We have a long and successful track record of investing in software companies, whether they use perpetual licence models or SaaS. We therefore have first-hand experience of both models and we monitor with interest the long-running debate in the software industry about which is better.
Neither model will completely displace the other. Rather, both will apply in different customer use cases and segments in the market, co-existing for a long time to come.
However, we are huge believers in SaaS. We were the first UK mid-market private equity firm to invest in a true single-instance, multi-tenant software product with a single version of code. That investment, 4Projects, was recently exited to a US trade acquirer for an excellent return to both our investors and the 4Projects management team.
4Projects is a great example of a UK software company that believed in and embraced SaaS from the outset, benefiting from a highly scalable, recurring revenue business model and opening up a large, global addressable market.
We learned a lot about SaaS during this investment period, working with the management team to accentuate the positives of the model as well as managing some of the challenges and pitfalls.
We want to share our experience; our eight key observations on the SaaS model we hope will prove valuable to chief executives and management teams on various stages of the journey towards building a great SaaS business.
Don't give in to temptation; no bespoking. For those starting on the SaaS journey, we cannot emphasise enough the importance of building a single-instance, multi-tenant offering with a single version of code. This drives scalability and a lower cost base.
It is inevitable that customers will, at some stage, ask for bespoke development and dangle the carrot of lucrative professional services fees. If the aim is to build a valuable and scalable business, our advice is to politely decline.
To the extent there are no regulatory or compliance barriers, the same message should be delivered to requests for on-premise deployments or dedicated hosting. You can of course virtualise to create multiple instances - but this makes your engineering team much more expensive and less agile.
The suite is dead, long live best of breed. We accept that is something of a generalisation, but historically software customers have tended to trade off a suite with easier integration but limited functionality against best of breed with optimal performance but higher integration costs.
Chief technology officers no longer need to think along those lines. We also believe that it was a false economy to start with. How many large companies have implemented Oracle, SAP or PeopleSoft suites across their business only to find that licences run to tens of millions of pounds, professional services to implement were likely thrice that number, and the whole system was so heavily customised that the time and cost to upgrade new versions wiped out an entire IT budget?
That was if the implementation even got that far; many system deployments have been cancelled part way through a cumbersome project.
SaaS has changed all the above, and best-of-breed offerings are wanted by customers and are changing the software landscape.
Today, the best applications for each need and business case - CRM, HR, marketing, finance, and so on - can be selected with standardised and pre-integrated APIs, a pricing model based on the exact number of seats required by duration and location, and deployments in days or weeks rather than months and years.
SaaS travels well, and the market opportunity is enormous. In our experience, most markets for SaaS applications are significantly larger than management teams initially believe.
By their very nature, SaaS is instantly available to businesses of all sizes and geographies and new mobile devices and platforms enable every worker to bring technology into the workplace.
The key challenge for early-stage SaaS businesses is how to access the large addressable market. There are, of course, pros and cons to the many routes to market.
With 4Projects, we ultimately conquered international sales, but we learned a few hard lessons along the way. For that business, feet on the ground in the US, particularly UK nationals, were expensive, disruptive and unsuccessful.
In the end, our international success came from understanding the supplier ecosystem in each of our target territories and finding and providing incentives to the right partners to sell 4Projects software.
Our fourth point is to strive for dominance in your category. The best-performing SaaS businesses are viral in nature. Their software delivers their customers sufficient tangible business benefits, ease of adoption and ease of use so that the early adopters within a customer become "evangelists" and the rest of their team soon follow.
Many of the best SaaS businesses also have such deep knowledge of their customers' end vertical - especially compared with purveyors of traditional suites - that their software becomes the de facto industry solution.
We like to call it vertical IP.
To become the category leader you need to grow, and you need to grow fast. Growth rates are now becoming the primary driver of valuations for SaaS businesses as they represent a proxy for how big the business can become and how real future category leadership is.
It's the law of compounding numbers: a £1m business that grows at 100 per cent each year for 10 years will reach revenue of £1bn and dominate its category, whereas a business growing at 10 per cent per annum will reach only £2.6m in revenue.
Buyers and investors in SaaS businesses are now beginning to adjust to 30 per cent or better growth rates, having spent decades looking at traditional licence models in mature, yet relatively plodding, markets, albeit still growing at respectable rates of 10 per cent to 15 per cent with strong margins and cash flow.
The best SaaS businesses, the ones that have achieved or are on their way to category leadership, are capable of delivering both significant top-line growth as well as long-term sustainable profit margins of 25 per cent or more.
