🏴☠️ ⚡️ The #1 Factor to Determine Max Valuation in Micro SaaS (Acquisition Concepts)
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TABLE OF CONTENTS:
The Most Important Factor in Micro SaaS Transactions is Debt Financing
Conventional Valuation Methods Explained, plus their Challenges in the Context of Micro SaaS
Business Income > Available Debt > Valuation
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Valuations are a VERY intimidating topic for most Micro SaaS Founders / Sellers and Acquisition Entreprenuers.
And rightfully so. There is almost no publicly available data to inform benchmarks/assumptions (think: what similar firms sold for and the performance metrics of those firms), and most deals come with unconventional deal structures (seller’s notes, earnouts, etc.). To make matters worse, other valuation methods rely on complex financial topics and require solid modeling skills.
Oh ya, and the stakes are HIGH. For most, these transactions represent a life’s work or life’s savings.
To demystify the topic, I'm excited to explain conventional valuation methods and discuss the challenges unique to Micro SaaS. However, the most important factor in Micro SaaS transactions is debt financing.
Most buyers in the $500,000 to $2 million valuation range use SBA loans, which come with specific requirements. The SBA requires a Debt Service Coverage Ratio (DSCR) of 1.25, meaning the company needs $1.25 of income for every $1 of debt payments.
In simpler terms, the key question is:
Can the business afford itself?
Does the Micro SaaS firm generate enough income to cover the loan needed to buy the business? As the valuation rises, so do the loan and debt payments. At some point, the valuation requires a loan that breaks the DSCR requirements.
The upper limit of a Micro SaaS valuation is ultimately determined by the maximum loan a buyer can secure based on the company's income.
Here's a simple calculator to illustrate this concept, helping us all determine valuation more accurately based on the real world 👇
Start with this Valuation Calculator in Micro SaaS
Okay, let’s now move on to exploring conventional valuation methods in the interest of utilizing everything at our disposal to build conviction around almighty valuation.
Conventional Valuation Methods & Their Challenges in the Context of Micro SaaS
Multiples-Based Valuation:
Think of the multiples-based approach like real estate appraisals. When valuing a house, an appraiser will look at recent sales of similar houses in the neighborhood, adjusting for factors like square footage, bedrooms, and amenities, etc. This gives a ballpark range of what the target house might sell for. Similarly, in multiples-based valuation, comparable companies serve as benchmarks, and their valuation ratios help estimate the value of a target firm, adjusted for differences in revenue, profitability, growth potential, etc.
Multiples-based valuation estimates a company's value by applying a multiple to a specific financial metric like Annual Recurring Revenue (ARR) or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Comparables are derived by identifying similar companies in the same or a closely related industry, typically firms of similar size, growth potential, and market focus. Once comparable firms are identified, financial ratios like Enterprise Value(EV)/Revenue or EV/EBITDA are calculated based on publicly available data or transaction records. The average or median multiple is then applied to the target company's financials to estimate its value.
Example (Using ARR Multiple):
Scenario: A SaaS company generates $1 million in Annual Recurring Revenue.
ARR Multiple: Comparable companies have an average ARR multiple of 2.5x.
Calculation: The valuation would be $1 million × 2.5 = $2.5M
Example (Using EBITDA Multiple):
Scenario: A SaaS company has an EBITDA of $500,000.
EBITDA Multiple: Comparable companies have an average EBITDA multiple of 4x.
Calculation: The valuation would be $500,000 × 4 = $2M
Challenges in the context of Micro SaaS:
DO NOT USE ARR MULTIPLES: ARR multiples are a convention from public investing and Venture Capital, which has bled into Micro SaaS. In essence, other investor profiles prioritize Annual Recurring Revenue (ARR), as it's perceived to indicate a company's potential to expand, retain customers, and increase profitability over time. It also represents a single annualized figure that simplifies trend analysis and benchmarking against peers. They are essentially buying a firm’s ability to grow ARR like crazy, to then strip out all the costs and collect cash flow to generate a return. Micro SaaS is about acquiring and modestly growing enduringly profitable, high-margin businesses to generate income for buyers and investors. Thus, EBITDA multiples are a true guidepost.
Very little publicly available data: The best you’ll do is trend reports like this one from a marketplace, though most of these benchmarks are based on asking price with far less data on what these businesses actually traded at.
Market Sentiment Risks: Multiples reflect market sentiment, which can shift rapidly in the SaaS space. If there's a sudden downturn or change in SaaS trends, sellers may struggle to secure valuations aligned with historical multiples, while buyers risk overpaying.
