Singapore is well known for having one of Southeast Asia’s most attractive startup ecosystems. Its flexibility in foreign ownership and low tax rates make Singapore an accessible location for investors.
Within the third quarter of 2021, Singapore startups raised SG$11.2 billion, and just in the fourth quarter of 2021, two of Singapore’s most popular startups, Carousell and Ninja Van, attained unicorn status.
Of the fifteen Singaporean startups that have attained unicorn status over the years, two of them, Trax and Acronis, are Software-as-a-Service (SaaS) companies.
Trax, a retail analytics company, founded as recently as 2010, attained unicorn status in May of 2019 and is valued atUS$2 billion in 2021. Meanwhile, Acronis, a cybersecurity vendor, which was founded in 2003, attained its unicorn status in September 2019 and is valued at over US$2.5 billion in 2021.
SaaS companies have proven an attractive investment. This is due to its business model, which allows SaaS companies to own recurring revenue. On top of that, they offer predictable revenue, have a lower barrier of entry for their clients, and scale quickly.
The range of products made available by SaaS companies has also made investing in them very profitable, leading to many venture capitalists actively investing in SaaS startups. According to Growthlist, the top VCs in the world investing in SaaS startups are sure of the massive potential that SaaS has.
Basic framework for evaluating SaaS companies
Software-as-a-service (SaaS) companies operate with a distinct business model. SaaS companies spend an upfront marketing cost (also known as customer acquisition cost) to generate prospects.
Upon signing up, the customer will pay a subscription fee (usually on a monthly basis) to use the software product. With continued satisfaction with the platform, the customer will renew their contract or purchase additional software features. If the platform is unsatisfactory, the customer leaves or churns from the platform.
This business model gives SaaS companies certainty over their revenue as they can expect a certain group of customers to continue paying for their subscription over the contract time. SaaS companies typically measure monthly recurring revenue (MRR) as their key metrics.
With an understanding of a SaaS company’s business model, how would investors evaluate the attractiveness of different SaaS companies? What are the key metrics that SaaS founders should note to prove their business’ viability?
Also Read: How can you build a living, thriving community around your SaaS product?
This article will explore an investment evaluation framework that acts as a guideline that investors follow when evaluating SaaS companies.
Does the company provide a valuable service to its customers?
Investors first evaluate if the SaaS provides services well received in the market.
Four key metrics that investors pay attention to are:
- Monthly recurring revenue/annual run rate
- Renewals
- Churn
- Non-financial metrics such as net promoter score (NPS) and user engagement score
Monthly recurring revenue is the total revenue generated from all active subscriptions within the month. This metric is important as it helps to predict incoming monthly cash flows.
Annual run rate (also known as revenue run rate or sales run rate) is a method of forecasting future revenue over a more extended time period (often one year) using previously generated revenue.
Run rate assumes that current recurring revenue will continue and uses that information to forecast a company’s annualized recurring revenue’s future performance. The annual run rate can be calculated as monthly recurring revenue multiplied by twelve times.
The renewal allows investors to gauge the number of repeat customers or sales upon contract expiration. It also indicates if the SaaS company fulfils users’ needs compared to its competitors. This is because users would already have done a comparison before renewing their contract upon expiration.
Churn measures the number of customers or amount of sales that have been lost. A SaaS company with a high churn rate indicates the company’s inability to meet users’ needs, and it could work on improving its products/services.
A net promoter score (NPS) measures how likely customers will recommend the product, which will lead to future sales. User engagement score measures the number of time users spends on their platform, indicating future churn or renewals.
Is the business model sustainable?
When evaluating SaaS companies, traditional GAAP accounting is not useful due to its revenue nature.
With most SaaS companies, acquisition (CAC) costs such as sales and marketing and other operating expenses are expensed upfront, but revenues are recognized evenly over time.
Investors assess the sustainability of the SaaS companies using:
- Gross profit margin
- EBITDA before sales & marketing cost
- The” Rule of 40”
The gross profit margin is indicative of the cost to serve customers. The lower the margin, the less scalable the SaaS company would be.
EBITDA pre-sales & marketing cost (operating profit, including R&D, spent, with depreciation, amortization and sales and marketing costs added back) measures underlying profitability if investment in growth is halted.
The “rule of 40” accommodates a loss-making business if growth is fast enough and a slowing business if profitability is large enough. The general rule is that Revenue growth rate + EBITDA margin should be greater than 40 per cent.
Is there a product/market fit in an attractive market?
Investors use three key metrics to evaluate if the products/services of SaaS companies have product/market fit in an attractive market.
The following three key metrics are:
- Growth
- Average selling price (ASP) trend
- Market size
Investors would measure the growth of a SaaS company by looking into its booking growth, which measures the value of the contract signed and is indicative of future revenue.
In addition, investors would also measure MRR growth, which measures the level of recurring revenue over a month, and churn rate to evaluate the growth of the SaaS company.
ASP trend helps investors evaluate if there is an attractive market or not. A low ASP cannot support long sale cycles or the high cost of acquiring customers (CAC).
Also Read: What metrics to monitor as a B2B SaaS company?
High ASP indicates greater marketing effort, beyond inbound marketing, is required to win customers. Increasing ASP indicates that customers are more willing to pay for services, meaning an improving quality of service.
Investors pay attention to the total addressable market by using market size as a product/market fit metric. The total addressable market must be large to support long term scalability potential, and the market should also be expanding to accelerate SaaS companies’ prospects further.
Can the company scale profitability?
Investors take on a holistic view of the company, considering both qualitative and quantitative factors when gauging if a SaaS company can scale profitability or not.
First, investors would understand the deployment model and sales efficiency and margin to get insight into the business’s scalability, viability, and efficiency.
Second, investors would understand the Go to Market (GTM) strategy. An effective GTM strategy is highly significant given the profitability of delivering a standardized software service.
The acquisition cost should also be compared against the customer lifetime value (LTV) to gauge how effective the marketing spend is. LTV measures the amount of profits that a customer will generate over their expected period of usage of the software.
In general, for every dollar incurred in acquiring the customer, lifetime value should be three times or higher for a business to scale profitably.
What is the company worth?
Determining the valuation of a SaaS company is ultimately the most important decision for investors. Using the framework mentioned above, investors could solely focus on the quantitative metrics or both quantitative and qualitative metrics in determining the valuation of a SaaS company.
Putting all these factors together will help ascertain the fair valuation multiple of the SaaS company.
This article is co-authored by Charles Phan (Project Lead) and Darrell Su (Senior Analyst), Capital Advisory at Paloe.
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