean lower churn, and high initial purchases can help your startup get off the ground. Despite this, data collected from closed FE International deals shows that MRR was valued as much as three times higher than equal revenue from lifetime plans. Focusing on gaining monthly subscribers will keep growth steady, even if it makes for slower growth overall. A 5:1 ratio of MRR to ARR will net most SaaS businesses the highest possible valuation based on revenue profiles.

It’s also important to consider that MRR and ARR do not show the whole picture of revenue, though they are considered the most crucial revenue when it comes to SaaS valuation factors. Other channels of revenue can include non-recurring fees, installation or support services, temporary add-ons, and more. While they won’t help much when it comes time for a business valuation, they can help keep your business stable instead of selling high-ticket lifetime plans when starting out.

Revenue Churn

To state it broadly, revenue churn is a measurement of revenue lost. More specifically, it depicts the percentage of revenue your business has lost through cancellations and downgrades. Whether a customer ends their subscription or uses your SaaS business less in a certain period of time, it has a—however minor or major—negative effect on your revenue churn. The higher your revenue churn, the lower your SaaS business’ valuation is likely to be. Thus, it is a critical metric to calculate and focus on from the outset.

The importance of churn is widely accepted. However, it is less easy to find consensus on the acceptable rate of monthly revenue churn for SaaS businesses.

Here the line again blurs between smaller, SDE-valued SaaS businesses and the larger EBITDA revenue-valued VC-funded SaaS businesses. Bessemer Venture Partners, an investor in VC-funded SaaS businesses, says an acceptable churn rate for these is in the 5 – 7% range annually (0.42 – 0.58% monthly). This is also supported by Pacific Crest’s Private SaaS Company Survey that shows roughly 70% of surveyed large SaaS companies had annual churn in the <10% range, with 75% of those at 5% or under.

Contrast this with GrooveHQ’s SaaS Small Business Survey, which profiled 712 smaller SaaS businesses with an average MRR of $10,500 and found the average monthly churn rate was 3.2% (annualized that is 32.2%). Similarly, Open Startups sampled 12 companies with an average $18,900 MRR and found a median monthly customer churn rate of 5.4% (46% annually) and a monthly revenue churn of 11.2% (75% annually).

So why the substantial difference? It comes down in large part to which customer segment the business is targeting.

To begin with, most SaaS businesses focus on servicing the needs of small to mid-sized businesses. Small businesses have lower demands and less sophisticated needs, so this is an easier point of entry than enterprise-grade software.

The challenge though is that smaller customers tend to have higher churn rates. Generally speaking, SMB customers tend to alternate SaaS products more regularly because switching costs are low, and are more likely to go out of business.

Gross Churn vs. Net Churn

There are two ways we can categorize revenue churn: gross churn and net churn. While gross churn measures revenue lost from your SaaS business’ revenue base—excluding any benefits from expansion revenue like cross-sells and upsells—net churn, on the other hand, looks at the net revenue leftover from your current customers in a specific time period. Net churn’s measurement includes expansions, cancellations, and downgrades. 

However, this number varies depending on the business and industry; what may be a good churn rate for one SaaS business may be lackluster or disappointing for another. 

The most successful SaaS businesses boast a negative net churn rate, as that means that their expansions outweigh their downgrades and cancellations. In contrast, a SaaS business’ gross churn rate will always be higher than the net churn rate, and by definition, it cannot be a negative value.  

The higher your revenue churn rate, the less likely investors are to find your business appealing, as it indicates a lack of sustainability in the business for the long term. 

Which Revenue Churn Rate Should You Measure?

Net churn rate is a broader measurement that holds more information, which may make it the more favorable option for many SaaS businesses—especially ones with high growth rates.

Alternatively, the gross churn rate measures the longer-term viability of your SaaS business. As gross churn rate doesn’t include the expansion sales that net churn does, gross churn allows you to see how your churn is impeding your ability to scale.

For the most clarity and fullest picture of your churn, it would be beneficial to examine both revenue churn rates. Once it comes time to value your business and ultimately divest, investors will appreciate that you have already considered both gross and net churn rates, as these metrics will help inform their decision to invest.

How to Calculate Gross Churn

Whether you want to calculate MRR churn or ARR churn, the basic formula is the same. To calculate your gross churn rate, you simply must find the total value of canceled contracts (your churn) over the past month or year and then divide that number by your revenue at the start of the period. Finally, you will multiply that number by 100 to convert it to a percentage.

