Episode 513 | SaaS Valuations + Dos and Don’ts When Selling A SaaS

Rob: Welcome to this week’s episode of Startups for the Rest of Us. I’m your host, Rob Walling. This week, I have a conversation with an M&A advisor named David Newell. David is a Senior Advisor at Quiet Light. According to his bio, he’s an industry expert in evaluation and sale of SaaS businesses. He’s a former investment banker at Citi which he did for three years before moving into the online business space.

He’s advised on the sale of several well-known bootstrapped B2B apps including in the sale of Drip back when he worked for FE International. He also helped with sale of apps like LessAccounting, Sifter, Codetree, and HitTail as well, which is another one that I had sold through FE back when David worked with them.

I’ve known David for several years. I met him at a few conferences. I believe he was at Rhodium Weekend, Chris Yates’ event in Vegas years ago. David just has a lot of experience on the sales side and also working with buyers of SaaS apps.

In our conversation, we talk about what valuations look like today and it’s fun because I threw out my rules of thumb and he says, “I think they’re a little bit richer.” He said, “I think they’ve gone up. It’s a little hotter.” My valuations were probably from (let’s say) 2–3 years ago and that’s the beauty of SaaS. It just keeps going up into the right. You can hear us bat back and forth some rules of thumb valuations, both on if you’re going to sell for net profit versus I’m going to sell for revenue multiple, at what point that transitions and then what instances you can sell for profit versus revenue multiple.

We talk about things that sellers do really well and things that some sellers do very poorly. You can mentally evaluate where you, yourself might fall even if you never plan on selling or buying a SaaS company. Still a lot of good information here about how to have a business that is well-documented and that operates well.

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Thanks again to Basecamp and I hope you enjoy my conversation today with David Newell.

David Newell, thank you so much for joining me on the show today.

David: Thank you.

Rob: As I said in your intro, you’re a Senior Advisor at Quiet Light Brokerage and you specialize in SaaS. I wanted to have you on the show today because obviously, a huge chunk of our listenership are either SaaS founders, aspiring SaaS founders. I’ve been saying this for years and people don’t tend to believe me. I’ll say you may never sell your business, you may never sell your SaaS app, but my guess is you will. Most people do.

We can point out a few examples, like Yesmail, MailChimp, Basecamp, and Wildbit. There are a couple others, but the majority of people eventually either get tired, get bored, get old and want to retire. They do whatever and they want to get rid of their business. Even if you don’t and you want to run it forever, running it as if it was a saleable asset can make the business more efficient. Not only make it more valuable if you want to sell it, but it can just remove your day-to-day stress and how much you need to be an operator in your business. Just make it a more efficient asset.

David: 100%. It’s very funny, actually, when almost everything that you do to improve the business for sale actually makes the business better operationally. It’s been said to me at least a dozen times when we’ve gone through the prep process for going to market. Owners have said I actually decided that I really, really love my business. I’m not sure whether I want to sell it now, having gone through the kind of understanding that it’s needed to prep it for the market. It’s a philosophy and a mindset that if you build in from the get-go, you’re only going to improve your life operation in and of course when you come to market.

Rob: That’s the thing we’re talking about before we hit record, that whether you’re a seller or whether you’re going to operate your business, thinking like a buyer is just helpful to have that context and that it can improve your business, as you’re saying, operationally. I think a key piece to this is as a listener, if you’re listening to this you think, I never want to buy a business or I never planned to sell a business. I would reconsider that mentally because I thought that I wanted to, and now I’ve sold many. Also, even if you truly never do, still hearing how this works can improve the business you run day-to-day.

As we get into it, I want to set the stage for folks. They may have heard of Quiet Light Brokerage. Quiet Light’s been around for 13 years, you were telling me since 2007. I didn’t realize that they’d been around that long. I’m curious how many deals approximately or just some idea of how large the brokerage is, how many deals you guys do in a year?

David: There are 10 of us now internally working as advisors in the business. The deal count varies by year (I think), but it ranges usually between 75 and 100 close transactions a year. The average is about a million to 1.5. Say, it’s typically around the 75–100 million in close transactions a year.

It’s a lot of activity across a lot of people and a lot of business models around us. We do e-comm, SaaS, and content. We really get to see a lot of different digital business models and interact with a lot of different buyers and sellers.

