Running a B2B SaaS business is no easy task. We understand that time is valuable. Yet, one reflection we frequently hear from clients is they wish they started focusing on growing value years ahead of an exit. Even if you are not interested in exiting in the near term, tracking these four simple metrics and honing them will garner immense value down the road.
We evaluated our previous blogs and identified four quantitative factors SaaS CEOs and entrepreneurs need to know before it comes time to sell their business:
- Gross Margin
- Rule of 40
Several factors contribute to a company’s valuation, including both qualitative and quantitative measures. However, few metrics have a more demonstrable impact on SaaS company valuation multiples than net dollar retention.
Net ARR retention looks at retention on a dollar basis. It is defined as the sum of customer expansion ARR, contraction ARR, and lost ARR, divided by the company’s beginning of year ARR. Upon analyzing and plotting data for SEG SaaS Client multiples over the past few years, primarily in the lower to middle market, we discovered wave-like patterns and created the chart above (see our blog for a detailed explanation and examples).
Retention is within your control today. How much are you focusing on your existing customers? Continuously win over your EXISTING customers, and they will reward the company with a much stronger valuation at capital raise or exit.
Read More: SEG Net Retention Wave
2. Gross Margin
Gross margin, also known as gross profit margin, is an essential metric for SaaS businesses. Simply, this metric looks at gross profit as a percent of total revenue. It is the amount available to pay operating expenses and reinvest back into the business.
Gross Margin = (Revenue – COGS) / Revenue
Gross margin is a very important metric Software Equity Group looks at when evaluating a business. Based on our experience, a good benchmark is over 75%. Typically, most privately held SaaS businesses we work with have gross margins in the range of 70% to 85%. Anything below 70% begins to raise a red flag, requiring additional analysis. It is important to note we occasionally see SaaS businesses incorporating ongoing services into their business models. While this causes us to look deeper into the company’s scalability, we often see a favorable tradeoff resulting in exceptionally strong gross retention and net retention.
For more on the importance of COGS and ways to improve it, check out our virtual coffee with SEG Senior Analyst Austin Hammer and Jonathan Christie, Manager in Transaction Services at Grant Thornton.
For SaaS companies moving beyond their product development and early growth stage, efficient resource allocation and high customer retention are important drivers of growth.
LTV is the gross profit a single customer is predicted to generate over their engagement with the company: LTV = (Average ARR X Gross Profit Margin) / Churn Rate
CAC is the cost to acquire one customer. This is calculated by ascertaining the sales and marketing expense on potential new customers by the actual number of new customers obtained. This number can be calculated using a monthly or annual timeframe. In general, the lower the CAC, the better for the company: CAC = S&M for New Customers / Number of New Customers
LTV:CAC remains one of the most critical indicators of a SaaS company’s health and potential for growth and capital infusion. Beyond providing insights into resource allocation, customer success, and marketing efficiency, it is one of the key calculations used by investors to determine valuation. SaaS executives should make LTV:CAC ratio a focal point for their company.
4. Rule of 40
The Rule of 40 is a common metric used by private equity investors and strategic buyers to measure the performance of SaaS companies. Measuring the tradeoff between profitability and growth, the Rule of 40 asserts that a successful SaaS company’s growth rate and profit margin should add up to 40% or more.
The Rule of 40 calculation considers two key financial metrics: growth rate and profitability margin. Revenue growth and EBITDA margin are most commonly used to gauge a company’s profitability and growth. The EBITDA margin strips out differences in interest expense and tax treatment, making EBITDA margin the best indicator for profitability when comparing SaaS businesses. However, you may find that some use net income or cash flow as other measures of profitability, and ARR growth instead of revenue growth.
Rule of 40 = Revenue Growth + EBITDA Margin
The Rule of 40, a well-known and often used metric, is a popular tool for SaaS companies for comparison purposes.
Read More: Calculating the Rule of 40
If you would like to discuss these critical metrics for your SaaS company, don’t hesitate to reach out.