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SaaS Framework A differentiated point of view for analysis of SaaS companies PitchBook is a Morningstar company. Comprehensive, accurate and hard-to-find data for professionals doing business in the private markets. Key takeaways • Analyzing SaaS companies requires unique metrics and a differentiated point of view. This framework seeks to provide a comprehensive lens through which to view these companies. • The framework assesses businesses across five categories: the company’s solution, sales and marketing, revenue, path to profitability and balance sheet. Investigating product market fit, total addressable market, customer acquisition costs and the company’s financing history serves as a starting point for complete company analysis. • SaaS business models are well-positioned for future growth. The proliferation of SaaS businesses was driven by the business model’s asset-light nature and ability to generate recurring revenue, and the influx has only been perpetuated by a number of large VC exits in the space over the past few months, paving the way for more investment activity. Published on July 5, 2018 COPYRIGHT © 2018 by PitchBook Data, Inc. All rights reserved. No part of this publication may be reproduced in any form or by any means— graphic, electronic, or mechanical, including photocopying, recording, taping, and information storage and retrieval systems—without the express written permission of PitchBook Data, Inc. Contents are based on information from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Nothing herein should be construed as any past, current or future recommendation to buy or sell any security or an offer to sell, or a solicitation of an offer to buy any security. This material does not purport to contain all of the information that a prospective investor may wish to consider and is not to be relied upon as such or used in substitution for the exercise of independent judgment. Credits & Contact Analysts CAMERON STANFILL Analyst cameron.stanfill@pitchbook.com DARREN KLEES Data Analyst darren.klees@pitchbook.com Contact PitchBook RESEARCH reports@pitchbook.com Contents Key takeaways 1 Introduction 2-3 Solution 3-4 Sales and marketing 4-7 Revenue analysis 7-8 Path to profitability 8-9 Balance sheet 9-10 Conclusion 10 2 PitchBook 3Q 2018 Analyst Note: SaaS Framework Introduction The rapid advancements in bandwidth and cloud infrastructure over the past two decades enabled a new wave of cloud-native software firms to provide powerful software solutions directly via the internet. This cloud-based business model has since been dubbed as software-as-a-service (SaaS) and has seen massive adoption by upstart companies looking to disrupt the legacy, on- premise software providers and incumbents adding a cloud-based offering. A main drawback of legacy offerings is that the housing, ownership and operation of the hardware have historically been the responsibility of the client. SaaS addresses this shortcoming and drastically reduces the total cost of ownership by eliminating expenses for in-house servers, data storage and dedicated personnel for maintaining infrastructure. With SaaS adoption being primarily motivated by these cost savings, we think that SaaS businesses still have a degree of pricing power when it comes to software licensing fees, which should facilitate continued growth. While the potential cost savings have been evident for some time, security concerns regarding the storage of sensitive or confidential information on third party systems were a main hindrance to SaaS adoption; however, improvements in cloud security have dramatically reduced these issues. Still, handling client data securely will continue to be a priority for SaaS businesses and advancements in cybersecurity should be quickly adopted or innovated on by players in the space. Not your parents’ software company In addition to differences in how services are delivered, legacy offerings and SaaS providers have drastically different sales models. Legacy products often charge a large upfront software license fee, whereas SaaS businesses typically sell service subscriptions through which revenue is earned ratably over the life of the contract. In a similar vein to the increased flexibility in pricing, SaaS allows for immediate product updates and upgrades, an improvement on the periodic version releases of on-premise software. SaaS businesses are asset-light and generate recurring revenue that drives cashflow, but revenue recognition policies caused by the subscription model can skew evaluation of SaaS companies because of the mismatch between revenue and costs. Since most 3 PitchBook 3Q 2018 Analyst Note: SaaS Framework major costs (including sales and marketing) are recognized upfront, analyses of SaaS companies that rely on GAAP earnings measures can be difficult and unreliable. Improvements have been made to address this, as new rules that went into effect on January 1st, 2018 now allow companies to recognize