Rob: Some people hear those numbers and they think that’s not a lot and other people think that’s a lot, depending on the perspective you come from. When I think of building a little business and selling it for a $250,000– $500,000 sale price, you have to do a lot of deals in a year to get to that $100 million mark. I’m curious. Let’s say I own a SaaS app today and I was going to sell through a broker like Quiet Light. What’s the bottom end? It’s seller discretionary earnings, but let’s define that in a minute. Let’s just call it net profit for now. We both know it’s SDE, but what’s the bottom end net profit that would be worth going through a process like this for a SaaS app?

David: I think the floor really for us varies by different advisors. For us, it’s about $100,000. We tend not to list anything below the $250,000–$300,000 mark. There are the more independent brokers or smaller and […] places that might do it. Once you hit that $100,000 threshold in SDE, then it’s very much worth stepping into working with one of the more established brokerages.

Rob: Right. Let’s define SDE. Let’s get into that. Seller Discretionary Earning, the way I’ve heard it described to me or the way I understand it is, it’s your EBITA, it’s your net profit that you would make from the business in a year, but you get to add things back to that.

For example, I always charge my laptop, my cell phone bill, my home internet bill because I work from the house. Some people charge their cars, I don’t know how they justify that if you’re earning a SaaS app, but people charge all types of stuff. I’ll charge trips to conferences. I just charge it all to my business. Even a salary that I take out. All of that, I can add back in because it is profit in essence and I’m just taking out and maybe using for expenses that are maybe on the edge that otherwise, I would just pay for it personally. Is that an accurate representation? Do you have anything to add?

David: Exactly. I think it’s operating profit plus three big categories of expenses. All of your owner compensation, and that could include your health insurance and anything basically attached to you and compensating yourself, dividends and so forth. And like you said, anything that’s personal expenses—travel, meals, accommodation. Just random things that people like to add in to reduce their end-of-year tax bill. The third piece is one-time sunk expenses. For example, you got a trademark that year or you did something like intellectual property work or some legal work that sunk. Anything that’s not going to be recurring or that a new owner taking over the business wouldn’t like routinely have to pay for, so you’ve taken that on, you can add that back. Those three categories of expenses you can add back and then you get to that magic SDE number.

Rob: And then if we were to roll from SDE right into valuations. Let’s talk about SaaS valuations these days. I have some rules of thumb, I’m curious to see if they’re still relatively accurate.

There’s this conversation around selling based on SDE or profit, in a sense, versus selling on revenue multiple. The way I try to describe it is if you have a strategic buyer where they’re going to acquire the company usually with the team and the technology, if I were selling my company and their strategy was buying, I would only sell for a revenue multiple if I were selling a SaaS app.

In addition, there are private equity firms that are paying revenue multiples. Once you get started getting to seven figures, they will pay revenue multiples. This is specifically SaaS because I’m not hearing about this in ecommerce and I’m not hearing about this in content sites, but SaaS is hot these days. Versus selling on the net profit multiple, the SDE multiple.

I’m throwing this out and I want you to counter or correct it. But those tend to be the smaller deals that I hear about. If you’re doing, like you said, $100,000 a year in SDE, then you get a multiple on that. You’re not going to get a multiple on top-line revenue. Where am I correct and incorrect with that analysis?

David: You’re absolutely right. SaaS is very interesting as a valuation landscape. As you said, it’s the only business model that straddles to different valuation approaches. Your earnings led multiple or your revenue led multiple. I guess some of the confusion that comes up with that—which one to use when—is really in thinking about where’s the life cycle of the app?

As a rough guide, I would say that the revenue multiple starts to kick in as a valuation approach app, like you said, $1 million in ARR. That’s not an absolutely hard and fast number, but the reason it’s chosen there is typically because the business has started to achieve a level of scale at which the buyers that are operating there, like PE and strategics, feel that its commencer to apply that kind of valuation approach.

There are some other caveats to it, which the business also needs to (at that point) have been really reducing its churn down to 4% or lower per month. It really needs to have a proper team in place, proper CTO, proper development customer support, onboarding, customer enrichment team. All of which would have done the work of reducing the churn component. The last piece is it really needs to be starting to grow very, very strongly, at least 40% year over year in revenue growth.

