Software as a Service (“SaaS”) businesses are unique and require special considerations when valuing them.
Over the past decade the SaaS industry has exploded in size driven by continuous product innovation and constant optimization of business models. According to Deloitte, the size of the global SaaS market went from $210.0 million in 2011 to $1.57 billion in 2020, a mind-boggling compounding annual growth rate of 25.0%. Additionally, capital markets have been favorable to SaaS enterprises as seen by increasing M&A activity in the space.
With all the excitement and growth in the SaaS space, how do SaaS leaders drive the value of their business upward?
What metrics should executives focus on optimizing?
The answer: Going back to basic and understanding 1) Churn, 2) Customer Acquisition Costs and Customer Lifetime Value, and 3) Monthly Recurring Revenue vs. Annual Recurring Revenue.
Churn is simply the percentage of customers that cancel their subscription in any given time period—a quantification of customer loss. There is a wide breadth of opinions with respect to what is an “acceptable” churn rate and what is not. However, what is self-evident is that a SaaS based business cannot grow if new customers are only replacing customers that have left.
What to do: Minimize churn by making the customer experience a core-competency. The product’s user interface design, client-onboarding, payment, customer service, and troubleshooting should be as frictionless as possible.
2. Customer Acquisition Cost (“CAC”) and Customer Lifetime Value (“LTV”)
CAC is the total marketing and sales costs associated with acquiring a customer while LTV is the average amount of revenue that is earned from a customer while they are paying for service. When taken together LTV and CAC (or a ratio of LTV/CAC) speak volumes about the efficacy of a firm’s sales and marketing strategy and how desirable the business is to investors. If a company’s LTV/CAC is too low that indicates that the firm may need to continuously raise capital or in more extreme cases that the firm is highly susceptible to market downturns where pricing pressure is highest.
What to do: SaaS businesses should focus on upselling and cross-selling whenever possible to help maximize LTV. Additionally, the sales and marketing expense incurred when selling products to existing customers is substantially less than the sales and marketing expense incurred by winning new business.
3. Annual Recurring Revenue (“ARR”) vs. Monthly Recurring Revenue (“MRR”)
The most common pricing structure utilized by SaaS firms is a subscription fee either charged on an annual or monthly basis. SaaS firms commonly offer annual plans at a discount to the annualized monthly subscription cost. This usually offers a short-term cashflow boost but comes at the cost of revenue predictability. A lot can happen in the span of a year; what started as an initially excited customer may turn into a subscription holder, not a product user, who will not renew when the time comes.
What to do: SaaS firms should focus on building MRR and offer discounted annual subscriptions to long time clients. This gives the SaaS firm the benefit of rewarding their long-time clients while also improving revenue predictability with new clients.
Valuing SaaS Companies
As described above, SaaS businesses are unique and require special considerations when valuing them. Additionally, understanding the application of a revenue multiple vs. an EBITDA multiple can be confusing. Stories of wildly high revenue multiples for unicorn SaaS businesses can seem at odds with the modest earnings multiples for smaller SaaS businesses. The reality is that different SaaS companies can represent entirely different investment propositions.
Typically, the main differences come down to the size and growth of the businesses in question.
For SaaS companies, the EBITDA being generated today (which could be $-0-) is not always a good proxy for potential future earnings. This is because growing SaaS businesses make significant upfront (and sunk) investments in growth, which are all expensed in current EBITDA. Owing to their recurring revenue model and assuming customers stay with the business, the profit in the future will expand significantly as the business matures and spends relatively less on these items. Measuring revenue makes sense for a growing SaaS company valuation, but it is very important to note that this valuation philosophy is entirely based on growth. If the SaaS business does not grow then the revenue is not there to support the forecast profit in the future, which is what the valuation is actually based on.
If you are interested in how Quist would approach the valuation of your SaaS-based business, click here to contact us.
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