For instance: Let’s say a SaaS business’ total MRR is $5,000, and its customers cancel $600 worth of contracts. Based on the formula above, the gross MRR churn would be 12% for that particular month:

($600 ÷ $5,000) x 100 = 12%

How to Calculate Net Churn

The calculation for net churn is similar to what we did for gross churn, except it first subtracts expansion from churn. Expansion is the revenue gained from upgrades/service expansions over the month or year that you are tracking.

If we take the same scenario from above and consider the fact that this SaaS business had three customers upgrade to a premium plan in that month—resulting in an additional $200 in MRR—we see that the net churn rate would be 8% for that month.

[($600 - $200) ÷ $5,000] x 100 = 8%

Both gross churn and net churn are vital metrics to consider when determining the worth of a SaaS business. By understanding how to calculate and interpret both revenue churn rates, you can take steps to improve these numbers and elevate your SaaS business’ overall value.

Acquisition Channels

Where do you meet your customers for the first time? Is it on your site, through social media or even at industry trade shows? The importance of acquisition channels when it comes to SaaS valuation factors can’t be overstated. While all SaaS companies can technically access all the same acquisition channels, whether they are effective for a specific business model will vary.

Some popular acquisition channels include organic search, cold outreach, paid social media, paid placement, industry trade shows, and referral programs. Some of these will work better for you than others, and it depends on your ideal customer. Is your SaaS product something that appeals to a wide range of people or something that requires more of a laser-focused marketing effort? Is your price point accessible for many users, or are you shooting for fewer, higher-paying clients?

While some acquisition channels will work better for your individual business, SaaS companies are more likely to succeed when they tap into multiple channels to draw customers. Higher valuations can be achieved by keeping acquisition channels diverse and checking in regularly to determine the ROI (return on investment) for each route.

Organic Website Traffic

Organic acquisitions, or those that have occurred thanks to users finding your site via organic search results, are extremely valuable. These conversions speak to high brand recognition and excellent organic search placement; additionally, they benefit from being low-cost from an ongoing marketing perspective.

One excellent method for driving this type of traffic is content marketing. Content marketing is an accessible marketing method for businesses of all scopes and budgets: A website blog with weekly posts can be handled by a core team member or even the owner for small brands just starting out. As the business scales, this marketing tactic can be expanded to include contractors or even dedicated content managers.

The use of keywords and relevant posts with high word counts will build customer trust and help your business rank higher in search results. According to HubSpot, B2B marketers that use blogs get 67% more leads than those that do not. One glowing benefit of this marketing method is that it never expires: Once you own content, it is the property of your company to use and benefit from forever, unlike ads that require ongoing funding.

Paid Advertising

Another equally helpful but more resource-heavy way to bring in potential acquisitions is via paid advertising. This is a great method for tried-and-true products that benefit from a high volume of clients caught in a wide net. These require constant capital investment to remain online, in addition to expenses such as demographic analysis and retargeting campaigns.

Paid search placement is one of the most effective channels for attracting buyers to your site, especially for SaaS companies. Do some specific keyword research to be sure you’re drawing in your target market to get the most conversions out of your clicks. Another interesting avenue to consider for paid ads ties back into the content marketing tactic: Paid content discovery, or placing links to your content on other content sites, can either be achieved through affiliate relationships or simple paid postings. This is an excellent way to target your market with near surgical precision by advertising on content your ideal customer is likely to read.

Social Media Advertising

Everyone you know is on social media. But how useful is social media advertising for SaaS businesses, though? For those trying to reach marketing or communications professionals, the answer is, “incredibly.” According to Gartner, by 2025, 80% of B2B sales interactions will occur on digital channels. People like receiving information on sites they already use, making this an invaluable acquisition channel for reaching your audience. While organic engagement is highly valuable, paid placements can help spread the word about your products more quickly. Moreover, please don’t overlook the value of influencer marketing, especially when it comes to targeting users in your niche.

Wrapping Up

There are multiple metrics at play when it comes to SaaS valuation factors, and the ones discussed here are just a few key pieces of information to consider. Other valuation factors to consider include your customer lifetime value (CLV), research and development (R&D) costs, and the overall growth trajectory for your business.

Gathering a comprehensive valuation of your SaaS business can be tricky to go at alone, so we’re here to make the process simple. FE International has sold over 1,100 online businesses since 2010 at a 94.1% success rate, totaling $1 billion in acquisition value. Our team has the expertise to help you earn what your SaaS business deserves; reach out today for a free valuation.

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