What you see basically is most apps—you know this, Rob, because you started several yourself—start as they often a single owner operated businesses. You build out the code base, you start getting your customer base, you start generating some earnings, and you can beget to $100,000, $200,000 or $300,000 in MRR. An app can actually get to be relatively profitable if you start adding back your owner compensation.

That’s the kind of early stage life cycle of an app. If you want to, you can exit for an SDE-type multiple. But there’s almost a decision point you need to make there, and I think you did this expertly with Drip, of course, where you just decide, I’m going to start reinvesting all of the profits of the app, everything I have into getting a team in place, into getting proper development, customer support, and start ramping as much as the marketing as possible. You then start to head up to that seven-figure ARR figure and then you’re really solving some of the bigger challenges in the business. You’re taking it from this smaller side project app, if you like, into what starts to look like a proper company.

When it comes to deciding, is my business earnings or revenue multiple based, what does it command, you really have to look at what’s the stage in the life cycle that it’s at, how fast is it growing, does it have a proper company operator surrounding it. That’s going to inform who’s going to be interested in buying the business, which to your point, informs what actual valuation approach it takes.

That’s how the dynamic works. It can vary a bit even around the size because you can still get a revenue multiple for a business that sets (say) $400,000 or $500,000 in ARR because you may have solved all of those problems very quickly and you may have a strategy that’s a great fit knocking on your door. But on average, it tends to be at the seven figure and up.

Rob: Yeah. I’ll keep some folks anonymous for obvious reasons, but through stuff we’ve worked on with TinySeed, I know of a founder who got an offer and accepted it. It was 10X revenue and his revenue was approaching six figures ARR. He’s still in five figures, but he had really good tech and he had just enough traction. It was worth it and he wasn’t going to sell for less. There are always exceptions to the rules, of course, but I like the way you’ve thought about it, the way you described it.

When I think then, let’s talk about selling for SDE multiple. Someone asked me the other day. They said, I have a SaaS app that’s doing a couple hundred grand a year in net profit. What type of valuation should I expect? I said it depends on how fast it’s growing and stages, that and stuff, but I would think 3–4 times your annual net profit or your SDE.

Often, when I run a loose rule of thumb, I’d go 3½ is a typical one I use today. And then I said if it’s flat or declining, it might be something a business that I sold, that you and I worked on several years back. If I recall it, it was like 2.7X because it was either flat or actively declining a few percent per month that time. Of course, I was willing to sell it because it was still a nice chunk of cash for me and I had so much else going on that I just wasn’t going to turn it around. With that range in mind, what do you think?

David: I think the markets probably got a little bit more buoyant since then, which is good for sellers. I would say that now, the typical range is between three and five. The median, I would say is probably 3.8, 3.9 or so. The big informing, there’s always multiple variables that really define where you fall in that range, but I think the big things are really age, growth, churn, and owner time. Obviously in the one that we worked on.

Typically, you probably wouldn’t try and list something like that. We felt that we like the underlying app and even with slight decline, we probably got away with it. And we did at the end. I think 3–5 is a solid range to think about. If I think of an app that’s doing 25% growth year over year, that (say) 20 hours of work a week and maybe they’re 2 or 3 years old, that’s probably going to come on to something around the kind of 3.7–3.8 level with relatively low churn.

Rob: Yeah. This is great. I was doing this buying and selling stuff before I knew about any of the brokers. Really before the brokerage ecosystem had evolved in our space. I was buying and selling on SitePoint, and then on Flippa when it came around. The multiples there were 12–18 months of net profit. It was really gnarly.

David: It was the Wild West back then.

Rob: It was and it was tough. I bought a few deals I just got completely screwed on and then I got several deals that allowed me to quit my job. But I, for one, like the fact that we do have this. As a seller of apps, as a builder, as a maker, I think the fact that we have raised that multiple for SaaS, that this 3X–5X range exists, and then we all know that because it was really helpful.

It was similar to buying and selling real estate. Yes, we have Comps, Zillow, and Redfin. You can get an idea of what something’s worth versus certain assets like art of really expensive silver-age comic books. It’s not as liquid a market and often it’s hard to really find out how much this thing is worth. Having these rules of thumb is helpful for us as an industry. It just allows there to be more of a liquid space because buyers don’t come and think, I want 1X, and sellers aren’t thinking, I want 10x. That’s an illiquid market. The closer we can narrow it down to where everybody’s on the same page you’re coming to a transaction, the more likely it is to go through.