commissions over time to match revenue more closely. While investors familiar with software firms have begun to understand the dynamics of the SaaS model, we often see these companies examined through the same lens as traditional business models, revealing a fundamental misunderstanding in how they should be analyzed and valued. The maturation of cloud providers in recent years and relative ease to set up a SaaS business have attracted many startups to pursue this distribution model. This influx has only been perpetuated by a number of large VC exits in the space over the past few months, paving the way for more investment activity to follow in the near future. As a result, many of today’s SaaS companies are coming through the VC funnel and scaling rapidly due to the benefits that the model provides, including the stability of recurring revenue, an expedited path to cash flow positivity and favorable operating leverage. Because of the limitations of traditional analysis techniques and our familiarity with SaaS businesses, we created a framework to provide a comprehensive lens through which to view these companies. This piece is meant to serve as a starting point for company analysis and as a guide to some of the most important data points of SaaS businesses. This will also serve as a template for our own company research and coverage of the broader SaaS market. We hope this is beneficial to you and your practice. Framework scope 1. Solution 2. Sales and marketing 3. Revenue analysis 4. Path to profitability 5. Balance sheet Solution The goal in this section is to determine the market size, product market fit and the problem the company is solving. These are the first key factors in determining a company’s potential size and growth. Here the company must find its balance between 4 PitchBook 3Q 2018 Analyst Note: SaaS Framework target market size and level of competition. These two factors tend to have a positive correlation (i.e. the larger the market, the greater the competition), so finding the correct mix is critical to the company’s success. It is also important here to assess the differentiation of the business that makes it unique to innovate on an existing process. The distinction between filling an unmet need or creating a new solution to disrupting or competing in an existing field will have a marked effect on the total addressable market (TAM) and the long-term outlook. Qualitative assessment Does the company’s solution fit into an existing SaaS category? • Customer relationship management (CRM) • Enterprise resource planning (ERP) • Accounting or billing • Marketing • HR • Collaboration or project management • Other Determine the company’s TAM either from management statements or via outside research if the company doesn’t report. What are the end markets a given service can serve? What would be the individual TAM within each end market? Is there any potential for the company to pivot to increase TAM? Consider the associated costs and benefits of a potential change of course. Who are the company’s competitors? What makes the solution differentiated? Does it address an unmet need or fill an underserved niche? Does the company communicate why it chose this product? • Sector • Business expertise • Leadership team background • Other Sales and marketing Sales and marketing represent the largest and most significant expense category for SaaS businesses, which makes it essential to determine how the company positions itself in its market and to assess the viability of the sales approach. Much of this will depend on the business’s ideal customer profile and the complexity of the product. For example, while heavily integrated products for 5 PitchBook 3Q 2018 Analyst Note: SaaS Framework enterprise clients might require field and inside sales forces, other products may be just as successful employing channel sales or self-service strategies. While sales approach and efficiency are key to the growth of the business, the marketing function must be effective enough to supply a sufficient quantity and quality of sales leads. Determining the company’s demand generation strategy or pipeline of leads is an important predictor of whether the company will meet sales goals. Investing money into these expenses is critical to growth; however, monitoring related efficiency metrics is important to understanding if the company is allocating capital prudently or implementing a growth-at-all-costs mindset. These spending decisions will determine the trajectory and long-term success of the business. Qualitative assessment What is the company’s go-to-market strategy? • Platform or horizontal • Targeted or vertical While a company can be targeted from an end user (focusing on healthcare firms) or use case perspective (pure accounting solution), for this analysis we will focus on targeted strategies from the use case or solution perspective. However, it is essential to exercise some prudence here, because there is a good deal of nuance in this determination. Based on the