(This story originally appeared in CFO.com.)
By Tom Aiken
While more companies transact and store their business off premises, SaaS companies have seen a run up in their valuations.
Since 2015, the SaaS market continues to grow—18% annually—while 99% of organizations are using at least one cloud solution to drive demand.
From an investor perspective, SaaS companies provide a dependable revenue stream like real estate rentals along with high growth.
This might be the right time for SaaS founders to exit.
It’s about accumulating the right information so investment bankers and/or buyers can draw a conclusion. You have to make sure the information is accurate and available.
Here are five factors SaaS founders should consider if they want to cash out:
1. First Impressions Matter
Financial records provide a glimpse into the operations of SaaS companies. Having your company’s financial house in order makes a terrific first impression for any potential suitor. Presenting numbers with missing or jumbled information will only lower expectations for your company.
For investors, today is about tomorrow. They want to quickly determine the present value of cash flow so they can project the company’s future value. To arrive at that number, investors will look at value drivers such as the growth of the business, scale of revenue, the market size, revenue retention, gross margins and product mix for starters. Customer acquisition and churn rate also will be part of the initial conversation.
SaaS companies will need three years of financial records based on an accrual basis—not cash—and a strategic plan covering three to five years.
2. Repeat Business—Again
A SaaS company valuation is annualized revenue times a multiplier.
The multiplier for valuation is typically annual recurring revenue (ARR). ARR is normalized on an annual basis revenue that a company expects to receive from its customers for providing them with products or services. ARR is a metric for quantifying a company’s growth, evaluating its subscription model and forecasting its revenue. Most early-stage SaaS companies are not profitable, and the value is in the recurring revenue contracts.
While other businesses would look at profits, that’s not the case for SaaS companies. It’s important to focus on customer retention, agreement and contracts that provide recurring revenue. One-offs, such as selling licenses, aren’t as meaningful.
Double-digit ARR valuations for growth-stage companies are more common than they were before 2020, but they are still reserved for only the best performers. The division line looks to be around 50% annual growth. For companies with more than $1 million in ARR, the bottom 75% of companies are growing at less than 55% per year, while the top quartile is growing at least 55% year-over-year, according to SaaS Capital’s annual survey of private, B2B SaaS companies.
The median growth rate for all companies with at least $1 million in ARR is 28%. Median private valuations have pulled up also, albeit more modestly, from around 4x pre-2020 to around 6x ARR today.
Unlike other businesses, SaaS companies are driven by revenue and revenue, which eventually turn into cash. That’s where the value comes in. It’s in retained revenue. Repeat business becomes the value of these businesses.
Recognizing revenue, however, becomes the tricky part.
Revenue recognition is simple in a typical commercial setting. A buyer and seller exchange something of value at the same time and the transaction is complete.
But there is a different rule for SaaS revenue, which mainly comes from ongoing subscriptions. Accounting Standards Codification (ASC) 606 is the relatively new revenue recognition standard that impacts businesses that enter into contracts with customers for transfer of goods and services.
Once a company begins to scale, the accounting task can become more challenging if done manually or using older systems.
Using ASC 606, a portion of the annual subscription fee is treated as earned income and deferred revenue through the course of the contract. For instance, revenue must be recorded in the period when the product or service was delivered (i.e. “earned”), whether or not cash was collected from the customer.
If you don’t account for it the right way, it could result in a restatement of the financials, which would create delays and added expenses. That’s a problem if you are trying to sell a business.
The more streamlined your contracts are from customer to customer, the easier it is. Smaller SaaS companies will do anything to get the business so they will fold other things into the contracts like professional services and discounts based on number of seats. It becomes important to review each contract and establish the correct accounting for that contract.
3. Safety in Numbers
When it comes to product mix, there is safety in numbers.
For SaaS companies, there’s a phenomenon called the growth ceiling, which is the highest number of customers you can retain based on the current offering of your business. In other words, new customers, in effect, are being cancelled out by existing customers who are leaving. And that leaves the company with a zero-growth rate.
