The test for Revenue VS EBITDA VS SDE
Here is a simple test to choose between the SDE, EBITDA or Revenue Multiple methodologies.
For the questions below: a ‘yes’ to any or all of them means the SDE should be used for the valuation of the SaaS business. A ‘no’ would then mean the EBITDA or Revenue multiple would be more appropriate.
- Does the business depend on the owner?
- Are the revenues growing in less than 50% or more, year over year?
- Does the business earn at most $2,000,000 a year?
Valuers and investors would tend to value a business on the basis of comparable data and use an appropriate multiple for the final business valuation.
So now, how then should the multiple be decided?
Finding The Right Multiple
The multiple is one of the important parts of the equation used in a business valuation. It is mainly affected by the business’s core drivers – its transferability, sustainability and scalability.
Unfortunately, the core drivers are in turn influenced by many factors – usually related to various aspects of the target business, such as operations, financial and traffic.
Hence when any of the factors directly or indirectly affect the business’s core drivers, its valuation multiple will definitely be affected.
With this in mind, we would usually use a sole ownership valuation model to work out the value of an SaaS business for the final business valuation. To consider all possible factors of the multiple, we will analyse a number of variables of a SaaS business, then identify a comparable against several data points, and finally confirmed the company’s valuation. We will also consider the Discounted Cash Flow (DCF) model, the business’s historic performances and the analysis of its revenue regression.
Valuing An SaaS Business
Using the SDE method, a SaaS business generally has an annual profit range of 3x to 4.75x. This can be derived from a large SaaS metric.
The initial assessment will then consider a selection of the following variables, based on their degree of influence, to tell whether the multiple is in the low or the premium end of the valuation spectrum:
- Owner involvement
One of the appeal of an SaaS business is its potential of predictable passive earnings. Another is its need for only a team and relatively little time to operate; it is then possible for outsourcing, which makes it even more appealing than a business that requires a lot of time, effort and energy from the owner.
However, should the owner’s technical expertise become indispensable to the business, then the acquisitors or investors will face a significant replacement cost or other challenges. Many will be put off by such demands, which then greatly reduces the appeal of the SaaS business and its value.
- Age of the business
An old surviving SaaS business would have proven its sustainability. Its long track record would also facilitate a substantial estimation of its future revenue.
Hence an SaaS business has to be at least 2 years old to be eligible for M&A; 3 years old or more, and it will start receiving a more premium multiple.
However, it is a misconception to think that old businesses will definitely sell: a young business can sell too – but only to investors with a higher risk tolerance, which is a very small group.
- Trends of growth
An SaaS business that is outdated and declining would definitely lose its investors.
Then again, very few of the rapidly growing SaaS businesses would be put up for M&A.
Hence the key to selling an SaaS business is to ensure its consistent ability to be modestly upward and trending. When a business is growing fast, and its growth is consistent and continuous, its multiple will more likely move to the premium end.
- Churn and other SaaS metrics
Customer metrics are important to an SaaS business and its owners, and thus very attractive to interested investors – such an observation was well recorded.
Investors tend to analyse Churn – a LifeTime Value (LTV) and Customer Acquisition Cost (CAC) – when evaluating the customer database. This analysis then helps determine the quality of revenue of an SaaS business.
To know what metrics apply for your business, contact us today.