While more companies transact and store their business off-premises, software as a service (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.
An exit is about accumulating the right information so investment bankers and 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:
Financial records provide a glimpse into the operations of SaaS companies. Having a company’s financial house in order makes a terrific first impression on any potential suitor. Presenting numbers with missing or jumbled information will only lower expectations.
Investors want to quickly determine the present value of cash flow so they can project the company’s future value. To arrive at that number, they will look at value drivers such as the growth of the business, the 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.
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 and is revenue the 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 the subscription model, and forecasting revenue. Most early-stage SaaS companies are not profitable, so the value is in the recurring revenue contracts. 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 55% or more 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 4 times pre-2020 to around 6 times ARR today.
While SaaS companies are driven by revenue, which eventually turns into cash recognizing that revenue can be tricky. 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 the transfer of goods and services.
Once a company begins to scale, the accounting task can become more challenging if done manually or by 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 finance doesn’t account for revenue 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 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 the number of seats. It becomes important to review each contract and establish the correct accounting.
When it comes to product mix, there is safety in numbers.
For SaaS companies, there’s a phenomenon called the growth ceiling. That’s the highest number of customers you can retain based on your current offerings. In other words, new customers, in effect, get canceled out by existing customers that are leaving. And that leaves the company with a zero-growth rate.
Improving the churn rate, which captures departing customers, is one way to raise the ceiling. A good SaaS churn-rate benchmark falls between 5% to 7% for annual churn and under 1% for monthly churn. This year, SaaS 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, including for each product, for reporting purposes. The buyer needs that information to properly value the service in the present and the future.
From the start, SaaS companies should build the value of their future valuation.
Even direct competitors, also known as comparables, can help. 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 16.9 times ARR by the end of 2020. Since peaking at that all-time high in December 2021, these companies have traded in a fairly narrow range of 14.5 times to 16.3 times ARR.
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 (R&D) for new products to make the profit and loss 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.
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 know how to put together a good team and they are not confident about the financial dynamics surrounding business operations.
From an investors’ 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.
In general, only 10% of people have a natural talent to manage others, while 20% have some leadership talent but need training. Research shows that leaders succeed when they focus on a team’s strengths. Doing so can boost profits, and increase customer and employee engagement.
To fill the CEO spot, 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 they can do it again.
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.