Take your own medicine when it comes to cloud sales and marketing as well. One trick missed by many B2B software businesses is not embracing and harnessing the power of online sales and marketing.
B2C has revolutionised the buying process of the consumer, with most consumers today doing substantial online research before ever acquiring big tickets items - cars, holidays, mobile packages, and more. And the target buyers of SaaS are becoming no different to consumers in their buying patterns.
B2B SaaS businesses should learn from the consumer internet market. There are a number of technologies that companies should look to embrace to turbo-charge their demand generation: content marketing, search engine optimisation and email marketing are just a few.
In addition, social media cannot be ignored; businesses should at least be monitoring and shaping discussions on its business, its market and its competitors.
Our sixth tip is to manage your investment into sales carefully. One of the biggest pitfalls we see when looking at growing SaaS businesses is that too many sales personnel are hired too early on. This burns cash without getting a commensurate uplift in growth.
A 2006 article in The Harvard Business Review by US tech entrepreneur Mark Leslie called The Sales Learning Curve outlined principles therein that remain highly relevant to growing SaaS companies.
The essence of the curve as reported is that sales teams should be populated cautiously until the optimum sales model is discovered and the true messaging and buyer purchasing criteria have been established.
Only then do you ramp up your sales headcount. A simple rule for establishing this threshold is the ability of one or two salespeople to deliver contracts at an annualised revenue run rate equal or greater to twice their fully loaded sales cost (full package plus engineering, marketing and service costs associated with securing the customer).
It is also vital that sales staff are given incentives according to monthly recurring revenue or some other suitable metric in the business that can stand for improvements in the recurring revenue base.
Automate the service offering as well, thereby minimising professional services. The ability to automate the provisioning, scaling and billing of an offering will lead to higher valuations for the business.
Look at the revenue-services split
All investors and buyers look for the split between recurring monthly revenue and professional services. A large proportion of the latter reduces the valuation, as it slows down implementations, restricts the ability of the business to scale up or down, and dilutes gross margins.
Measure performance through established cloud metrics. There are numerous metrics that SaaS businesses can use to measure and monitor performance. This article is not the place to go into the arithmetic, but when evaluating an opportunity we focus our attention on four simple questions.
What is the quality of your revenue? We measure this through Committed Monthly Recurring Revenue (CMRR), which gives a snapshot of the underlying billing base, taking into account monthly recurring revenue adjusted upwards for all signed or committed contracts still being on-boarded, and adjusted downwards for customers who have turned off or are expected to turn off their subscription.
This metric provides the best barometer of the health of the business.
We mentioned the diluting effect of professional services on valuation. As a result, older methods of capturing performance such as Average Contract Value (ACV) and Total Contract Value (TCV) effectively reward contract value and therefore professional services.
This metric does not therefore correlate closely to company valuation and is not a measure we recommend for running a SaaS business.
We also look at churn rates - not based on "logo" churn, but on the value of CMRR lost over a given period. The churn rate measures customer satisfaction with the service and the ability to grow significantly as moderate churn rates make aggressive top-line growth almost impossible.
We see top-performing SaaS businesses having churn rates of less than five per cent.
How cost-effectively do you service the existing recurring revenue base? We measure this by looking at the profit margin made by the business excluding any sales and marketing cost. It therefore assesses the efficiency of non-growth overhead, such as cost of sales, research and development and general administration, when serving existing customers.
The best-performing SaaS businesses according to this metric have typically invested in highly automated back-office systems with seamless quote-to-cash-to-renewal processes.
How long does it take you to get paid for new customer wins? We look at this as a measure of efficient business growth. It measures how long it takes the business to recoup the sales and marketing investment, excluding account management, required to win customers and grow the recurring revenue base.
Typical payback periods are six to 18 months. Any shorter, and more should be invested in sales and marketing to capitalise on the short time elapsed before profitability. Any longer, and the business should pause for reflection until it establishes a more efficient sales model.
The observations we make above have varying degrees of applicability to companies, depending on where they are on their growth journey, the nature of their subscription model (for example: multi-month or year contracts, pay as you go or freemium) and whether they are transforming themselves into SaaS providers.
They do, however, represent what we would strive towards and look to implement if we were starting a SaaS business with the benefit of experience and a blank piece of paper.
Any business that meets most of our main eight observations will be valuable and sought after.
The UK SaaS sector is developing rapidly. Many exciting companies are emerging with proven offerings, established customers and growing revenue. August Equity is a committed investor in the software sector looking to invest in exciting SaaS companies where our knowledge and experience of the model can help management expedite the growth of their business.
Keith Davidson is investment director at August Equity
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