Industry report - 'Churn is king': how SaaS business models affect software company valuations 02 Apr 14
Foresight Valuation Group LLC - IP valuations
In 2012 Oracle CEO Larry Ellison announced the availability of Oracle Cloud, declaring cloud computing “a fantastic opportunity for technology companies to help customers simplify IT". Software vendors across the world are embracing the 'software as a service' (SaaS) cloud-based business model in growing numbers. According to San Diego-based investment firm Software Equity Group, SaaS software revenues will likely represent approximately 25% of the overall software market in the next five years. Research firm Gartner estimated that global spending on SaaS will reach $22.1 billion by 2015. Some software vendors are converting their software delivery and revenue models to SaaS, while others acquire SaaS companies to gain access to this market. Adobe is a recent example of that shift: in May 2013 the company announced that it was halting future updates of its flagship product, Adobe Creative Suite, in favour of expanding the subscription-based Adobe Creative Cloud. On the M&A front, SaaS M&A transactions grew 25% last year and the median SaaS exit multiple was more than double that paid for traditional, on-premise software targets, according to the Software Equity Group.
The transition from licensed software models to SaaS subscription models for software vendors is not trivial, due to security concerns and the initial cost of switching from existing corporate IT infrastructures; however, the long-term benefits manifest themselves not only in higher revenue growth rates, but also in higher company valuations. While the majority of software businesses today – especially those catering to large enterprise clients – still generate most of their revenues from traditional, perpetual licences and maintenance revenues, the valuations of SaaS companies are about twice those of traditional licensed software companies generating the same revenues (Software Equity Group, 2013 survey). What is driving these higher valuations and are there real economic advantages to the SaaS model over traditional software licensing models?
SaaS business model
SaaS subscription models are gaining ground over the traditional software licence and maintenance models as enterprise customers become more comfortable accessing their software in the cloud and paying monthly subscriptions, compared with a large upfront perpetual licence fee. As the global computing industry is becoming more diversified in terms of networking platforms and access devices, software delivery is slowly morphing into a subscription service that can be accessed anywhere, at any time, on any device. Users receive timely, automatic upgrades rather than having to wait for the next version to be released and pay an additional fee for maintenance.
The SaaS business model is disrupting the traditional cash-flow pattern associated with a software user: high, upfront payments (with annual maintenance fees of about 18% to 20%) are substituted by a longer stream of smaller, periodic (mostly monthly) subscription payments. This results in a cash 'squeeze' in the early period after the launch of a SaaS product and can cause delays in revenue recognition for the SaaS vendor and a cash management challenge to SaaS providers of all sizes, from start-ups with limited resources to public companies managing their earnings. While recurring revenues are usually preferable to providers and investors alike, the nature of the monthly SaaS subscriptions – as opposed to a one-time transaction fee – shifts the emphasis to customer acquisition and retention as key to the survival and success of SaaS companies. This observation is particularly critical in understanding the key SaaS business metrics, such as 'customer churn', which is defined as the rate of subscriber attrition (usually measured as a monthly percentage, typically under 2% for a healthy SaaS company).
Churn is king: new SaaS metrics driving success
Churn is one of several key performance indicators (KPIs) that are closely monitored by investors, especially in early-stage SaaS ventures, where they serve as a precursor for survival. These metrics and KPIs have been articulated in a series of popular articles and models by venture capital investor David Skok of Matrix Partners:
Churn = percentage of customers lost every month (can be negative or positive)
In order to sustain profitable growth, SaaS companies need to minimise churn, increase MRR and keep CAC down. A common rule of thumb applied by investors assumes the following ratios between these KPIs:
- LTV > 3 times CAC
- Months to recover CAC < 12 months
The old valuation adage 'cash is king' seems to have been replaced by 'churn is king', as these SaaS models are extremely sensitive to the churn rate. Using a simple set of numbers can highlight this point. Assuming a CAC of $10 per customer, the LTV needs to be at least $30. In order to satisfy both ratios, with an assumed churn rate of 2% monthly, the net MRR needs to be at least $0.83 so CAC is recovered in 12 months. The resulting LTV is about $42, higher than the $30 threshold. However, let us assume for the sake of example that the churn rate goes up only slightly to 3% monthly: on the same MRR of $0.83, the LTV is now at $27, below the required $30. MRR will need to go up, or CAC to go down, in a constant balancing act of these ratios.
Why are SaaS company valuations so high?
According to the Software Equity Group, traditional software companies have an average enterprise value of three times revenue, while SaaS companies trade at a much higher multiple of 6.5 times revenue. There are several explanations for the observed higher valuation multiples commanded by SaaS companies:
- SaaS companies are growing faster. Data released by venture capital firm Redpoint Ventures show that from 2004 to 2009 the average revenue growth for SaaS companies was around 25%. From 2010, SaaS companies started reinvesting about 50% of their profits in growth, and as a result average growth rates have increased to 35% in the past three years.
- They have a higher percentage of recurring revenues. David Cowan, managing partner at Bessemer Venture Partners, highlighted this point in a quote from his article on high-growth, recurring revenue businesses, which he calls Technology Service Vendors (TSV):
“Recurring revenue (RR) is the flywheel in the engine that drives value in a TSV. So the primary metric of value must derive somehow from RR. New accounts, higher pricing, lower churn and upsells all contribute to RR, so they simply become components of the primary metric."
- MRR increases annually. In order for SaaS companies to maintain profitable, accelerated growth, they must consistently generate higher recurring revenues from the same subscriber base (MRR). It is easier to upsell additional services into an existing subscriber base: Salesforce and Netsuit are two examples of successful SaaS vendors which have been following that path.
The SaaS segment of the software industry is still young and growing, so any empirical conclusions on valuation trends will have to go through a longer observation cycle in order to establish a solid pattern. SaaS companies will need to keep balancing ratios such as churn, MRR and LTV in order to keep their profitable growth and high valuations.
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