From Crain's Cleveland: Software-as-a-Service (SaaS) Market is Hot

Author: Christopher J. McKenna

The $20 billion Software-as-a-Service (‘SaaS’) business model is growing rapidly within the $300 billion global software market and public markets are rewarding SaaS companies with robust valuation multiples.

In With the New. SaaS refers to a new model of how software is delivered in which the software and associated data is centrally hosted on the ‘cloud’ instead of being resident on a user’s servers or computers. Customers pay a monthly fee for use of the software, which for many customers is scalable, dynamic, configurable and economical. Due to its single-instance design, SaaS distributes major IT costs over many clients and improves the vendor’s ability to seamlessly and rapidly deliver upgrades and updates. In contrast, the old installed software model requires significant computing capital and operational expenditures to install, support and update.

Key Performance Indicators. New metrics to measure current and future business value are needed with SaaS, such as net monthly recurring revenue (NMRR), cost to acquire a customer (CAC), and customer losses (‘churn’). One fundamental measure of SaaS economics is how quickly there is a payback on a company’s CAC. The payback period can be calculated by dividing the CAC for the prior quarter by the NMRR added during that quarter. Ideally, this CAC payback is less than 12 months for companies experiencing modest churn, but can be longer for those with high customer retention and upsell opportunities. These new metrics can help managers and advisors understand if a company should be adjusting strategies, such as increasing sales and marketing spend if the payback is favorable.

Heady SaaS Valuations. SaaS companies typically transact based on revenue multiples (many public SaaS companies traded between 5x and 9x in 3Q13) since they experience volatile earnings due to scale-up spending. Investors award the highest valuations to SaaS companies demonstrating strong revenue growth and healthy gross margins. One example includes fast growing Marketo, which trades at 15x revenue despite operating losses. Even the well-established trades at 6x revenue. While published multiples are useful benchmarks, valuation depends on SaaS metrics and such factors as addressable market size, product functionality, competitive position, and team.

Local Spotlight. The local economy is alive with emerging SaaS companies, such as COMS, OnShift, SparkBase, DecisionDesk, Zerys, and StreamLink Software, among others. National investors are taking notice as evidenced by Summit Partners’ recent $21 million investment in COMS or Technology Crossover Ventures’ $66 million investment in TOA Technologies.

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