Annual Recurring Revenue (ARR) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are both financial metrics that can be used to assess a company’s performance and value, but they focus on different aspects.
Depending on your goals and your start-up’s development, you may want to focus your reports on one more than the other. This will enable you to gain better insights and improve your strategies.
In this article, we detail and explain both ARR and EBITDA valuation techniques. Based on insightful advice from successful CEOs, we analyze both methods to help you focus on the most suitable one for growing your business effectively and sustainably.
ARR VS EBITDA: What should you use during your business journey?
When valuing your SaaS start-up, choosing the appropriate method can significantly impact your strategic decisions and growth trajectory.
Early-stage growth
At the beginning of your business journey, your primary focus should be gaining a solid customer base and market presence. During this stage, prioritizing profitability is not the main focus; instead, you concentrate on increasing your overall revenue. Here, ARR becomes crucial, as it will provide a clear direction for your growth path.
As a SaaS expert, Ben Murray, emphasizes the importance of ARR at this stage: ‘In the earlier stages, companies are typically focused on growth and reinvestment into the business, so they’re not focused on EBITDA. They’re just trying to grow the top line. Focusing on ARR and ARR multiples makes a lot of sense versus when a company is much larger.’
Similarly, Nicolas Lespinasse, CEO and founder ofAbby, considers monthly recurring revenue (MRR) and ARR to be the primary indicators of business health essential for sustainable growth. He analyzes them alongside retention rate and average basket size.
Understanding ARR Multiples
ARR multiples are valuation metrics used to assess a company’s worth based on its ARR. An ARR multiple is calculated by dividing the company’s valuation by its ARR. For instance, if a company is valued at $10 million and has an ARR of $2 million, the ARR multiple is 5.
The ARR multiple is influenced by several factors:
- Financial markets: Market conditions and investor sentiment play a significant role. Bullish markets with high investor confidence can lead to higher ARR multiples, whereas bearish markets may result in lower multiples.
- Economic news: Economic stability, interest rates, and overall economic health impact investor behavior and valuations. Positive economic indicators can boost multiples, while negative news can suppress them.
- Sector comparable transactions: The ARR multiples of recent transactions in the same sector provide a benchmark. If similar companies are being acquired at high multiples, it indicates strong market demand and can elevate your multiple.
- Company-specific factors: Growth rate, profitability, customer retention, and market position also affect the ARR multiple. High-growth companies with robust customer retention rates typically achieve higher multiples.
Using ARR to gain strategic insights
ARR multiples such as MRR can help you gain different insights into your business’s trajectory. While MRR offers a detailed view of your revenue on a monthly basis, reflecting short-term changes, ARR provides a broader perspective, helping you to foresee your start-up’s growth over the long term. This broader perspective can be particularly useful if your business offers seasonal subscription models.
To best use your data at the beginning of your journey, you should track and leverage your ARR to gauge your business’s revenue-generating potential and customer loyalty. By effectively using ARR multiples, founders can assess their company’s valuation and growth prospects.
Additionally, you should regularly update and analyze your ARR to identify trends and adjust your growth strategies accordingly. For example, if you notice a particular customer segment driving most of your ARR, tailor your marketing efforts to attract similar customers, to enhance growth and customer loyalty.
Maturity and profitability
EBITDA
As your SaaS venture matures and reaches profitability, generally above $5M in ARR, your strategic focus should shift toward optimizing operational efficiency and maximizing cash flow. EBITDA seems like a critical valuation metric, offering better insights into your company’s profitability and financial health.
Yet, Ben Murray underscores the relevance of EBITDA: ‘Further along in their maturity lifecycle, growth will still be there obviously, but it will slow down just given the business scale. Generally, companies are starting to generate cash. They’re more profitable now than maybe five or six years prior. Maybe in that scenario, it would make more sense to look at profitability or EBITDA.’
FE International CEO Thomas Smale recommends using EBITDA for bigger SaaS businesses, as they might have more employees, management personnel, various shareholders, and a more complex structure overall. In this case, EBITDA encompasses the complexity of your start-up more efficiently than only looking at ARR. However, Thomas mentions that relying solely on EBITDA may not accurately reflect future earnings potential for growing companies. He also recommends keeping an eye on revenue growth and potential.
To best use your data, you should assess your company’s operational efficiency using EBITDA as the key metric to understand and evaluate your cash flow generation from core business operations.
Other metrics remain interesting and insightful and can complement your analysis. From then on, you can adjust your start-up’s strategies to align with your goals or redirect your business’s direction to maximize growth.
Alternative valuation metrics include EV/Sales, EV/EBIT, Price/Earnings, Price/Book, and DCF. The choice of method depends on your business, industry, and buyer.
Subscription-based revenue and complex pricing models
Advantages of ARR multiples
ARR multiples provide a solid valuation basis as they rely on 3 key advantages of the ARR:
- Stability: , it provides a stable foundation reflecting the baseline revenue your company can expect from its existing customer base.
- Predictability: With ARR, your revenue forecasts become more predictable, aiding in budgeting, resource allocation, and strategic planning.
- Growth Potential: ARR growth directly correlates with the expansion of the customer base and the effectiveness of retention efforts, offering insights into your business model’s scalability and long-term viability.
Mark Friend, managing director at Friend & Grant and experienced business founder, recognizes the advantages of ARR valuation for SaaS businesses: ‘This method aligns well with the SaaS business model. ARR multiples directly consider the recurring revenue, which is the lifeblood of a SaaS business. It reflects the company’s ability to generate predictable income over time.’
