High-growth SaaS companies are often unprofitable, yet financial institutions value them highly. The median net income for Public SaaS companies is negative 4.5%.
Yet, despite these losses, the Price to Enterprise Value ratio for SaaS companies is 8.0x compared with 3.2x for Software companies, according the Q1 2014 Software Equity Group 2014 Software Industry Financial Report.
Investors are looking beyond profitability. They see the value in SaaS businesses that isn’t reflected in traditional financial statements. That value is the ongoing revenue stream, which provides future value (and profits) not shown by GAAP financials.
We need a quantitative method to assess the outlook for SaaS companies that takes into account the value of future revenue against the cost of rapid growth. These financials should show the underlying profitability of the core business separately from the cost of growth.
Why doesn’t GAAP show the value of SaaS companies that investors see?
Product companies realize their revenue when the product is sold. SaaS companies realize the revenue as the product is used; it generally takes approximately three years of SaaS subscription revenue to equal the revenue from a product sale.
GAAP gives no accounting of the value of the ongoing SaaS subscription – not even a footnote of its predicted value of the future revenue stream.
What makes SaaS companies successful?
The objective is to use different metrics to reveal the actual long-term value of the subscription revenue stream relative to the cost of obtaining these recurring revenue streams. There are three primary drivers of very successful SaaS companies:
1) Growing revenue
2) Growing the long term recurring revenue stream annuity
3) Growing efficiently
Zuora has advocated 3 key metrics that matter in assessing the SaaS company’s growth:
1) Retention Rate – keeping the customers who were so expensive to acquire
2) Recurring Profit Margin – making money to fund new sales after taking care of customers
3) Growth Efficiency Index – having a prudent cost of Revenue Acquisition relative to the cost new revenue
By excelling in these three key metrics, SaaS companies can grow efficiently increasing their aggregate Customer Lifetime Value of their customers, which is a significant driver of the company’s value.
So when will SaaS companies become profitable?
For the successful SaaS company, the answer is “when they want to be.” Grow faster with low profits or even a loss. Grow slower, boost profits, but potentially lose the market opportunity.
The company can trade off profitability for growth since the revenue acquisition costs for growth occurs immediately while the SaaS subscription annuity stream is realized over years.
So what should SaaS companies do?
Grow if you can grow efficiently. Near term profits are not so important if you’re growing efficiently.
Growing efficiently means that the core business (without the cost of growth) is profitable and the cost of growing the business is substantially less than the future value of that business.
With a goal of maximizing shareholder value, the equity markets sensibly value growth over GAAP profits.
How to assess if you are growing efficiently?
1) Separate the P&L from maintaining your existing revenue from the cost of growing to show the profitability of your core business
2) Evaluate the return on investment of adding new revenue from the net present value of the subscription revenue stream
3) Ensure your churn is low so you are not losing the future revenue stream that drives your ultimately success
4) Benchmark key metrics against your peers, and watch your cash
The bottom line is this: now metrics outside of GAAP are needed to assess the outlook for SaaS companies. These businesses should be taking into account the value of future revenue against the cost of rapid growth and ultimately showing the underlying profitability of the core business.
A replay of the Cloud Strategies/Zuora webinar, “How to Measure the Performance of a Subscription Business,” to explain techniques and benchmarks that will help you measure, analyze, and understand your SaaS business is available at Proformative here.