Impact of Growth Prospects: The multiples often hinge on growth projections, and exaggerated growth expectations can lead to discrepancies between seller and buyer valuations. Sellers tend to focus on potential future growth, whereas buyers remain cautious about scalability, competition, and market changes.
Discounted Cash Flow (DCF) Model:
Think of DCF-based valuation as assessing the value of a tree by predicting its future harvests. The tree may grow larger over time and yield more fruit, but there are uncertainties like weather conditions, pests, or market demand for the fruit. We determine what the tree is worth today by estimating future harvests and applying a discount rate to account for the risks involved. Similarly, the DCF model estimates future cash flows and discounts them back to a present value, considering the risks of market competition, economic shifts, and company performance.
The DCF model (Discounted Cash Flow) calculates a company's value by estimating the present value of future projected cash flows. Cash today is worth more than the same amount in the future due to inflation and the returns a dollar can generate if invested today, so the model converts future cash flows into present value terms. The model also applies a discount rate to account for risks, ensuring returns adequately compensate for uncertainties and potential changes in the market environment.
Process:
Projection: Estimate future free cash flows (operating profit or EBIDA) over a forecast period, often 5-10 years.
Terminal Value: Calculate the terminal value representing the company's value beyond the forecast period. This value approximates the remaining worth of the business once the projection period ends.
Discounting: Apply a discount rate to convert future cash flows and the terminal value into present value terms. The discount rate represents the investor's required rate of return (given the risk profile they’ve assigned to the investment) or the opportunity cost of investing capital elsewhere (like the S&P 500).
Example:
Scenario: A SaaS company projects annual free cash flows of $1 million for the next five years and estimates a terminal value of $5 million at the end of year 5.
Calculation: Using a 10% discount rate, each projected cash flow and the terminal value are discounted to present value. These values provide an estimated valuation of approximately $6.9 million.
Challenges in the context of Micro SaaS:
Cash Flow Uncertainty: Although Micro SaaS firms typically have predictable subscription-based revenue streams, high churn rates or competitive pressures can impact future cash flows. Sellers may overestimate predictable revenue, while buyers are wary of churn and competition affecting long-term projections.
Assessing Risk Premiums: Micro SaaS companies usually have higher business risks due to their size and market niche. Buyers face challenges in determining a suitable discount rate that reflects these risks, while sellers aim to minimize the perceived risk in valuation discussions.
Intangible Value: Key intangibles like intellectual property and customer relationships are difficult to quantify but play a significant role in Micro SaaS valuations. Sellers often emphasize these as differentiators, whereas buyers may struggle to evaluate their actual contribution to future revenue.
Income > Accessible Debt > Valuation
In the Micro SaaS acquisition landscape, it's common for buyers targeting firms with $250,000 to $1.5 million in Annual Recurring Revenue (ARR) to use debt financing, often through SBA loans. Understanding the constraints of such loans is crucial, as these constraints impact valuation considerations for both buyers and sellers.
Debt Financing via SBA Loans:
DSCR Requirement: The Small Business Administration (SBA) typically requires a debt service coverage ratio (DSCR) of 1.25. This ratio ensures that a company's net operating income is 25% greater than its total annual debt service. For every $1 of debt service, $1.25 of income is required.
Income as a Driver: Given this requirement, a firm's ability to generate sufficient net operating income drives the amount of debt available to buyers. This limits the financing capacity and subsequently caps the valuation a buyer can offer.
Impact on Valuation: The DSCR requirement ensures that the income the acquired Micro SaaS firm generates comfortably covers debt repayments. Buyers will evaluate target firms based on their ability to meet this threshold. If the firm's income doesn't suffice, the valuation will likely be adjusted downward to ensure the buyer can meet the DSCR requirements while securing financing.
Achieving maximum valuation requires navigating these key steps:
Income Generation: Ensure consistent, predictable, and growing revenue. High-quality, recurring income through subscription models or long-term contracts strengthens your valuation.
Identify the Amount of Debt the Business Qualifies For: Use the calculator above!
Conclusion
The goal is streamlined negotiations and expedited financing, where everyone wins.
To achieve a balanced and accurate valuation, it's essential for both buyers and sellers to address key challenges openly. They should jointly evaluate comparable multiples, realistic projections, and market risks. Understanding the constraints imposed by financing requirements, particularly the DSCR (Debt Service Coverage Ratio), sets a framework for negotiations. Buyers will use the DSCR to determine financing limits that shape their offers. On the other hand, sellers need to recognize these limitations and strategically optimize their income streams to meet DSCR requirements, ensuring they can justify higher valuations.
That’s a wrap!
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