SaaS business valuation is now one of the pressing questions among entrepreneurs and investors. The key problem here is what way to choose — SDE, EBITDA or Revenue?
The main differentiator for the way of valuation is the business’s size and growth speed.
SDE vs. EBITDA vs. Revenue
Most small businesses valued at under $5,000,000 are valued using a multiple of SDE (seller discretionary earnings or so-called seller discretionary cash flow). It is particularly used for the businesses that grow relatively slowly and do not have a management team in place.
SDE is the profit left to the company owner once all costs of goods sold and critical (i.e. non-discretionary) operating expenses have been deducted from the gross income. It is worth mentioning that any owner salary/dividends can be added back to the profit number as well.
Small businesses are valued with an SDE to demonstrate the business’s true underlying earnings power. Since the majority of small businesses are owner-operated and somewhat owner-reliant, they have an associated owner salary and expenses. A SaaS founder can pay a salary from his/her own money. The rates may not correlate with the market ones though. The founders also tend to pay several personal items through the business for tax efficiency.
But when the business grows, the situation becomes different. Such businesses have more employees and more management personnel. The ownership structure tends to fragment with several shareholders, who usually play a less active business role, often hiring a general manager or CEO to run operations. In this case, any owner compensation or discretionary expenses should be reflected back into the business to show its true earnings power. Thus, a new benchmark of EBITDA (earnings before interest, taxes, depreciation and amortization) is used. It is a common valuation benchmark used for companies with over $5,000,000 in value.
For the majority of businesses SDE or EBITDA is the best valuation approach. But for SaaS companies, the EBITDA being generated today (which could be zero) is not always a good proxy for potential future earnings. This is because growing SaaS businesses make significant upfront (and sunk) investments in growth, which are all expensed in current EBITDA. Owing to their recurring revenue model and assuming customers stay with the business, the profit in the future will expand significantly as the business matures and spends relatively less on these items.
Maksym Babych, a SaaS products expert, says that measuring revenue is efficient for a growing SaaS valuation, but we should not forget that this valuation approach is entirely based on growth. But in case the SaaS business doesn’t show growth, then the revenue cannot support the forecast profit in the future, which is what the valuation is actually based on.
Here are three main questions that will help to choose SDE, EBITDA or Revenue valuation for the business:
Is the business reliant on the owner?
Are revenues growing less than 50%+ YoY?
Does the business generate <$2,000,000 revenue per year?
If you have answered “yes” to any or every question in the list, your SaaS business should be evaluated using SDE. It is likely that the investors will evaluate the business based on this benchmark alone and apply a multiple to make the final business valuation. If the answer is “no” to any or all listed questions, EBITDA or revenue might be more appropriate.
Maksym Babych, serial entrepreneur and SaaS professional.
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