If you are thinking about selling your software company, you may be wondering, “What affects the valuation of my software business?” It’s an important question to ask. Your valuation stands at the heart of your exit journey. Knowing how your business is valued and the factors driving its value can make or break a profitable and successful exit.

In this article, we discuss six key factors affecting business valuation. These include:

• The difference between light SaaS and company SaaS
• Business growth
• Risk and company value
• The importance of documentation
• Transferability between owners
• How the market can impact software business valuation

Related Article: Software as a Service (SaaS): Business Model Pros & Cons

1. The Difference between Light SaaS and Company SaaS

Many software companies are SaaS companies. When it comes to valuing a SaaS company, it is important to first distinguish whether it is light SaaS or company SaaS business. The appropriate SaaS business valuation method to use depends on this distinction. Below, we take a look at light SaaS and company SaaS designations as well as how to value each type of business.

“When it comes to valuing a SaaS company, it is important to first distinguish whether it is light SaaS or company SaaS business.”

Light SaaS

Light SaaS is a term that describes SaaS businesses that are generally smaller, younger, and at an earlier stage of development. As we will see, light SaaS companies typically have different performance characteristics than company SaaS businesses.

SDE multiple method

These performance distinctions mean that each type of company is more accurately valued by a different valuation method. For light SaaS, the preferred method is the SDE multiple method.

With the SDE multiple method of valuation, company value is equal to the seller’s discretionary earnings multiplied by a number, called the multiple.

Value = SDE x the multiple.

Getting your SDE correct and accurately assessing your multiple is crucial for a useful valuation. The seller’s discretionary earnings (SDE) is the total money-generating capacity of a business after taking into account certain discretionary expenses. To calculate SDE, start with profits, and then add back all allowable discretionary expenses. This includes:

• Taxes
• Interest expenses
• Depreciation
• Noncash expenses
• Owner compensation
• One-time investments
• Unrelated costs or income

SDE is similar to income. By including discretionary expenses, however, it more accurately describes the true value of a business to its owner. As such, it is more useful than profit when it comes to comparing two or more businesses to each other. We will explore the multiple later on in this section.

SaaS company valuations are not always easy to get right. Given the importance of creating an accurate valuation for your business, many software company owners choose to work with a business Advisor when doing their valuation. An experienced Advisor knows how to determine an accurate SDE figure. They also know how to evaluate your company to assess a fair multiple number.

Company SaaS

Company SaaS is a term to describe SaaS businesses that have mature operations, have been around longer, and generate more revenue. Company SaaS businesses are larger and more established than light SaaS businesses.

In order for a SaaS business to be qualified as company SaaS, it must pass “the four tests.” These criteria include:

• Size Test: Annual recurring revenue must be equal to or greater than $1M.
• Growth Test: Year-over-year revenue must grow at a rate of 40% or more.
• Product Market Fit Test: The monthly churn rate should be less than 4%.
• Key Man Test: The company must have dedicated development and customer success teams.

It is helpful to note that these four criteria are guidelines. If a business meets or exceeds three of the criteria but falls just short of the fourth, it may still qualify as company SaaS. If you have any questions, speak with an Advisor to determine which category your software company falls into.

“Company SaaS businesses are larger and more established than light SaaS businesses.”

Revenue multiple method

Company SaaS businesses are valued using the revenue multiple method. With the revenue multiple method of valuation, value is equal to the company’s revenue multiplied by a multiple. When calculating revenue, it is appropriate to use several different methods. These include:

• Trailing 12-month revenue
• Annualizing the current monthly recurring revenue
• Forward-looking 12-month revenue

Why is the revenue multiple method used for company SaaS businesses instead of the SDE multiple method? The short answer is SaaS businesses perform much differently depending on their stage of development.

As SaaS businesses grow, they place a lot of focus on scaling, reducing churn, improving customer retention and experience, and standardizing processes. These efforts can increase costs significantly, reducing short-term profitability and SDE. Company SaaS businesses are often willing to maintain a high customer acquisition cost, reducing the near-term profitability of each customer.

Given the nature of recurring revenue, however, this business model allows for each customer to turn a profit over the course of their customer life span. Essentially, during certain periods of growth, SaaS companies heavily reinvest profits back into the business, reducing SDE but fueling future growth. During these periods, SDE would be a poor indicator of the expected future value of the business. Thus, revenue is used in its place.

