This is the first part of a 4-part series where I try to explain the various factors important in SaaS valuation.
Part 1: Understand the market
Software-as-a-service (SaaS) is a business model in which providers offer solutions hosted on the cloud, and customers make periodic payments to access these solutions. Unlike legacy software companies that require costly on-premise infrastructure and on-site maintenance, Software-as-a-service (SaaS) providers not only address this drawback but also reduce one-time licensing fees, increasing the accessibility and the affordability of complex technology solutions.
The cashflow intensity, the asset-light nature, and the recurrence of revenue are some of the key attributes of the Software-as-a-service (SaaS) business model favored by investors. According to Pitchbook, the SaaS annual M&A deal volume proliferated from US$24.9 billion in 2014 to US$68.7 billion in 2019. Alongside a strong economic outlook and broader adoption of emerging technologies, the advancements in cloud infrastructure and ease to set up also enabled software-as-a-service (SaaS) providers to continue to disrupt the technology space and penetrate further into more verticals.
Analyzing software-as-a-service (SaaS) businesses requires investigation from macro perspectives to the product level. This series of articles aims to provide a comprehensive lens and eliminate some of the ambiguities when it comes to SaaS company valuation.
To estimate the value of a software-as-a-service (SaaS) business, it is important, yet often overlooked, to first understand the market size and the market position of the product the business offers. The following three concepts are commonly used in the market analysis, and they offer a snapshot of the potential of the product as well as the current market share of the product.
Total Addressable Market (TAM):
Total addressable market (TAM) is a metric to measure the overall size of the business opportunity. It is defined as the financial benefit generated by the company’s product or service if every customer in this market is using the product or service. Typically, there is a positive correlation between target market size and level of competition; a bigger total addressable market comes with more competition. A successful market strategy would be the balance between the two. As more software-as-a-service (SaaS) model continues to challenge incumbents, high growth providers can easily outpace the market in the earlier stage; in this case, the total addressable market (TAM) provides a benchmark to the long-term growth of the company.
Serviceable Available Market (SAM):
Serviceable available market (SAM) account for resource limitations, regulation barriers, and geographic & demographic target in the total addressable market (TAM). It is a subset of the total addressable market which the company can reach. For example, financial technology software-as-a-service (SaaS) providers may be subjected to local securities regulations and compliance requirements, hence exclusive to certain regions. Software-as-a-service (SaaS) businesses store and process the information on third party systems; thus, concerns over security and confidentiality need to be considered when estimating the serviceable available market. Though the ongoing trade conflict and reverse globalization might temporarily fragment some verticals, such hindrance is reducing in the long run as security technology, and data regulations continue to evolve.
Serviceable Obtainable Market (SOM):
Serviceable obtainable market (SOM) is the share of the serviceable available market (SAM) that is realistic to capture for the SaaS vendor in a relatively short term in the current competitive landscape, which can be gauged by applying moat and porter’s five forces analysis. This process also requires an appraisal of available resources, including sales and marketing capacity, financial clout, and current team composition. If the company’s product has the potential to expand its current serviceable obtainable market (SOM), yet lack of resources to do so, external capital can scale up the commercial activity, bring external partnerships and talents, accelerating the expansion of the company’s market share.
Please stay tuned for our second part of the Important Factors to Consider in SaaS Valuation where I will be covering factors such as Revenue (ARR, MRR) and Growth Rate.
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