The Next Generation of...

The Next Generation of Software

6/17/2013 Maximizing Value

Not all SaaS companies are created equal. Through a

partnership between America’s Growth Capital and Joseph

Hosler of Auour Advisory, this paper will delve into the broad

definition of SaaS and offer visibility into methods to increase

the value of your business.


Page 1

TABLE OF CONTENTS

BROAD DISPERSION IN VALUATIONS ....................................................................................... 2

THE SAAS BUSINESS MODEL ...................................................................................................... 3 Software-as-a-Service Defined .................................................................................................................... 3 Benefits of a SaaS Model .............................................................................................................................. 3

Customer Benefits .......................................................................................................................................... 4 Vendor Benefits ............................................................................................................................................. 4

Pricing Strategies ............................................................................................................................................. 5 Horizontal vs. Vertical ..................................................................................................................................... 7

DRIVING TOWARDS A PROFITABLE MODEL ............................................................................. 9

TRANSITIONING TO A SAAS MODEL ...................................................................................... 10

LESSONS LEARNED .................................................................................................................. 11 Neglecting the Low End ................................................................................................................................ 11 Too Profitable Too Early .............................................................................................................................. 11 Beware Usage Based Pricing ...................................................................................................................... 11 Overages Can Cause Discontent ................................................................................................................ 12 Beware Infrastructure Lock-in ...................................................................................................................... 12

CONCLUSION ........................................................................................................................... 13

AGC’S EXPERTISE IN SAAS ...................................................................................................... 14


Page 2

THE NEXT GENERAT ION OF SOFTWARE

BROAD DISPERSION IN VALUATIONS

The Software-as-a-Service segment is no longer just a niche within the software industry. It has evolved over the past decade to become the preferred method of delivering applications to end users. And yet, it is still in the early phases of its lifecycle. Though still in an immature state, the participants have achieved varying levels of success, allowing for a more granular discussion into the characteristics that drive success.

We have reached a point to confidently say that not all SaaS companies are created equal. The wide variation in valuation multiples within both the public and private markets (Figures 1 & 2) highlights the roles played by different factors and allows for a discussion of the various forms that a SaaS company can take and the competitive position they hold within the industry.

As Software-as-a-Service has grown to become its own sector, permutations of the model have multiplied. Because of this, it allows for distinctions to be made as it pertains to the valuations within the industry. Attributes that can help define the dispersion observed include;

Growth trajectory of revenue, Total addressable market, Pricing mechanism and its impact on predictability, Competitive position, Horizontal versus an industry specific application.

This whitepaper will attempt to clarify the characteristics that exist within the SaaS market and to glean those attributes that lead to superior valuations.

0x2x4x6x8x

10x12x14x16x18x

0 1000 2000 3000 4000 5000

Ente

rpri

se V

alue

/ S

ales

Market Capitalization ($mil)

Public Market SaaS Valuations

0x1x2x3x4x5x6x7x8x9x

10x

0 200 400

Ente

rpri

se V

alue

/ S

ales

Transaction Size ($mil)

Private SaaS Transaction Valuations

FIGURE 1: PUBLIC MARKET SAAS VALUATIONS (CAPITALIQ) FIGURE 2: PRIVATE SAAS TRANSACTION VALUATIONS (CAPITALIQ)


Page 3

THE SAAS BUSINESS MODEL

SOFTWARE-AS-A-SERVICE DEFINED

Some have drawn conclusions that SaaS is a throwback to the timeshare models of 1960’s or the Application Service Provider (ASP) models of the late 1990’s. Or that it is nothing more than a traditional software company with a different revenue model. These comparisons are far from true. The SaaS models of today are a complete rewrite of application delivery to end users. It is a new way of thinking about the delivery of value through digital means and it requires a new way of thinking around how a software company is built and operated.

A SaaS company can be defined as a company selling a service that digitizes a specific workflow. This differs from a traditional software vendor that sells a digital product which fits into a customer’s current workflow. The difference is material as it requires a completely new approach to the business; architecting a multi-tenant offering, implementing a more efficient selling process, lowering the cost of on-boarding, etc. This approach should drive better profit potential with lower variability in future revenues and profits, and therefore, lead to a better valuation outcome.

However, the benefits of selling a service as described above are not pre-ordained. Much thought needs to be done to determine the right pricing models, delivery options, and cost structures to maximize value creation.