The Four Pillars of Value

The multiple is a number that incorporates tangible and intangible factors that impact the overall value of a company. There are many individual factors that go into the multiple; however, these factors can generally be grouped into four main categories often called the Four Pillars of Value. These include:

• Growth
• Risk
• Documentation
• Transferability

“Strong past and current growth patterns indicate a healthy business that is more likely to grow moving into the future.”

2. Business Growth

Now that we have an understanding of the valuation process, let’s take a look at some of the factors that can impact the value of your SaaS business. One of the most important factors potential buyers look for when considering a business is its past and current growth trends as well as potential for future growth.

Past and current financial metrics

All buyers will take a close look at the past and current financial performance of your software company in order to assess its growth. Strong past and current growth patterns indicate a healthy business that is more likely to grow moving into the future.

If you are thinking about selling your SaaS company, it pays to implement changes to generate consistent growth long before you plan to sell it. This will raise your valuation and lead to a more profitable and successful exit.

Opportunities for future growth

Astute buyers also look for clear opportunities for future growth. Identify low-hanging growth opportunities within your business and communicate these to interested buyers. For example, let’s say you have strong growth and respectable revenue, but there are clear ways your marketing efforts can be optimized.

By pointing out these opportunities, you can highlight the methods a new owner could use to drive growth. This can make your business more attractive and raise its value.

3. Risk and Company Value

Owning and running a business entails risk. However, some companies come with more risk than others. When all other factors are equal, the more risk a business has the less valuable it will be. There are several things to consider when determining how risk will affect the value of your SaaS company.

Software stability

Educated buyers will assess how stable and sustainable your software product is in the long term. The more stable and predictable, the more valuable your SaaS company will be. On the other hand, if they sense the likelihood of potential issues with your product, they may be willing to spend less or stay away from your company altogether.

There are many factors that affect product stability in the long run. For starters, how modern is your product, and how relevant will it be in the future? If it is already becoming outdated or obsolete, this represents a risk of underperformance in the future.

Buyers will also look at how satisfied your customers are with the user experience and user interface. The more satisfied your customers are, the less risk your product will have in the long run. Buyers may look at the size of your customer service department in order to get a rough assessment of customer satisfaction.

Business age

The age of a business has an impact on its likelihood of failure or success. If a business is going to fail, it’s much more likely to fail in the first few years. A business is considered stabler the longer it has been around. A proven track record instills confidence in the buyer and raises company value.

If you aren’t in a hurry to sell your business, it may pay to wait until your business is sufficiently aged before selling it.

Recurring revenue

One of the main advantages of SaaS businesses is the recurring revenue business model. In addition to the many benefits recurring revenue brings, investors or buyers look at this business model as stabler than other models.

If a SaaS company has a strong existing customer base, they are likely to continue seeing strong revenue in the future. This reassurance reduces unpredictability and mitigates risk, driving up company value.

Legal considerations

Legal issues can derail or shut down even the best-performing SaaS businesses—and buyers know this. Before deciding to invest in a business, they will do a thorough assessment of any potential legal risks or challenges your business faces. If they identify any areas of concern, it could torpedo the deal or reduce their offer price.

Before listing your business for sale, it is important to vet your business for potential legal issues. This could include pending or possible patent infringement lawsuits or warnings, making sure your IP is properly protected, and ensuring all of your legal and business formation documents are up to date and in good order.

Given the complexity and nuance of assessing legal risk, it may pay to hire a qualified business attorney to work with you throughout this process.

“Legal issues can derail or shut down even the best-performing SaaS businesses—and buyers know this.”

Single points of failure

Any part of your business’s success that relies on a single point of failure incurs greater risk. If the point of failure fails, your entire business could be in jeopardy.

For example, let’s assume your sole customer acquisition method is Facebook ads. When they’re working, the ads perform well. But what would happen if your ad account were suspended? New customer sign-ups would take a nosedive, putting your entire company at risk of failure.

It is important to assess your business for single points of failure and eliminate them before listing your business. In the example above, you would need to establish additional customer acquisition channels such as affiliate marketing, content marketing, or other paid advertising methods. In addition to reducing risk, this would have the added benefit of driving additional sign-ups and creating growth.

4. The Importance of Documentation

All serious buyers will assess your documentation practices when vetting your company. They will want to see that you have clear and orderly documentation for all business processes. If you don’t, they will be willing to pay less than they would have had you had clear documentation.

Clear documentation makes it much easier for an interested buyer to assess the performance of your business in order to determine if they want to make an offer. At the same time, it helps to instill confidence in the buyer that you run your business in a responsible manner.

If they do make an offer, it makes the due-diligence process much more streamlined. Once they take over ownership, clear documentation makes it easier for the buyer to manage and run the company.