By analyzing your historical ARR data, you can identify where significant portions of your revenue come from (ex: long-term enterprise contracts) or why you have inconsistent revenue streams (ex: fluctuations in customer renewal rates).
EBITDA-based valuation limits
While EBITDA is widely used for business valuation, its application to SaaS companies may be challenging, mainly to capture growth potential and reinvestment strategies.
Indeed, EBITDA may not fully encapsulate your company’s growth trajectory, especially during periods of rapid expansion or market penetration, due to its focus on earnings before accounting for factors like deferred revenue from subscriptions and investments in long-term growth initiatives.
According to Rizwan K., Managing Director of RMK Associates, evaluating EBITDA has drawbacks. It overlooks non-operating expenses and capital expenditures, which can overstate a company’s cash flow and financial health.
By primarily concentrating on operational earnings, EBITDA might not adequately reflect how your company is investing in its future growth. With this narrow focus, you could undervalue your start-up’s true potential and its strategic endeavors.
Seth Klarman has criticized EBITDA as a valuation metric, arguing it was popularized in the 1980s to justify high takeover prices. He believes EBITDA overstates cash flow by ignoring non-cash gains, expenses, and working capital changes. This critique is supported by a University of Oxford study on Twitter’s 2014 valuation, which found that Twitter’s reported Adjusted EBITDA of ~$300 million excluded significant costs like $600 million in stock-based compensation, leading to misleading valuation metrics and an inflated enterprise value.
Maximizing valuation
If EBITDA remains a relevant metric for business valuation, particularly for larger enterprises, ARR multiples-based valuations emerge as a more insightful indicator for assessing the stability, predictability, and growth potential of subscription-based SaaS businesses.
Moreover, beyond ARR and EBITDA, other key metrics such as Customer Acquisition Cost (CAC), Customer Lifetime Value (CLTV), Churn rate, and Growth Rate can complete your valuation.
All these KPIs play pivotal roles in completing the valuation analysis. They provide deeper insights into customer acquisition efficiency, revenue generation potential, customer retention, and overall growth trajectory, offering a holistic perspective for maximizing valuation and strategic decision-making.
Here’s what different founders used at varying stages of their business journey:
- Emeric Arnoult, CEO of Agorapulse, adapted his focus on metrics as his company evolved. Initially, he emphasized inbound marketing for customer acquisition, which was effective for smaller businesses. As the company scaled, he shifted his focus to metrics like Net MR Churn and customer expansion strategies to offset churn, recognizing their increased importance as revenue grew. He highlights the necessity of transitioning from acquisition to retention and expansion metrics as a business matures.
- Toinon Georget, CEO of Waalaxy, emphasizes income and income growth as the most critical metrics in a startup. Additionally, Toinon recommends monitoring the following metrics:
- Churn rate: indicates customer satisfaction and retention levels;
- Conversion rates: assesses the effectiveness of trial offerings;
- NRR: reflects revenue retained from existing customers over time;
- CHR : measures customer satisfaction;
- Retention rate: evaluates customer loyalty;
- LTV : estimates the long-term value of customers;
- LTV/CAC ratio: compares the value of customers acquired to the cost of acquisition, aiding in sustainable growth strategies.
Like Emeric and Toinon, leveraging these metrics alongside ARR and EBITDA can help you gain a comprehensive understanding of your business’s performance, identify areas for improvement, and make informed decisions to drive long-term value and maximize valuation.
ARR & EBITDA memo: different metrics for different focuses, yet complementary approaches
ARR (Annual Recurring Revenue)
ARR represents the predictable and recurring revenue streams from annual subscriptions or contract renewals. It’s crucial to your company’s revenue stability and growth potential. It provides a clear picture of the revenue you can rely on for future periods, assuming subscription renewals remain steady.
Why does it matter?
ARR is a crucial indicator of your business’s health and growth trajectory. Investors closely track it to assess your company’s revenue-generating capacity and customer loyalty.
How to calculate it?
Add the total annual value of all your subscription contracts or renewals to calculate ARR. For example, if you have 100 customers paying $100 each per year, your ARR would be $10,000.
EBITDA
EBITDA offers insights into your company’s core operational performance and profitability by excluding non-operating expenses like interest, taxes, depreciation, and amortization.
It provides a clear view of your business’s ability to generate cash flow from its primary operations, free from the impacts of financing decisions and accounting practices.
Why does it matter?
EBITDA helps you understand your company’s operational efficiency and profitability. VCs use EBITDA to assess your business’s cash flow generation potential.
How to calculate it?
To calculate EBITDA, start with your company’s net income and add interest, taxes, depreciation, and amortization expenses.
For example, if your net income is $100,000 and you have $20,000 in interest expenses, $10,000 in taxes, and $30,000 in depreciation and amortization, your EBITDA would be $160,000 ($100,000 + $20,000 + $10,000 + $30,000).
The choice between ARR and EBITDA as valuation metrics depends largely on the stage of your company’s development, maturity stage as well as from market conditions.
During the early stages, ARR emerges as a crucial metric. It offers insights into revenue stability, predictability, and growth potential, providing you with a clear direction for scaling your business. However, as your venture matures and reaches profitability, EBITDA becomes more relevant for assessing operational efficiency and maximizing cash flow.
Furthermore, to complete the valuation puzzle and gain a global view of your business’s performance, you should consider other key metrics to gain insights into customer acquisition efficiency, revenue generation potential, customer retention, and overall growth trajectory.
By leveraging other metrics alongside ARR and EBITDA, you will make informed decisions, drive long-term value creation, and maximize valuation.