David: Yeah. Not to pat myself too much on the back here, a lot of that actual improvement evaluation has come from professionalization at the secondary market and that has come from a lot of advisors working really hard to present deals better, get better metrics, do a lot of buyer and seller education and just make the whole ecosystem way more transparent and robust now. That’s why the numbers have gone to where they are.

Rob: Yeah, I would agree with that. Those are SDE (Seller Discretionary Earnings) which again, in my mind it translates to net profit valuations. If we’re going to talk about revenue valuations, I don’t think we spent too much time on it, but again, when I think of an app that’s growing (like you said) 40% a year more, hits that seven-figure ARR mark, again, as a seller I would always do forward-looking ARR especially if I was growing. Meaning you take the current month then multiply it by 12. You don’t look back at the last 12 months.

I would think if I got to that million-dollar mark, then I’d be looking at between maybe 2X and 4X of revenue. As they start to get up to $3, $4, $5 million, I’m thinking 3X–5X, 3X–6X revenue. It can go up and down from there. Obviously, a lot of factors, but is my mental model (you think) is accurate or what are you seeing in the market today?

David: I think it’s probably a little richer again. This is a difficult one because as you know and you’ve seen a lot in TinySeed, there’s a big distortion factor between where should […] can come in on specific deals, when the right stars align, and where private equity (I think) arguably set a more stable financial approach to valuing businesses. I tend to try and stick with the financial private equity model because you never know when the strategics are going to come in with the whacking multiple that makes sense specifically for them.

I look a lot at this concept of the rule of 40 when it comes to revenue businesses. That’s a revenue multiple in SaaS businesses. That’s basically if the businesses’ revenue growth plus its EBITDA margin for that year is at or above 40%. Let’s say it’s growing at 35% year over year and it’s got 5% in EBITDA margin, then it’s just to that threshold. It starts to command (probably at that point) around the 3½X–4X revenue, and then every kind of meaningful step-up is above that level. If it’s growing 50% year over year or 55% year over year and has a 5% EBITDA margin, add it together it gets to 60%. Then, it’s 20% north of that rule of 40 number, so it really starts to approach higher than that. All of that needs to be qualified with the quality of that revenue growth, which then feeds into what’s going on with the churn number.

The range that I think balances revenue multiple would stretch if we’re just talking about where PE guys land. Yes, anywhere between two at the bottom, where something that’s really, really flat, stretching up to eight times of seeing private equity guys comfortably go to, they tend to tap out a bit after that. Then, north of that is very much the realm of strategics. That’s very, very specific and unique to the deal in question.

Rob: And the higher the revenue, the multiple it tends to edge up to you. If you’re at $2 million ARR versus $8 million ARR, it’s a different conversation.

David: 100%. That’s the same across every business model. The reason for that is simple, which is that it’s much harder to grow faster in a scale and you have a much more valuable business oversee your scale than you do believe that. If you’re continuing to grow 40% year over year doing $10 million in ARR versus $1 million then yeah, it’s going to be a meaningful shift in multiple.

Rob: I want to mix it up a little bit. You’ve done a lot of deals in your career, but maybe if you can think back to an example in your head of a deal that you worked on in the past year where you’re representing a seller. First, I want to talk about—obviously, we’ll keep it anonymous because of NDAs and all of that—when was a deal where you felt like the seller just did everything right, had all their ducks in a row and as an advisor, it was just a really, really easy deal to present and it was obviously had all right information and stuff?

I love to hear some items on that list where you showed up and this thing is dialed in. Then, we’ll flip and point where someone did everything wrong or most things wrong and maybe hear about the most common pitfalls that people have in businesses that lower their valuations. I really hope the one who did everything wrong was not me. Let’s start with everything right.

David: I think if you want to get the best value in the market, you have to have transparency and you have to be able to display how good a business is. That really pours through into two deep components, which is the SaaS metrics, pertaining to all of your revenue churn, LTV, ARPU, everything. The more granular you can get into that, the better that […], the better. The second is (of course) the financial side of things.

Where I see the biggest challenge come up with SaaS businesses is that, in my experience working with a lot of SaaS businesses, they often have multiple projects on the go at any one point in time. They hold them all under one particular holding company and they share their resources across different apps. Some of which works out, some of which don’t. Which means that you then have this incredibly mixed expense base across all of these different apps. When you go to sell it, it becomes extremely impossible or extremely difficult to articulate to a buyer how much expense should be attributed to a particular app, the particular app in question.

