“Every generation a chaotic event occurs reordering the players and their equity value.”
Jim Armstrong, Managing Director, Clearstone Venture Partners on SaaS
Justin Perreault of Commonwealth Capital Ventures says SaaS, along with developments in mobility and other corners of the cloud market are driving a renaissance in venture capital.
Forward thinking investors and boards wanting to capitalize on the higher valuation for SaaS companies are investing in new SaaS companies and moving their on-premise companies to pure SaaS or Hybrid on-premise/SaaS models. Venture Capitalists have shifted funding from on-premise software companies to SaaS, Big Data, and Mobile software. Private Equity groups are seeing major opportunities to fund traditional on-premise software companies to move to a SaaS model and reap heightened valuations. Financial firms are getting comfortable monetizing SaaS subscription revenue stream helping SaaS companies reduce their working capital requirements.
This “sea change” in the investment community’s attitude in embracing SaaS has occurred due to numerous SaaS company successes, improved understanding of working SaaS business models, and the lust for high investment returns from successful SaaS companies
Top 5 reasons why Investors and Boards are driving to SaaS
1) SaaS Company Valuations average 2.25 times higher P/R ratio
SaaS companies’ Price to Revenue ratio on exit is 2.25 times that of on-premise companies according to the Software Equity’s M&A report. This understates the relative value of SaaS companies to on-premise software companies as SaaS companies are rapidly being acquired by large software companies to accelerate their transition to SaaS while traditional software companies are less likely to be acquired at any price. Even if the transition to SaaS resulted in a revenue decline of 30%, the greater P/R ratio on exit would yield a 58% greater valuation.
2) Private Equity is flowing into software companies transitioning to SaaS
Many software equity firms are aggressively pursuing a strategy of seeking software companies with good fundamentals, making significant investments to fund the development of new SaaS offerings for the company and to provide the working capital to cover the cash flow decline during their transition to SaaS. The conversion of an established on-premise software company to SaaS can result in a large increase in valuation with a moderate investment.
3) Investor are getting comfortable with SaaS business models
Certainty of the SaaS business model has been a barrier to Software companies adopting a SaaS model. Most early SaaS companies had a negative EBITDA and consumed cash for years. The successful SaaS business model is much better understood today both from the perspective of being better able to project the long term profitability and cashflow, and understanding of the key factors in obtaining this profitability. Investors now have the historical records of successful SaaS companies enabling them to better assess the potential of new investments.
a) Cost of Sales as a multiple of the number of months of Contribution Margin
b) Weighted Attrition expressed as the percent of lost revenue for the period
c) GP% of Subscription Revenue (World Class cost of providing SaaS services is 10%)
d) Growth in Revenue under Contract
e) Growth in MRR (Monthly Reoccurring Revenue)
Investors that rigorously track the crucial SaaS KPIs (in addition to the standard software business KPIs such as the sales pipeline) will have good visibility into the health and potential of the SaaS business, and allow them to intervene if the company needs help. The improved certainty of the SaaS business model and the superior exit valuations of SaaS companies are driving many more SaaS investments.
4) Finance institutions are beginning to finance SaaS revenue streams
One of the greatest obstacles to the adoption of the SaaS model by software companies has been the inability to finance the negative cash flow resulting from the deferred receipt of subscription revenue. Banks and other financial institutions routinely financed receivables, but had not been willing to finance contract revenue streams. With a better understanding of the risks of SaaS reoccurring revenue streams, finance institutions are now beginning to allow companies to monetize their contractually assured subscriptions helping reduce the working capital requirements of SaaS companies.
5) VC software investments have moved from on-premise to SaaS companies
Investments in traditional on-premise software companies have become scarce as VC investments shift to the Cloud. These investments are resulting in a new crop of SaaS companies creating new products that are now entering the market. As Leo Spiegel of Mission Ventures stated, “SaaS offers a whole new generation of competitors — SaaS will become dominant”. These new offerings are greatly expanding the range of available SaaS products providing a SaaS alternative to on-premise software in nearly every segment of the software market.