Improving your churn rate, which captures departing customers, is one way to raise the ceiling. A good SaaS churn-rate benchmark falls between 5%-7% for annual churn and under 1% for monthly churn. So far this year, companies are trending toward adding tutorials about product features, onboarding videos and additional high-value content intended to reduce churn and create an opportunity for new revenue streams.
SaaS companies must be able to isolate each revenue stream to properly value the service in the present and the future.
Public company reporting doesn’t break out profitability by individual products, merely revenue, subscription revenue, professional services, etc. It’s important to have each product broken down. The business must be able to do revenue projections for each revenue stream. In part, that’s what you are paying for in an investment banker. It is very difficult to obtain private company comparative data and the investment bankers are better able to obtain the data.
4. Know Your Competition
From the start, SaaS companies should build the value of their future valuation.
Even your direct competitors, also known as comparables, can help. Start with a benchmark.
The average SaaS company has a multiple of 6.5, a $65 million valuation and a 74% gross margin. Those are places you can start to look at for areas of improvement. Public companies were as high as 16.9x ARR by the end of the 2020. Since peaking at that all-time high in December, these companies have traded in a fairly narrow range of 14.5x to 16.3x ARR. Median private valuations are more modest, ranging from 4x pre-2020 to around 6x-6.5x today.
Although SaaS companies may have a lower 60% gross margin, a deep financial analysis would determine how they account for things relative to sustaining products or research and development for new products to make the P&L statements more accurate. Often, private companies don’t recognize R&D properly, so the financials can be misleading, especially involving product enhancements.
Knowing your own numbers is also mission critical. What is the cost of customer acquisition? Does it cost 75 cents for every dollar in revenue? How much annual revenue is generated from each dollar spent on sales and marketing?
Investors will look at it.
Early in the business cycle, SaaS companies don’t spend much time worrying about profitability because ramping up customer acquisition is a costly endeavor. In fact, on a customer basis, these companies might lose money in the short term. But once the recurring revenue kicks in, there are higher operating margins because the sales and marketing expense has gone away.
The notion of profitability, however, does become relevant in a valuation process when growth slows.
Future cash flow from a business that is both unprofitable and slow growing is not the best situation. Being acquired becomes extremely difficult unless the acquiring company can find synergies when combining the companies.
5. Manage Up
For many SaaS companies, finding an experienced CEO could play a large role in their exit strategy.
With early-stage SaaS companies, often the CEO is the inventor or scientist, the person who hatched an idea that became the business. In many instances, however, they don’t have management experience. They don’t know how to put together a good team and they are not confident about the financial dynamics surrounding business operations.
Numbers and key performance indicators aside, there are noteworthy X-factors to consider from a future investor’s perspective.
How strong is your management team? That’s probably more important than anything else. Nobody wants to invest in a management team that can’t make it happen.
That’s not always an easy question to answer.
In general, only 10% of people have a natural talent to manage others, while 20% have some leadership talent but need training. To acerbate the challenge, most companies (80%) are suffering from a talent shortage, making it difficult to onboard candidates in senior leadership positions.
Research shows that leaders succeed when they focus on a team’s strengths, driving up profits 14% to 29%, as well as 5% to 7% increases in customer engagement and 9% to 15% increases in employee engagement.
Past performance provides insight about the future.
You have to look for prior successes. You want someone with experience buying, selling and growing businesses. You can find ‘repetitive’ CEOs who have done it before, which gives investors confidence that they can do it again.
CFO Consulting Partners is comprised of a team of senior financial executives. We provide a broad range of financial management services to public and private companies. We work for CEOs, CFOs, as well as audit committees and boards. Our mission is to apply our consultants’ considerable collective experience to resolve client issues in a professional and efficient manner.
Tom Aiken of CFO Consulting Partners is a director in the firm’s software technology practice. He also has experience in electronics manufacturing, nonprofit, medical devices, cleantech, advanced materials, heavy manufacturing, social media and telecommunications.