With all the chatter about Billion dollar valuations — like Instagram, Evernote, Splunk — combined with recent S1 filings and IPOs, the topic of tech company valuation is coming to the forefront of people’s minds. Specifically related to the software industry, the growing number of SaaS IPO candidates of late is signaling an important shift in the way that enterprise software is built and sold. It also indicates that the subscription business model is here to stay. What does this shift towards a subscription economy means for startups, investors and the IPO landscape?
First of all – get Instagram out of your mind. The price it sold for is not relevant to us mere mortals who are building B2B software businesses. For all good, non-bubble reasons, SaaS companies need tens of millions in revenue, high growth, and solid business fundamentals. What you may notice though, is that revenue may be lower than what we’ve become accustomed to during the last few years of IPO drought.
Recurring Revenue is ‘worth more’ and is more predictable
For the last several years, the magic revenue number for going public was around $100M – but that seems to be changing. It appears that the market will be more tolerant of sub-$100M as long as the company’s metrics are healthy, and that the revenue that they do have is 1) growing and 2) recurring. With the recurring revenue that SaaS business models have, investors can better predict growth and model what trajectory the business is on. This makes them favorable bets.
Looking at recent S1 filings, you can see this in action: Jive Software filed its S1 with a revenue run rate of about $60M last summer. Eloqua filed with about $60M in revenue. ServiceNow looks more traditional with about $92M in 2011 revenue (filed earlier this month). Bazaarvoice filed in August with about $64M in revenue. When Yelp filed (sort of a SaaS play!) – it had $58.38M (first nine months of 2011). All of these companies had accumulated losses, and most of them were still losing money at the time of filing. That does not mean they are not good business models – with subscription businesses, the upfront investment in customer acquisition is relatively high, but the return from the customer takes a little bit longer than the old software licensing model (lifetime value is spread across the life of contract with SaaS, not upfront).
A different kind of Billion dollar club
What’s interesting and important to note, is that each of the above companies could all be worth north of $1 billion after their IPO debuts. Jive is already there, as is Yelp and Bazaar Voice has a $1B market cap. Other valuation conversations regarding SaaS have focused on companies like Taleo that sold to Oracle for $1.9B (6.5 times trailing 12-month sales) and SuccessFactors getting scooped for $3.4B (with 350M in revenue). While TechCrunch mostly writes about the private companies that make the billion valuation club – these companies have done it in the public market – in some ways even harder than what Twitter and others have done with VC valuations.
The Future of Business Software is SaaS, Subscriptions, and Pay-as-you-go
SaaS and Subscription Models are the future of software. Period. And according to Ben Horrowitz of Andreeson Horowitz, software is eating the world. So technically, SaaS is the future of the world. TechCrunch readers may already be over this hump, but the titans of enterprise software (Oracle, Microsoft, CA, IBM) are still clinging on to the licensing models of yesteryear – but they’ll be disrupted soon enough. Meanwhile, the financial markets are just starting to understand how to value the new business models of the Subscription Economy.
Easy to pay & stay, easy to go
Because revenue from each customer is recognized monthly, it takes a lot of customers to grow to sizable, IPO-ready rates. The old method of recognizing revenue from a big license deal doesn’t work with SaaS companies. Accountants won’t allow it. That means even if you get a big 2-year contract, you can only recognize it one month at a time. Early SaaS companies complained about this, but now we know that recurring, predictable revenue rocks! There a couple of useful metrics to understand here:
Good: The Lifetime Value Effect
The good thing about SaaS revenue? It’s recurring. If your product is well received, it grows. More seats, more servers – whatever your model is – your average revenue grows from each account. A good SaaS company will measure and share its growth per account – a rate of 20% more signals a healthy model.
Bad: Churn can kill you, or at least your market cap
If you are building a SaaS business, churn is your enemy. Most public SaaS companies report their monthly churn rate, either as a percentage of revenue or actual customers gained/lost. These rates depend on the type of business – 2% monthly churn is in the “tolerable range” according to many experts.
Bookings, ARR & other early indicators – In private companies, we have insight into quarterly new bookings – as does the management team at public SaaS companies. These bookings paint a picture of what’s to come, and provides visibility into future, predictable revenue growth. When you run your SaaS business by the numbers and understand your LTV (lifetime value) and Churn, you learn to love the benefits of the SaaS subscription revenue waterfall.
High Upfront Sales & Marketing expenses – On the surface, S&M expenses look high. But early on, as you’re building your subscription revenue base, you need to invest in these disciplines. Once you understand your lifetime value, you know how much you can spend to acquire the customer and most investors in private firms push you to push that to the max – and take those losses early so you can enjoy larger profits later.
Even if you are not the next Instagram, you can still achieve the billion dollar club status. The conventional metrics of bookings, revenue, licensing don’t apply to the new crop of SaaS IPOs getting ready to take flight. The new metrics are LTV, Churn, Customer Satisfaction, and Growth-oriented pricing. While these models tend to look expensive early on (high marketing, product development costs), the smart companies know that building a base early will pay dividends (perhaps literally) thanks to predictable, repeatable, growing subscription revenue. You just need to know what to look for.