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Understand your business valuation

Many variables can affect the value of your business. At the simplest level, your business’s valuation will be based on two numbers. The first is the amount of profit (seller discretionary earnings), and the second is the multiple. We’ll dive into the specifics below, but if your business makes $100,000 per year in profit, and it’s well run, with minimal involvement on your part, you could expect a valuation at a multiple of around 2x. Your sale price, then, would be upwards of $200,000. It’s not quite that simple, though. So let’s explore the variables that affect your multiple.

Seller discretionary earnings (SDE) are where it starts. The more efficient your business, and the fewer mandatory expenses it requires to run, the better. At a minimum, you’ll have infrastructure costs, the costs of the individual required to do support and basic maintenance, the tools you use to monitor it and build the product, and likely some marketing and advertising costs. Everything remaining after that is your SDE, and that’s your baseline.

In a perfect world, a business would run on autopilot with no human intervention. Of course, in the real world this is all but impossible. You can, however, minimize the amount of human intervention. How much would it cost a buyer to replace the work you do? How difficult would it be to find someone who could do that? The less you do, the cheaper and easier you are to replace. Thus, the business has more profit. It also means the business has more opportunity and less risk. These factors can definitely influence not only the profit but also the multiple.

Other factors will affect the multiple that you could expect to receive. A better multiple means that the buyer will be willing to pay more for a business with lots of potential upside.

The first major aspect is growth. Growth reveals potential. When a business is growing, it’s more difficult to quantify the possible upside, and so the valuation will likely be more optimistic and use a higher multiple of SDE. If growth has stalled, the multiple will be lower because there’s less potential for the buyer. Sometimes it’s best to sell while the business is still growing. However, a business whose growth has held steady for a year or more has proven its resiliency, and there’s still solid value there. The problems arise when your business is actively shrinking–the buyer has lower expectations of future income and is thus unwilling to pay more.

With SaaS businesses, there are several metrics that work together to quantify the overall health of a business: churn, lifetime value (LTV), average revenue per user/account (ARPU/ARPA), and customer acquisition costs (CAC). If you’re not familiar with these concepts yet, they’ll be the core metrics for measuring your business.

Lifetime value is pretty straightforward. The more your customers spend over their lifetime of using your product, the more you can afford to spend to acquire new customers (that’s your CAC). So, if the lifetime value of a customer is $1,000 and you can get new customers at a cost of $100 each, you’re going to pocket $900 per customer (before operating expenses, of course). But this is the strength of a SaaS-based business: your operating costs grow much slower than actual customer growth. If you increase revenue by $10,000 each month, your operating costs may only increase by $200 or $300.

Your operating costs will vary and could be much higher for a more complex application, but you’ll generally be able to charge more as well. From a revenue standpoint, once your infrastructure is in place, new customers increase your revenue much faster than they increase your operating costs.

Working out lifetime value is simple. How much money does each customer spend per month? And how long do they use your service? (Or, alternatively, what’s your monthly churn?) To increase lifetime value, you can either get your customers to spend more money, or stick around for longer. So reducing churn and increasing average revenue per user/account increase lifetime value.

The flip side is decreasing customer acquisition costs, which can be more difficult. It might involve increasing organic SEO or finding more efficient ways to spend your advertising budget. Either way, if you increase LTV and reduce CAC, you’re beginning to build a money-making machine. That’s when the multiple for your valuation will really begin to increase.

Another major consideration is whether there are opportunities for quick wins. If you’ve never done any marketing, someone who specializes in marketing could see an opportunity to grow the business quickly. Alternatively, if the buyer can rapidly improve something you’ve neglected, they could quickly boost the bottom line as well. If they’re able to increase LTV or reduce CAC, there’s potential that makes the business more valuable to them.

Similarly, risk plays a role. If your new customers primarily come from a single source that could disappear tomorrow, there’s a lot of risk. Let’s say your high-profile personal Twitter account brings in the majority of your new business; when you stop promoting it, the new buyer will likely have some concerns about what might happen. For this reason, the best way to increase your multiple is to diversify the sources of new customers. Balancing organic and paid sources is a good strategy. If most of your traffic is through referrals, ensure that no single source of traffic dominates–don’t put all your eggs in one basket.

Code quality is a more subtle but still key factor that affects your multiple. High-quality code, good test coverage, static analysis tools, and well-defined processes signal that the codebase is healthy. A robust codebase hides fewer secrets and means less risk. It also affords a quicker transition and less dependence on you or your team. Take care of your code. Document it. Test it. And remember, it’s much easier to do this as you go than circling back to clean things up before you sell.

Finally, age matters in business. A business with only two or three months of history doesn’t have a long enough track record for a buyer to feel comfortable. That’s not to say you can’t sell it, but your options will be limited. When a business has been consistently profitable for years, that’s a good sign.

Business valuations are part art and part science. Ultimately, your business is worth whatever someone is willing to pay. Keep all of these factors in mind, however, and you’ll not only make your life easier, but you’ll instill more value in your business. These are all activities and considerations that should be important regardless of whether you sell your business. And if you ever decide to sell, they’ll make you much happier with the final offer.

SaaS Metrics for Valuing a SaaS Business. Thomas Smale from FE International presents a much more granular view of the formulas and detailed considerations that will affect the value of your business.

The Secrets of LTV. Josh Pigford, founder of Baremetrics, lays out the basics of calculating lifetime value for a SaaS business.

Slaying the Churn Beast. Another short and sweet article by Josh Pigford covering the basics of churn and why it’s such an important metric.

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