BENEFITS OF A SAAS MODEL

One of the most powerful elements to the SaaS model comes from the strong alignment of the benefits that accrue to both the vendor and the customer. Too often in the traditional software model, the relationship would suffer as the vendor was only a small part of the complete solution. The linkage between the selling process and deriving value from the product risks becoming weak and diluted through the deployment process. As the provider of application logic only, the vendor would lose control as the project evolved to include the hardware, OS, middleware, customization of features, changes in project scope, and third party integrators. These elements lose significance in the world of SaaS as the vendor controls many of these decision points (Table 1). Importantly, the steps that involve multiple decision makers are shared with the actual end user, driving a higher likelihood of satisfaction.

TABLE 1: COMPARISON OF SOFTWARE DEPLOYMENT MODELS

Process Steps SaaS Model Traditional Model Develop Specifications SaaS Vendor,

End User (Independently) Internal IT, End User, Vendors

Hardware Implementation

SaaS Vendor SI, Internal IT, HW Vendors

Software Implementation

SaaS Vendor SI, Internal IT, SW Vendors

Configure

SaaS Vendor, End User SI, Internal IT, SW Vendors

Deploy/Train

SaaS Vendor, End User Internal IT, Vendors

SaaS is a broad category that encompasses various delivery options, pricing

models, and cost structures.


Page 4

Maintain SaaS Vendor SI, Internal IT, Vendors

CUSTOMER BENEFITS

From the customers' perspective, the benefits are clear and have been widely discussed in a broad array of literature. These include but are not limited to;

Lower upfront costs, Faster implementations, Adoption of best practices. Leveraging the collective knowledge of the entire user base.

Adopting a SaaS solution places the buying decision back into the hands of the business unit and end user. It allows for circumvention of an already over-burdened internal IT department and, in most cases, enables the business unit to gain access to a leading edge solution that continues to advance in functionality. The largest drawback comes from the lack of customization. With the rapid adoption of SaaS in the marketplace, one can draw the conclusion that the benefits listed above more than compensate for the lack of flexibility.

VENDOR BENEFITS

From the vendors' perspective, the benefits are equally as appealing. Broadly, for the management of a SaaS company, the overriding benefit is the faster feedback loop that allows for the rapid discovery of customer issues and the implementation of corrective action and new practices to enhance the customer relationship in order to protect and drive revenue. This is derived from a multitude of operational and organizational elements unique to a SaaS model that can drive better revenue visibility and higher operating efficiency.

Revenue

The recurring nature of revenue has many positive implications. The consistency of cash flows allows for an improved budgeting process with increasing visibility lending comfort to added investments. It also allows for a cleaner view into the lifetime value of a customer, providing more conviction into the sustainability of the company and ultimate profitability that can be achieved. The concept of subscription based pricing dictates a focus on more readily available operating metrics (e.g. churn, usage, LTV, CAC) which will provide better alignment of objectives for the entire organization.

Another benefit as it pertains to revenue is the potential to leverage the network effect of SaaS through the centralization of the data. SaaS vendors have the opportunity, unlike traditional software vendors, to derive new revenue streams from the aggregation and syndication of data that exists within their product offering. Of course, care needs to be taken that customer perception of privacy is not harmed.

Operating Expenses

Improvement in efficiency is most clearly experienced in the development and sales organizations, the two largest cost components to any software company.

The responsibility for the various segments of the sales funnel are experiencing significant changes with the marketing function expanding their zone of influence, allowing the sales effort to be more concentrated to those most likely to convert to customers. Though it has been true for B2C organizations, it is becoming the norm for B2B’s as well.


Page 5

According to a recent Corporate Executive Board survey, buyers are 60-70% through the decision making process before they engage with a salesperson. This has significant ramifications for software companies and their selling process (Figure 3). Though Awareness and Interest may be the same for both traditional software vendors and SaaS providers, the Consideration, Intent, and Evaluation phases of the purchasing decision will lead to a competitive dislocation between the two with the advantage going to the SaaS vendor. The SaaS product has a distinct advantage given the ease of trying before buying and self implementation, eliminating the need for costly on-site sales efforts and proof-of-concepts.