company’s solution or TAM desires, does one or the other go-to-market strategy make more sense? Anecdotally, a targeted approach is easier to sell because the product can be specialized and the value proposition is simpler to communicate. It is also easier to build an initial product, as the platform approach requires building out multiple services at the outset. Does this make them a more likely acquisition target or an acquirer? For example, vertical strategies may be easier to tuck into a platform business looking to expand its product offerings, while platforms may look to consolidate with other like businesses. What is the company’s sales approach? • Inside sales • Field sales • Channel • Hybrid • Self-service 6 PitchBook 3Q 2018 Analyst Note: SaaS Framework How long is the sales cycle? Determine if that information is available or use the best estimate based on client type and product complexity. Who is the company’s ideal customer? Either find or develop the company’s ideal customer profile (ICP). While the following bullets provide a starting point, additional detail is always valuable. • Enterprise (e.g. money-center banks, diversified insurance companies) • SMB • Consumers—which subset? • Derive an exact figure or estimation for average contract value (ACV). If no explicit value is given, make inferences based on customer type or monthly recurring revenue (MRR/# of customers). Is there a benefit to its chosen sales approach given its product or go-to-market? For example, channel sales eliminate the need for a full salesforce, as the product is sold through partners or resellers, a self-service channel for individuals, very small businesses, etc. What is the company’s marketing or demand generation strategy? Does it have a clear pipeline of leads or an existing customer base it can upsell? What are its primary channels used to generate leads? What is the cost to generate demand or leads? Relevant metrics Customer acquisition cost (CAC) should be broken out by the costs allocated to procuring new business versus retaining current clients, if possible. Consider the length of the sales cycle to determine the lag of expenses. It’s also worth determining how much of marketing’s effort is spent on new business. Use CAC to calculate other key SaaS metrics. CAC = sales & marketing expense # of new customers acquired CAC payback period (months) = CAC MRR x gross margin x 12 Customer lifetime value (CLTV) = ARR - average cost to service churn % + WACC - subscription increase 7 PitchBook 3Q 2018 Analyst Note: SaaS Framework Customer lifetime value (CLTV) is a measure to value the cash flows produced by one customer. Breaking down the formula, CLTV consists of the margin the customer generates after discounting for churn and the time value of money. This can be an important metric on its own, but the CLTV/CAC ratio gives context and meaning to the customer value calculation. This ratio gives a picture of the company’s return on every dollar used to acquire customers. A three to one CLTV/CAC ratio has been posited as a positive benchmark, and a ratio of greater than one is key to confirm the company isn’t spending more on customer acquisition than the margin the customer provides over their lifetime. This measures the percentage of revenue that is spent by the company on the sales & marketing function. How has the ratio evolved historically? Are there levers to be pulled here to lessen the burden? Revenue analysis As investors have looked to software for top-line growth over the past 20 years, revenue metrics have had an outsized effect on valuations. While many valuation models are based on earnings, SaaS companies tend be valued based on revenue, especially at the earlier stages of their lifecycle. Revenue streams can also be used to access debt via revenue-based financing. To assess the quality of the company’s revenue, we examine gross margin, payback period and churn. Churn is especially important, because this measures the amount of revenue or number of customers that the company loses annually, which indicates the stickiness of the product. The churn figure is also useful when evaluating the business’s current state if it were to stop investing in growth initiatives (i.e. sales and marketing). Sales & marketing burden = sales & marketing expense revenue = CLTV CAC Customer lifetime value to CAC ratio 8 PitchBook 3Q 2018 Analyst Note: SaaS Framework Relevant metrics Break out by subscription revenue (ARR or MRR), if possible. Also consider sales growth, which gives insight into future revenues. Conduct a year-over-year (YoY) and competitor comparison. This measures the company’s cost to provide the service. Is the trend toward improvement or deterioration? Does this have anything to do with product or services mix and/or mix shift? Conduct a YoY and competitor comparison. This measures the annualized increase in revenue the company makes by spending one additional dollar on sales and marketing. A ratio above 0.75 is preferable, and investment in sales