Thinking about this contrast of one business that worked really and one that didn’t, […] six months or so. The biggest marker as a difference was that in the case of the one that was working very well. She turned up everything was incredibly well dialed-in in terms of […] well her metrics. Financials were completely crisp and clear in QuickBooks, isolated within one corporate entity, everything was measured up and tracked. She had IP assignments already in place with third party developers. Measures how to […] documentation, set and ready.

The biggest thing that she did right was she had taken a very, very structured approach to marketing in terms of contacting, lots of affiliates, lots of influences in her space, and put everything that she’d ever done into a spreadsheet in terms of contact information and communication. That was an example of incredible level of detail. But when you could display that to a buyer and say you can literally just pick this up, go, and run with it now, it was a slam dunk going to market. We had incredible success with that and put it under offer very quickly, a very high multiple.

Conversely, just recently, I had a listing where all of the customers have built essentially by wire. Nobody’s using Stripe or any of the classic merchant processes. There’s nothing to plug in in terms of SaaS metrics. There was no tracking of customer numbers, no tracking of any SaaS metrics whatsoever, you just got X dollars in the bank every single month. We like complete opacity into what’s actually going on inside the business.

We essentially had to go back three years and rebuild the customer waterfall chart that you would normally see in biometrics or something by hand, which is very time-consuming. I think he’d run into the same issue, again, with the number side of things. He had multiple app developers working across them all and then you just run into a real problem with buyers around how do they trust the numbers that you’re saying in terms of the expenses associated with it.

It’s a tricky one. To be really honest with you, that situation is not entirely cured through the multiple. I think a lot of the times sellers […] take a whole multiple, one or multiple off my price if I deal with that. Sometimes, actually, it becomes almost impossible to sell. You reduce the trust down because it’s just not enough transparency. I think really having metrics and financials dialed. I know it sounds incredibly basic, but it’s very, very important before coming to market.

Rob: I can imagine it sounds like documentation is a big part of it and just clean finances and clean metrics with SaaS would be the thing. As I think about it, when we go to invest in TinySeed or pre-TinySeed when I would go to invest with my own money, there were just a handful of things I asked for. That’s what it is. It’s like, what do your numbers look like? What’s your funnel look like? What are your conversion rates here and there? And I’d probably dig in more maybe than a buyer of a SaaS app would because growth is the end result of all of that stuff.

When we invest, I’m like, what is your trial-to-pay, what is your visitor-to-trial and all that stuff. It gives me a sense of the business. I’d have a mental model about how SaaS works and I can start fitting it into these buckets. It does make sense that that, to a buyer, especially a savvy buyer, can really describe the health of the business just by having clean finances, clean metrics, and having a reading document in a way that you can prove it out.

I remember when I sold HitTail, I’m trying to think if I had stuff split out and I don’t think I did. Certainly with Drip, by that point I had spun it out into its own S Corp (I think), whereas HitTail was mixed in and I did have to do some pulling apart of expenses. I remember it was a lot of work on my side. It was not an ideal situation. That would certainly be a mistake I wouldn’t make again in the future, is having shared bank accounts, having shared credit cards and all that. It just seemed easy at the time.

Again, it’s that thing of, I don’t think I’ll ever sell this. Then, you get to a point where I want to sell this. Now it’s a real pain in the ass to go back and reconstruct the stuff.

David: You can get away with that to a crazy degree on a smaller sale, which is a situation around HitTail. If you did try to do that with Drip, it would be almost a nonstarter. The challenge is that—this all Rob—when you’re building a business, it can be very easy to get stuck into the operation nuts and bolts and not really zoom out and have to think about that particularly on the finances side of things. I think most of the time people have got the metrics property data, still sit every now and again without paying a bit of a piece. If you start scaling the business, you end up in the situation where you are (I’m saying this) at a reasonable scale, but it looks like a car crash when you look at it from a reporting standpoint.

Rob: Speaking of reporting, there’s obviously these great metrics tools like Baremetrics, ProfitWell, ChatMogul are the three that I hear about most often and frankly a bunch of my investments I use them. If someone uses one of those, is it pretty much a slam dunk for you guys to pull stuff out?