FIGURE 3: EVOLUTION OF THE SALES FUNNEL (PATRIZI)

The second area of increased efficiency lies in the development function. Though the development process for a SaaS vendor increases in complexity to incorporate many features that are not as important in a traditional software approach such as enhanced user authentication, scalability, and latency to mention a few, the benefits overwhelm the added effort. One of the largest benefits comes from having one code base rather than multiple instances deployed in the field. Another benefit comes from one hardware/network/OS stack, dramatically reducing the permutations for QA and allowing for a more secure, stable, and scalable offering. Technical expertise can also be centrally located and fully engaged versus having to blindly troubleshoot on the customer premises and in their unique compute environment. It also increases the feedback loop for modifications as a more direct link between the developer and the end user is created.

PRICING STRATEGIES

As was stated earlier that not all SaaS companies are equal, the same can be said for pricing models within the sector. Descriptively, pricing models within the sector can be broken down into three categories with each carrying a different level of predictability.

Pricing Models

Usage Based Revenue Share Subscription Less Predictability More


Page 6

There is no right answer as the offering in many ways will dictate the structure of the pricing model. However, managements need to be cognizant to the repercussions of their decisions. Though usage based and revenue share based pricing models may be termed a SaaS offering, it must be acknowledged that there is a material difference between subscribed business and repeat business. Predictability of future revenue streams will be enhanced in a subscription based model. Second, within a pure subscription based model, the vendor has a higher likelihood of

keeping pricing negotiations focused on value delivered. Lastly, subscription based models allow for a more partnership based selling approach, allowing the sales cycle to separate out the benefits of the offering from the negotiation of the contract price.

This is not as easy in a revenue share model. Aside from taking on the volatility of the end users’ revenue pattern, it can become more volatile at the end of the contract term. As it is based on the customer’s revenue line and is actually

stated as a percent of their gross revenue, it runs the risk of becoming viewed as a cost center rather than as a value driver.

Usage based models carry the same risk as revenue share models in that it is easier for the contract negotiation to turn from value enhancing to cost avoidance. End users understand the leverage inherent to a SaaS model and will likely look to offset increased volumes with pricing discounts.

Looking at the public market valuations of the various SaaS companies and scoring their revenue visibility, as described above, depicts the difference in value investors place on the various models (Figure 4).

FIGURE 4: IMPACT OF REVENUE VISIBILITY ON SAAS VALUATIONS (CAPITALIQ, COMPANY REPORTS)

0x

5x

10x

15x

20x

25x

30x

35x

40x

Ente

rpri

se V

alue

/ S

ales

Revenue Visibility

Impact of Revenue Visibility on SaaS Valuation

Less Recurring More Recurring

Revenue visibility drives valuation so choose your pricing strategy wisely.


Page 7

HORIZONTAL VS. VERTICAL

Differences in operating models present themselves with the various approaches taken by management teams. One of the cleaner differences arises from the focus of the offering. One path is to provide a horizontal workflow solution that spans a function that exists in all industries (e.g. Human Resources, ERP, Expense Management, Supply Chain Management). The other option is to provide a deep workflow solution targeting a specific industry (e.g. Insurance Claim Management and Policy Underwriting, Auto Dealer Infrastructure, Fleet Management).

Valuations within the public market vary greatly within and between the two approaches (Figure 5). Those that approach a horizontal strategy have demonstrated the ability to garner premium valuations. However, the variability in valuation multiples is larger as success rates and market penetration play a vital role.

FIGURE 5: VALUATION RANGES BY MODEL TYPE (CAPITAL IQ)

Dissecting the public market companies further, each category can be split into more granular buckets. Though operating models, as depicted by gross margins, differ greatly between the Horizontal and Vertical models, it is not the prime factor driving valuations. The difference in margins are an outcrop of the vertical focused firm’s need to take a more full service approach to their offering, whereas the horizontal focused companies can focus more on carefully selecting one or a few distinct workflows. For a vertically focused firm, the loss in gross margin can be offset by the efficiency that is seen in a more targeted selling and support process. What is highlighted in the data below (Figure 6) is the premium attributed to the leaders versus those that have experienced troubles in leveraging their position in the market.

