Hall Chadwick Director of Corporate Finance Mark Bailey discusses the reasons why Software as a Service (SaaS) companies warrant different approaches to valuation, and why they can be compared with eighteenth century steam engines (seriously).

Why do accountants need some knowledge of SaaS companies?

If you don’t have these kinds of clients today, you probably will in future. The SaaS business model is now well established. US-listed SaaS companies are now valued at over USD1 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 1,000% between December 2012 and 30 June 2021.

Is there more pressure on accurate valuations?

SaaS companies in the early stage and growth stage rely on their valuations to access the capital they need to grow, so accurate valuations are important. 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.

You have been known to compare SaaS companies with the commercial evolution of the steam engine. What’s the significance?

The steam engine holds some clues for how accountants could consider SaaS company business models.

The Boulton and Watt steam engine was commercially released in 1776. Rather than sell the engines to other businesses, which would involve a massive up-front cost, the company licensed use of the machines.

Licensing provided 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 the steam engine 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. Many are creating new markets with valuable products and services not easily replicated that provide repeat revenue.

What’s a common misconception about SaaS companies?

There is a misconception that tech valuations are running wild and defy logic, particularly in the SaaS space. This is not the ‘dotcom’ era. Generally SaaS businesses are based on strong fundamentals, a service that is needed by the market, the businesses are projected to or are growing rapidly with strong underlying cashflows and recurring revenue.

But so many seem to operate at a loss?

Yes, sales and marketing tends to be a major expense item. Hence they report EBITDA losses. Sales and marketing is an investment in building future recurring revenue and it is not necessarily an expense that relates to current revenue. The recurring revenue can be serviced with little in the way of ongoing costs.

Shouldn’t they spend less and generate a profit?

The risk of that strategy is a competitor grows faster and takes market share. As previously mentioned, 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. A slow growth strategy is likely to be a strategy to wither and die.

Why are you taking a SaaS roadshow to advisers?

I have seen valuers try to value growth stage SaaS businesses with traditional methods and not understand the business model nor how the market values Saas businesses. The traditional approaches do not allow for the unique features in these companies such as the very high gross margins, which are nearly as much as their revenue.

SaaS companies need to frequently raise capital, particularly during the early stage technology development and during their growth phase to fund the sales and marketing. These costs may run at a high percentage of their revenue, hence they need to raise capital.

Accountants to SaaS businesses need to understand and assist their clients to understand SaaS valuation. Accountants can play a key role in early stage and growth stage businesses building systems that measure the key metrics that drive the valuation of SaaS companies.

But aren’t revenue-based valuations foolhardy?

People may scoff at valuing on revenue but there are some good reasons why it’s valid for SaaS companies. SaaS companies are valued based on a multiple of revenue principally 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 recurring revenue: gross revenue may include consulting fees involved in setting up clients, and this revenue is not valued highly; it is the recurring revenue investors crave.

However, the valuation as a multiple of revenue 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.

What are the key metrics?

Many studies indicate growth in annual recurring revenue (ARR) is the number one factor in achieving a higher than peer valuation. Measuring customer retention/churn is a big factor in understanding ARR, market acceptance of the product, pricing and service. Gross margin, which is often extremely high with SaaS companies, is another key.

The total addressable market is an important consideration, as is the cost to acquire new clients as this is where the cash goes.

Great SaaS companies tend to be accounting nirvana. They analyse everything: they do, all the fundamental things most businesses know but don’t follow up with; things like the average lifespan of a customer, customer churn, the speed of delivery, customer satisfaction, how many leads are required to achieve a sale. This is all 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 its gross margin.

It is no surprise that companies which command the highest revenue multiple valuations tend to exceed the rule of 40.

Mark Bailey is currently running sessions with accountants on valuing SaaS companies. For more information on these sessions please contact Mark Bailey mbailey@hallchadwickmelb.com.au or +61 3 9820 6400.

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Mark Bailey

Director Corporate Finance Advisory

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