and marketing is worthwhile. If under 0.5, the business needs to change something before investing further in sales and marketing. It tends to track lower as a company ages and scales and as the market becomes more saturated. This measures how quickly your CAC is recouped. For example, if CAC is $10,000 and the ACV is $8,000, the payback period is 15 months (five quarters). This is almost synonymous to the inverse of the sales efficiency formula. A payback period of six to 12 months is best-of-breed, and less than 18 months would be highly preferable. Revenue churn can also be calculated. Churn is the sign of stickiness and customer retention for a SaaS business. It can be analyzed as a percentage of either revenue or clients. Net negative churn is seen as a holy grail in SaaS businesses, which Payback period (in years) = CAC ACV Churn = Δcustomers Δtime*beginning customers Sales efficiency = ΔQ = quarterly rev*4 sales & marketing exp t-1 Revenue growth = revenue t revenue t-1 - 1 Gross margin = gross profit revenue 9 PitchBook 3Q 2018 Analyst Note: SaaS Framework occurs when the net renewal rate or upsell is greater than the churn. This translates to revenue growth from the existing customer base. Path to profitability GAAP profitability isn’t always the company’s principal concern, especially at a relatively early stage when the company is still working to grow revenue and customers. For instance, companies may opt to increase headcount aggressively, which will lower current net income or operating income but expands potential for future growth. This growth is important in the world of SaaS, since that is what attracts many of the investors to the space. However, we think it is becoming more common and even necessary for companies to show progress toward profitability or at least have a plan to do so. Most recently, companies have tried to exhibit that progress by turning cash flow positive, a move that proves the company can fund itself internally and won’t need to rely on large secondary offerings in the public markets. Relevant metrics Net income/(loss), cash flow from operations (CFO) or free cash flow (FCF) margins. Is the margin trending positively or negatively? What expense categories are driving outsized effect? Where can potential levers be pulled? Conduct a YoY and competitor comparison. Use the “Rule of 40.” Growth and profitability of 40% or higher is a positive sign. This is a simple rule of thumb to judge the health of a SaaS business once it hits ~$1 million in MRR. For example, if you are growing MRR (you can also use ARR or revenue) at 20% YoY, you should aim to operate at 20% profitability. Choose NI, EBITDA, CFO, or FCF margin depending on the stage of business and fixed asset decisions. Balance sheet When evaluating the company’s balance sheet and financial condition, it is key here to examine the capital structure. This gives insight into how much equity the company has sold to investors or if the company has raised any debt and what that will mean for further financing needs. Also consider the current cash balance and how long of a runway this cash will provide at the current burn rate before needing to seek more capital. In the current VC environment where huge sums can be raised by successful 10 PitchBook 3Q 2018 Analyst Note: SaaS Framework companies, this cash on hand or the ability to raise outsized rounds is becoming a competitive advantage. SaaS businesses regularly operate with negative net working capital (NWC) due to the large sums in the unearned or deferred revenue account, especially if the company is growing sales. Efficiently managing working capital is key to the cash flow of SaaS businesses. For this, we consider the company’s cash conversion cycle (CCC), days sales outstanding (DSO) and days payable outstanding (DPO). Essentially, how fast do you get paid versus how fast must you pay expenses? A negative CCC provides the company with a cash benefit. Qualitative assessment What is the company’s financing history? • VC funding • Debt • PE ownership Are there any issues of which to be aware because of this? • Debt burden • Investor rights • Potential future dilution events • Other Based on cash flow information in the previous section, is it likely that the company will need to raise additional funds in the next 12-18 months? Relevant metrics SaaS CCC = average A/R billings / 365 ( ) average A/P cost of sales / 365 ( ) - Conclusion Now that we have gathered all relevant information for the company, it is essential to bring it all together and examine the full picture. It is helpful here to compare against general SaaS benchmarks and preferably a small group of public or private competitors. In general, this is the area to synthesize the answers from the five categories of the framework to get an idea about the overall state of the business and its prospects going forward. It is key to use the information gathered to make projections about the business as future results are what ultimately drive shareholder value.
