By Scott Meyer, Glenview James LLC
Everyone wants to invest in a high-growth software-as-a-service deal. It’s the holy grail.
But many times PE investors spend hundreds of thousands of dollars on diligence, only to find out that the target business isn’t really SaaS after all.
Here’s how to save time and money and make smarter bids for true SaaS deals.
What is SaaS?
SaaS is a way to deliver software through the cloud. Buyers pay annual or monthly subscription fees for licenses and support. This is totally different from the old method of delivering boxed software to premises, where buyers also had to invest in hardware and IT for maintenance.
In a nutshell, SaaS moves software from an upfront capex and depreciation decision to a predictable and manageable expense-line item.
For investors and portfolio companies, recurring SaaS revenue is beautiful. Unlike one-off sales, these revenues are predictable and occur at regular intervals going forward with a relatively high degree of certainty. Well-run SaaS businesses operate at gross margins north of 80% and renewal rates exceeding 90%.
That’s powerful stuff – and the market is taking note. SaaS valuations are at incredible multiples. So it’s no wonder that any company wants to get as much credit for being a SaaS company as possible.
Often, companies try to sell themselves as SaaS by manipulating the SaaS definition. Bankers and entrepreneurs have gotten savvy at putting the killer SaaS metrics of high LTV:CAC, high renewal rates and gross margins up front in the teaser. This can confuse potential investors and generate a lot of unnecessary deal heat.
Here are a few tips for how to tell what you’re really looking at:
Evaluate the company’s age and legacy
The older the company, the less likely it is to be pure SaaS. Legacy software products are hard to transition to SaaS. The old up-front investment with annual maintenance and upgrade revenue is a wonderful annuity that has been at the core of many great technology companies. Transitioning to selling and supporting a SaaS-based platform is challenging.
Even if some, or all, of the software is in a traditional on-premise model, companies often try to present the business as SaaS. A company can offer multiyear managed-service contracts, enabling contract revenues to be recognized on a monthly recurring basis. The company can also mix revenue by customer. Here, revenue from a single client might stem from two sources: true SaaS provision and non-SaaS services or software. This combination is then reported entirely as SaaS revenue.
Separate out long-term software contracts from SaaS contracts
A company that has a mix of SaaS and non-SaaS can very easily lump them together and argue for an SaaS valuation. Watch out for companies with high customer concentrations among products that have been in the market for more than five to seven years. They are unlikely to be SaaS businesses at their core. Their products may be very good with high retention rates, but they are probably not SaaS.
Look out for services businesses masquerading as SaaS
A lot of great managed services are out there. Here, the company selling the software also supplies the “hands on keyboard” to run it for clients. Other companies just sell you the services to activate SaaS contracts you have in place. These can be compelling businesses, but they don’t merit SaaS valuations. They are people businesses at their core, and they operate at much thinner gross margins, typically under 50%. They also are much less predictable than pure SaaS. Unlike a multiyear recurring SaaS contract, companies can much more easily switch service providers and/or bring the function in-house.
Avoid funding the conversion of a legacy software business to SaaS…
While some huge software companies have transitioned successfully to SaaS, it is a decade-long, risky process. This isn’t a good fit for private equity timelines. If a company is looking for PE to “build out our self-service SaaS model” or “transition to a cloud-based SaaS solution,” I’d recommend passing.
… But a company that is adopting SaaS solutions may be a diamond in the rough.
Companies of all types are moving to buy software via SaaS to save costs and gain competitive advantage. The margins can be huge when companies move from running their own data centers to an AWS, Microsoft Azure, IBM Blue Mix or Google Cloud setup.
Similar results can come from embracing SaaS solutions for CRM and Application Performance Monitoring. To capitalize on this, however, the PE sponsor must be experienced in these transitions or have a management team in place at the company that can pull this off. And just because a company is embracing SaaS solutions doesn’t mean it deserves a pure-play SaaS valuation.
Finding the next SaaS company that will change the world can return the fund. Similarly, smart bets on companies that know how to embrace SaaS to fatten their margins can deliver great returns. Knowing whether the deal is really an SaaS deal is where smart investors can win big in today’s market.
Scott B. Meyer is owner and principal consultant at Glenview James LLC. His practice centers on digital due diligence and digital transformation work for sponsors and portfolio companies. Reach him at firstname.lastname@example.org and @scottmeyer.