SaaS Under The Spotlight

Recently, questions have been raised about the sky-high valuations of Software-as-a-Service (SaaS) businesses and their comparative lacklustre performances. It’s important for companies to understand the key drivers behind these valuations in order to better position themselves in front of investors and financiers. It’s also important for potential investors or acquirers of SaaS businesses to value these companies more appropriately.

SaaS businesses typically charge customers a recurring licence fee for the right to use a software product. SaaS businesses typically have large upfront development and maintenance costs. However, they also anticipate significant economies of scale as the number of customers increases. This is shown in Chart 1.  It’s allowed SaaS businesses to attract high valuations when compared to traditional industries.

Chart 1 – SaaS Business & Economies of Scale

This scale-up dynamic has also led to several businesses marketing themselves, perhaps optimistically, as SaaS or technology businesses to seek favourable valuations. For example, The We Company (previously called Wework) planned an initial public offering (IPO) at a reported valuation of $47 billion while still unprofitable.  That valuation sought was more than 12 times the value of a core competitor, IWG plc which operates under the Regus brand. By contrast, IWG had reported profit for the half year period of £295m in its most recent interim report. IWG is listed on the London Stock Exchange and was founded 30 years ago. 

WeWork is the most recent company to market and value itself as a version of a SaaS business although its core business can be characterised as real estate. This resulted in a withdrawn IPO and was replaced by funding from existing investors.

PKF has supported technology and SaaS businesses to undertake various transactions, including capital raising, business sales and acquisitions. The following key learnings may help you to get the best outcome:

Exponential revenue: valuation of SaaS businesses is highly reliant on forecast revenue growth rates. As seen in Chart 2, our analysis indicated that valuation multiples increased as companies demonstrate high revenue growth rates. Revenue growth rates are typically the largest driver of valuation with higher revenue growth representative of profits in the near future:

Chart 2 – Revenue Multiple vs Revenue Growth

Balancing growth and profitability – “Rule of 40”: as a benchmark, revenue growth rate plus profit margin should exceed 40%. Young companies are expected to beat that mark with rapid growth. More mature companies, where growth has tapered off, expect to grow profit margins to hit their metrics. The “Rule of 40” is commonly used as a high-level gauge on the performance of SaaS companies by venture capitalists and growth equity providers, to help measure the trade-offs of balancing growth and profitability.

Understand and articulate the market: like most growth companies, SaaS companies are usually seeking growth in markets where strong share is not yet developed or captured, and through product features that are under development. As part of any transaction, it is important to illustrate how companies intend to increase revenue through new product launches or capturing new markets. The more clearly companies can illustrate how they will win market share and position the strengths of their technology features, the higher the likelihood of achieving a strong valuation.

We can assist you to how best position the business for a potential transaction and capture best value.