“Clear documentation makes it much easier for an interested buyer to assess the performance of your business in order to determine if they want to make an offer.”

Financial statements

One of the key areas of documentation a buyer will be looking at is your financial statements and accounting records. If you haven’t already, take time to ensure you have professional, accurate, and up-to-date accounting records. Unless you are an accountant, it may pay to hire one in order to establish and maintain your bookkeeping records.

Standard operating procedures

From marketing to software development, there are a ton of processes involved in managing your business. When a buyer takes over your company, they need to know how to run all aspects of your business.

The best way to impart this knowledge is by creating clear standard operating procedures, or SOPs, that cover all aspects of your business operations. Think of your SOPs as a guidebook for successfully running your SaaS company. By handing off the SOPs to the new owner, you make it much easier for them to successfully step into your shoes. This makes your business more attractive, raising its value.

If you have not done so already, take the time to create clear and thorough standard operating procedures. Go through your business operations and document your processes. While this can take some time, it pays off in the form of a more valuable business and an easier transition process.

5. Transferability between Owners

Your SaaS company is only valuable to a buyer if they can successfully take it over without negatively impacting the performance of the business. The ease and degree to which a new owner can run your business is called transferability. The more transferable your business is, the more valuable it will be. On the other hand, if your business is hard to transfer, you may find it difficult or impossible to sell it.

There are several things to think about when it comes to ensuring your business is easily transferable. These include:

• Process automation
• Owner time requirements
• Owner likeness or image involvement
• Team cohesion and culture

“The more transferable your business is, the more valuable it will be. On the other hand, if your business is hard to transfer, you may find it difficult or impossible to sell it.”

Process automation

Any smart prospective buyer will assess the degree to which you have automated your business processes. The more automated they are, the easier it is for a new owner to take over.

There are several ways to automate processes. Some can be handled efficiently by software services. For others, you may need to hire individuals or build teams to handle them. For example, as your company grows, you will inevitably run into customer complaints, questions, or concerns. To not get bogged down, it will be necessary to build a customer service department.

Owner time requirements

Process automation and building teams have a large impact on the overall amount of time and effort required from the owner. The less time required, the more attractive your business will be, increasing its value.

If you could choose between two businesses that generate the same profit, but one requires 4 hours per week to manage and the other 40, which would you be more likely to choose? The answer is pretty obvious. By decreasing the time requirements of the owner, you increase the transferability and value of your business.

Owner likeness or image involvement

Another factor that can affect transferability is your image, personality, or likeness being tied to your business. For example, let’s say you are a personal trainer with a subscription-based workout program that solely features video guides of you doing the workouts. Furthermore, you use social media content to generate a significant portion of your new customers.

In this scenario, a new owner would find it hard or impossible to step into your shoes without negatively impacting the performance of the company. It may not be possible to sell the company as it is.

While this may be a rare scenario in the world of SaaS, it is important to highlight. Before you plan to sell your business, be sure to go through your operations and identify any parts of your business that rely on your image or likeness. Then, take the steps necessary to shift these aspects of the business to a more transferable model. While this may take time, it is necessary if you wish to sell the company.

Team cohesion and culture

Team cohesion and culture can be hard to measure, but they can have a large impact on the interest level of prospective buyers. If your team doesn’t work well together or has a bad culture, it could make it much harder for a new buyer to take over ownership. At the least, it would require more time and effort on their part to clean up company culture. At the worst, it would impact the long-term bottom line of the business.

Before you sell, take note of your company culture. If there are areas to improve, leave yourself ample time to make necessary changes before listing your business for sale.

“The state of the market can have a significant impact on the overall value of your business.”

6. How the Market Can Impact Software Business Valuation

Everything we have talked about so far has focused on the internal qualities of your business. In order to be complete, it is important to take into account the external factors that can affect software business valuation.

The state of the market can have a significant impact on the overall value of your business as well as the right time to sell it. Factors to consider include:

• Buyer pool
• Market conditions

Buyer pool

Not all SaaS businesses attract the same buyers. The more buyers (and the more qualified buyers) that are in your buyer pool, the better for you. More qualified buyers can lead to greater competition for your business, raising the amount a buyer may be willing to offer.

Market considerations

Is your industry growing or is it in decline? Are there long-term prospects for your industry, or will it become obsolete with the progression of technology? These are just a few of the questions buyers will be considering about your market when deciding whether to make an offer. A software business in a growing market with long-term prospects will naturally be more valuable.