When interest rates rise and M&A activity slows, industries with recurring revenue such as business services and SaaS often continue to see relatively steady deal activity, as Scott Linch discusses in Middle Market Growth magazine. Yet to position themselves for a potential future acquisition—as buyers or sellers—SaaS companies must seek ways to continually improve enterprise value.
SaaS Valuation Principles
SaaS companies are typically valued by some combination of current and potential recurring revenue and the cash generated (generally approximated as EBITDA). The well-known “Rule of 40” measures value creation for SaaS firms across these two dimensions and is managed through two key drivers: Adoption and Profitability.
Adoption in its simplest form is the year-over-year revenue growth percentage and signals to stakeholders how well the product is capturing the market and “turning heads.” Profitability is generally expressed as EBITDA as a percentage of revenue for the same period. For many SaaS companies outside the initial start-up phase, value creation can be measured as a combination of the two with a benchmark of 40:
YOY Revenue Growth % + EBITDA % of Revenue >= 40%
In bottom-line terms, the Rule of 40 generally assures high-growth SaaS companies that, although investment in R&D, customer care, and infrastructure might impact bottom-line profitability, the product’s market adoption will pay off down the line. Conversely, mature companies with little or no new sales but a loyal existing customer base should focus on maintaining customer loyalty while driving out costs and aggressively managing pricing to improve EBITDA at or above 40% of revenue.
Value Creation Drivers for Recurring Revenue & EBITDA
Customer retention and pricing are two key factors in a value-creation strategy, typically enabled by a first-class product, excellent support, and strong back-office operations. Best practice companies leverage opportunities to upsell new products and upgraded features to a highly satisfied, captive customer base. For SaaS businesses focused on increasing enterprise value, we’ve summarized four value-creating opportunities to address recurring revenue and EBITDA.
Customer Growth & Retention
Recurring revenue is improved by attracting new customers while maintaining current customers and expanding service offerings for the long haul. Best practice companies invest in flexible, customer-friendly contracts that make it easy to do business with the firm. R&D balances building features that add value to existing subscribers with investing in updates that attract new customers. Customer support should be seamless and timely and result in opportunities to expand services provided through the SaaS product.
Best practice companies spend around 20% of revenue on developing new products and services. Based on the product’s maturity, value trade-offs can be made by determining the best source of recurring revenue: (i) targeting new customers or (ii) maintaining existing customer dedication to the product. Investments in R&D, customer care, and other functions should be made accordingly. Many mature SaaS developers focus 100% on existing customer needs when building out the product road map and limit costs to help ensure they renew. SaaS companies also should have knowledgeable implementation service resources available to help onboard the product into customer operations when the client lacks internal capabilities or capacity. A successful onboarding helps improve customer retention and facilitate expanded service sales.
Strong companies leverage product “stickiness” in their pricing strategies. Rather than focus on product investment cost and returns, leading SaaS companies understand their product’s value and criticality to customers and the pricing reflects this reality. Flexible pricing models—flat, usage-based, and tiered—should all be leveraged based on the customer base, relationship to the product, and overall strategy. Discounting is utilized only to lock in revenue on long-term (> 3 year) subscriptions.
While investors often analyze and value SaaS and software companies on multiple metrics—including billings or cash-basis revenue and EBITDA—they are particularly scrutinized on revenue recognition standards such as ASC 606. FORVIS has helped many clients develop and implement accounting procedures to set up and maintain revenue recognition practices and establish reporting capabilities that allow for flexibility in assessing various drivers of value. In addition, leading companies build an automated program, leveraging both CRM and ERP systems, to begin the renewal process the moment a customer signs up rather than when an expiration is approaching. Best practice SaaS companies help ensure that days sales outstanding (DSO) are reduced through automation and pre-pay opportunities that make renewals automatic and improve cash flow.
How FORVIS Can Help SaaS Companies With Value Creation
FORVIS generally assists software and SaaS companies along several underlying drivers of value. Our Value Creation services address industry-specific methods for generating EBITDA over the long term. For SaaS clients, our focus is on helping attract and retain customers to a mission-critical service, pricing based on value versus cost, and building the infrastructure necessary to renew and upgrade existing clients. Contact our team to learn how we can assist your SaaS company with creating value.