Annualized Recurring Revenue (ARR): Why one number really matters for SaaS company valuation

Simply put, SaaS businesses are traded on a multiple of annualized recurring revenue (ARR). All the other drivers of valuation are tied back to this benchmark in order to support a higher or lower multiple.

For an emerging SaaS company, annualized recurring revenue is the best shorthand number for benchmarking the real valuation driver of all businesses: the present value of its future cash flows.

In short, today’s value is based on estimating how big the future profits of the company are likely to be, and what are the chances that they will actually materialize? For SaaS businesses, the best place to start that estimate is their current size (ARR), and adjust from there. All other valuation discussions such as growth rate, retention rate, market size, contribution margins, CAC ratios, etc. are adjustments to the multiple that is then applied to the ARR.

Why not use EBITDA to benchmark SaaS valuation as is done in most other industries?

For most businesses, a company’s current cash flow as measured by EBITDA (earnings before interest, depreciation, amortization, and taxes) is the best proxy for future cash flow and is therefore, the basis of its valuation. For SaaS companies, however, the EBITDA being generated today (possibly none) is not a good proxy for future potential earnings because growing SaaS businesses are making large, up-front, and completely discretionary investments in growth which are all expensed in current EBITDA.

Assuming similar gross margins and customer acquisition costs, larger SaaS businesses are able to generate larger profits and are therefore worth more regardless of their current EBITDA. The larger businesses simply have more scale and have the capacity to generate larger future profits as they enter a more mature phase of their lifecycle. For theses reasons, current revenue is a better proxy for value than current EBITDA/profits.

Salesforce.com is the best example to demonstrate this point. They continue to invest heavily in growing the business to the point that their current profits are negative, yet their market cap is significantly large and their growth is consistently strong.

Interested in learning more about the valuation of your SaaS Company? Download our white paper What’s Your SaaS Company Worth? for more insight and analysis on this topic.

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