When acquirers buy a sub-scale SaaS business, it’s rarely for the business’s revenue. The revenue-based valuation rules that apply for scaled SaaS companies do not apply sub-scale.

Instead, sub-scale SaaS valuation is based on the particular reason the target is receiving interest, and this can vary.

As I’ve mentioned in previous articles, there are three main reasons why companies acquire sub-scale SaaS: (1) to accelerate a roadmap, (2) to access a new type of customer, (3) to avail a new product to existing customers.

This article will discuss reason #1; you are being acquired because a company believes your tech will accelerate their roadmap. There are 3 factors to consider in this scenario.

Factor 1: Acquirer’s Cost of DIY

The most obvious element of value in buying vs. building is that the buyer doesn’t have to pay their cost to build. I’ve heard a lot of entrepreneurs mistakenly assume that this is the only, or perhaps primary, component of value. “Why would they buy my co. for $X when they could just build it for $Y?” The answer is, there’s value way beyond the direct cost to build. Still, the cost to build represents value and should be factored.

To quantify, first consider the ways in which big companies do things differently. They tend to pay more for labor, they tend to have more project overhead in the form of product & project management, and projects tend to take longer because of all the various functions peering into development.

The extent of these differences will depend on the size of the co., where they’re located, culture. The point is, think in terms of what it would cost the acquirer to build, not what it cost you to build.

Factor 2: Foregone Opportunity while DIY

More than cost savings, the acquirer wants the ancillary benefits of the new feature…just sooner. To quantify this factor, calculate these benefits over the time period it would take the acquirer to develop.

The value might come from any of these effects:

  • Increased close rate
  • Decreased churn
  • Ability to charge more with the new feature
  • Cost savings (a more efficient workflow, lower infrastructure costs)

Tiny changes in large revenue streams create lots of incremental dollars. If a big company can have a revenue-impacting feature a few months earlier, it can make a big difference.

Factor 3: Integration & Transaction Expense

No one likes working with someone else’s code. Building it yourself, there’s no learning curve, no undesirable design to undo, no unwanted redundancy, no messy integration. Further, even the smallest acquisitions usually carry a cost surpassing $100K in due diligence and legal expenses. The size of the Integration & Transaction factor will depend on how dissimilar your code is to the acquirer’s, and how complex the transaction. Nonetheless, it’s important to remember to discount the value calculation by Factor 3.

Putting it all Together

The equation for setting your value looks something like this:

Acquirer’s Cost of DIY (+)

  • Developer cost at acquirer
  • Admin / project overhead cost at acquirer
  • Timeframe to complete at acquirer

Foregone Opportunity while DIY (+)

  • Time to develop
  • Increased close rate
  • Decreased churn
  • Upcharge potential
  • Cost savings from efficiency (workflow, infrastructure)

Integration & Transaction (-)

  • Learning curve
  • Integration time
  • Ongoing redundancies
  • Due diligence & legal expenses

An Example

You’ve developed a feature that enables a user to create an explainer video with a few clicks. Big Marketing Platform has been working to develop this feature, but it’s been slow going. Competitors have released the feature, prospects are taking notice, and users are starting to complain.

It cost you a small seed round to build the software, but that’s irrelevant. Big Marketing Platform pays its developers $160K/year and it would need 3 of them to build this over the course of 3 months. In addition, the build requires 50% of a project manager’s time at $120K/year and 25% of a product manager’s time at $200K/year. Big Marketing Platform loves meetings, so the 3 month build would likely expand to 6 months.

So the cost is:
Dev. $160K/12*6*3 = $240K
Prod. & Proj. Mgt.  ((.5*$120k/12)+(.25*$200K/12))*6 = $55K
Total $295K

Big Marketing Platform’s product is not showing as well as it did before competitors launched the video builder feature, and some current customers are upset. Adding the feature would increase close rate by 5% and decrease churn by 10%. Over the next 6 months, Big Marketing Platform is expected to do $20M in bookings and have $5M in churn. Adding your feature would create (.05*$20) + (.1*$5M) = $1.5M

You’re a small company with limited operating history, and this is an asset sale. So the acquirer’s due diligence and legal expenses will come in at around $100K. You expect that integration and learning curve will take a month, and will involve the full time effort of 3 developers and 50% of a project manager, or $45K. Double that because maintaining someone else’s code sucks indefinitely. So total factor is $190K.

So your value is $295K + $1.5M – $190K = $1,500,105

One big takeaway from this exercise is that the bulk of your value resides in the foregone opportunity. I find this is almost always the case.

A Side Note on Negotiating

Remember, whatever calculation you’ve made will be wrong in the acquirer’s eyes. The acquirer will have its own set of calculations from real inputs, and in their view, will arrive at the right valuation. Use your numbers as a guide to understand how they are thinking about value, but don’t get too stuck on them.