Software-as-a-Service companies (SaaS) need accurate valuations so they can access the capital they need to grow, yet valuing these businesses correctly is still often misunderstood across the business community including by some accountants.
Aussie SaaS standout Canva shows the way for other local SaaS companies — it is now bigger than Telstra, following its breakthrough recent $55 billion valuation. Traditional business pundits may wonder if it makes sense, yet there are some very good reasons for these stunning SaaS valuations.
To consider how important SaaS companies are becoming to our economy, consider US-listed SaaS companies are now valued at over US$1 trillion (1.35 trillion), and SaaS companies have vastly outperformed the NASDAQ and the S&P 500 over the last decade. The SaaS Capital Index maintained by SaaS Capital grew approximately 1000% between December 2012 and 30 June 2021.
It is important for all SaaS companies to be properly valued from the beginning — new SaaS firms can’t afford for their worth to be misunderstood because it may significantly hamper growth and leave them vulnerable to competitors.
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What SaaS companies have in common with steam engines
Rewind back to 1776, when the Boulton and Watt steam engine was commercially released. Rather than sell the engines to other businesses, they understood that most businesses could not afford to purchase a steam engine outright. The company instead licensed use of the machines.
Licensing gave access to a technology which businesses could not afford to buy outright or were wary of committing so much capital to. Boulton and Watt knew that once a business started using its steam engines they would soon depend on them.
Some of these engines were commissioned for more than 100 years, delivering recurring revenue to Boulton and Watt for a very long time.
Many SaaS businesses are not dissimilar. They are creating new markets with products not easily replicated, which businesses soon depend on, generating repeat revenue.
Valuations essential for early stage SaaS companies
SaaS companies in the early and growth stages rely on their valuations to access the capital they need to grow. If SaaS valuation is not understood and the valuation misses the mark, existing shareholders will be unnecessarily diluted in the capital raisings and alarm bells will ring with knowledgeable investors.
Accountants can play a key role in early stage and growth stage businesses, building systems to measure the key metrics which drive valuation — but they need to understand what makes SaaS companies different.
I have seen valuers try to value growth stage SaaS businesses with traditional valuation methods, not understanding the SaaS business model nor how the market values these businesses. Traditional approaches do not consider the unique features in these companies, such as the very high gross margins, which are can be nearly as much as revenue.
Traditional valuation methods may find it hard to deal with the loss-making nature of many early stage SaaS businesses. Large sales and marketing expenses may result in EBITDA losses being reported.
Sales and marketing is an investment in building future recurring revenue, and is not necessarily an expense relating to current revenue. Once established, the recurring revenue can be serviced with little in the way of ongoing costs.
The alternative strategy, to avoid losses by spending less on growing the business and focus on generating profits, may be unsuccessful in the medium term.
Many SaaS businesses are creating new markets. There is a prize for becoming the major player: customers and investors know this; Xero and Microsoft are classic examples. The risk of spending less is a competitor grows faster and takes market share. A slow growth strategy may be a strategy to wither and die.
Key metrics for accurate SaaS valuation
Revenue multiples are logical for SaaS business because they achieve gross margins of up to 90%; the average gross margin in the US is estimated at 76% and that revenue consists of up to 95% recurring revenue.
We need to acknowledge the difference between gross revenue and annual recurring revenue (ARR): gross revenue may include consulting fees involved in setting up clients, and this revenue is not valued highly; ARR is what investors crave.
However, a revenue valuation multiple oversimplifies the analysis required to determine an appropriate revenue multiple. There are many key metrics and market considerations that need to be understood, analysed and compared.
Many studies indicate growth in ARR is the number one factor in achieving a higher than peer valuation. Analysing and benchmarking customer retention/churn is a big factor in understanding ARR, it also provides insight into market acceptance of the product, pricing and service.
Other key metrics include the gross margin and the total addressable market as well as the costs to acquire new clients as this is where the cash is spent.
Where many SaaS companies have an edge is they analyse everything — they do all the fundamental things most businesses know they should measure but don’t.
For example, understanding the average lifespan of a customer, customer churn, the speed of delivery, customer satisfaction, and how many leads are required to achieve a sale. All these metrics are considered in determining an appropriate revenue multiple.
The above are summarised in an industry rule of thumb called the ‘Rule of 40’, which is a company’s growth rate plus gross margin.
It is no surprise that companies which command the highest revenue multiple valuations tend to exceed the Rule of 40.