David: Yeah. That stuff is de facto standard now. I think ProfitWell is free as well. It’s no excuse to not use it.

Rob: Yeah, no indeed. In fact, one of the TinySeed companies called Summit—usummit.com—integrates with all three of those and then pulls their data in and does forward-looking projections. If I was a buyer these days, of course I want to look back, but I almost would love to see different scenarios of like, hey, if I can improve this number to this or if I hire a salesperson, I think it’s going to do this, you can project it out. I think that could be a pretty interesting thing moving forward.

I think the founder’s headed where the puck is going in terms of this like SaaS tools, both metrics tools but just all the tools we have to build these apps as they get more and more sophisticated. They can make it just a little bit easier as it gets more competitive. I think we need better tools to be able to keep up.

As we start to wrap up, I want to ask you a little bit on the buy side. I tend to think on the seller side and I know you do, too. As an advisor, you deal with the seller first. You have to get their numbers together, put together a prospectus, and you’re essentially marketing that to buyers.

If there are so many audiences who’re thinking about maybe buying their first SaaS app and whether they have a couple of hundred thousand in cash, which most people don’t—I’m guessing—whether they do have some money to do it or whether they are going to be thinking about doing an SBA loan or come in a little bit of seller financing along with some cash, what are the best buyers have? What do the best buyers do that’s different than deals that are maybe more difficult or they don’t go through because of issues with the buyer?

David: The most intelligent buyers tend to understand that a really successful deal will come together if they go out in partnership with the seller that’s already there. I think they take an extremely collaborative operation even from the outside. As soon as they jump on the call, if they’re like the early call about discovering more about the business, they’ll send you to sign a bill of friendship and relationship right away.

Rather than looking at it as a closed-and-done transaction, where just going to pay the amount, do the due diligence, clays out, and leave it, they realize that the owner is still a massive storehouse of information within the business. That is going to give them, if they can keep them on site and maybe can keep them incentivized to help consult (for example) after the deal, that’s going to be massively conducive to their success in the business. Everyone that I’ve seen is a master operator when it comes to buying the business. That’s a kind of partnership vibe right away and they continue it through due diligence.

That intent to create that deep relationship per sale is incredibly important. Particularly the larger the deal, the more so. Then there’s just so much per sale and any deal that you don’t know fully about the asset that you’re buying, and obviously, you know this Rob to some extent, it was obviously moving over to Lead pages to help the first few months or the first year or so. The same principle applies even on smaller transactions. I think that really, really intelligent buyers get that.

I’d also say we respect their due diligence process as well. They get very deep into ensuring that they’re going to be able to run with the business per sale, so looking a lot into the quality of the codebase, looking how well annotated it is, looking at how documented it is, speaking a lot with the developers to really understand some of the critical components behind it so that you don’t end up in a situation, 3-6 months post sale, where you were tinkering around with the codebase that you don’t fully understand yet, and the seller’s not around and not particularly amenable to helping you.

Everyone that I’ve seen that does very successful by-side work, kind of sticks to those principles and plays them out from offer through due diligence and then to closing.

Rob: All right, David. Thanks so much again for taking some time with me today. Folks want to dig more into this stuff. You’ve done a lot of writing on this topic and one of the articles is like a damn book. It’s like an ebook length for sure. Will link it over the show notes, but it’s called How to Build, Value, and Sell a SaaS Business for Six, Seven or Eight Figures. There are eight different sections and you just talk more in-depth about all the stuff we’ve talked about today. Again, link that up into that show notes.

If folks want to keep up with you at Quiet Light, it’s quietlightbrokerage.com, and on Twitter it’s @quietlightinc.

Thanks again to David for coming on the show. I haven’t done a Q&A episode in a while, but I think in the next one or two episodes, I will be. If you have questions for me or a guest that I bring on the show about this ambitious yet sane SaaS companies, a lot of bootstrap, some self-funded, there’s a few that are raising their angel rounds and they’re indie funded, but just around this idea of building companies where it’s founder first, where founder maintains control, where we focus on building profitable, real companies, real businesses for real customers. Send those questions in questions@startupsfortherestofus.com. Voicemails always go to the top but always happy to accept text questions as well.

Thank you so much for listening and I will talk to you again next Tuesday morning.