Horizontal Vertical

Transactions 38 22

High 30 9.5

Low 1.5 0.6

Average 4.9 3

0x

5x

10x

15x

20x

25x

30x

35x

0

5

10

15

20

25

30

35

40

Ente

rpri

se V

alue

/ S

ales

Mul

tiple

Num

ber

of T

rans

actio

ns

Valuation Ranges by Model Type(Public and Private Transactions over the Past 3 Years)


Page 8

FIGURE 6: OPERATING MODEL IMPACT ON VALUATION (CAPITALIQ)

A number of the public market companies going through transition are experiencing issues revolving around a need to adjust their pricing models or a need to change their operating model to accelerate their revenue and customer count growth.

56%

58%

60%

62%

64%

66%

68%

70%

0x

3x

6x

9x

12x

15x

18x

Horizontal -Leaders

Horizontal -Niche

Horizontal -Transition

Vertical -Leaders

Vertical -Transition

Gro

ss M

argi

n (%

)

Ente

rpri

se V

alue

/ S

ales

Operating Model Impact on Valuation

Valuation Gross Margin


Page 9

DRIVING TOWARDS A PROFITABLE MODEL

Building for profits is different than delivering profits. Given the immaturity in the segment and the large opportunity in front of SaaS companies, building for profits is much more important than delivering profits today. The distinction comes from the knowledge that the economic and accounting models penalize SaaS companies for growth in the near term. Due to the ratable recognition of revenue and the upfront customer acquisition costs (CAC), the addition of new customers create a near term drag on profitability and acceleration in growth can lead to even larger accounting losses (equation 1).

.& &

EQUATION 1: CLOUD OPERATING MODEL (SALESFORCE.COM)

This is why SaaS managements need to focus attention on Lifetime Value (LTV) of a customer and the costs associated with acquiring that customer (CAC). It is the delta between the LTV and the CAC, along with the number of customers, that derive the future value of the firm. This argues for companies to create a value proposition that drives LTV higher (i.e. increase price and lower churn) while containing CAC and to strive for adding customers as quickly as practical. Stating the obvious;

EQUATION 2: VALUING A SAAS COMPANY

This has been demonstrated in the public markets with one of the stronger attributes driving valuation being revenue growth (Figure 7).

FIGURE 7: GROWTH DRIVES VALUE (BLOOMBERG)

0

10

20

30

40

50

60

70

80

0x 10x 20x 30x 40xEst.

Rev

enue

Gro

wth

-2

Yr

(%)

Enterprise Value / Sales Multiple

Foward Revenue Growth / Valuation

Ttcisimfrd

Ts

ToWas(mCulia

Transitioning fhe premium vcompletion ans obtained. Itmplementatiofeature releasrequired. Thediscontent and

Though dauntisuccessful.

The key to theof transitioningWith the avera traditional ssupported witFigure 8), a fmagnitude higCompanies waunderstand theifetime value acquire.

0x

4x

8x

12x

2003

EV

/ S

ales

0x

4x

8x

12x

2003

EV

/ S

ales

from a traditiovaluations thatd proven succt is a multi-ste

on and use, asse, and 3) a me biggest hurdd confusion. It

ing, it is not w

e internal trang the sales foage deal size

software salesh sales engineield sales app

gher in cost toanting to make cost to acqu of the custom

2004

2004

TRANS

onal softwaret SaaS providcessful. As staep transition ins well as, a onmaterial re-ordle lies in convt is analogous

without its succe

sition will revrce to a lowee materially los cycle, the useers becomesproach can be acquire versu

ke the transitiouire a custome

mer can be a m

2005 20

2005 20

SITIONING

e model to a Sders obtain wated earlier, tncorporating ne-to-many usrganization ofvincing the curs to performin

ess stories. M

olve around ter cost selling ower than thase of field sale challenging. e an order ofus an inside saon need to beer and determmultiple of the

006 2007

Ult

006 2007

As

G TO A S

SaaS model isill not be achithe conversion1) a completesage model, 2f the selling prrent customerng open heart

Material value

the success model.

at seen in es forces As shown

f ales force.

etter mine if the e cost to

2008

imate Software

2008

spen Technology

SAAS MO

s not a small oieved until then is not simplye re-architecti2) a change inrocess. And tr base to adot surgery whil

e can be creat

2009 2

2009 2

y

FIGURE 8: CU

The Next

DEL

or easy endee conversion py changing theing of the offn the developthose are just opt the changee the patient

ted once the t

2010 201

2010 201

STOMER ACQU

t Generation o

avor. Becausprocess is neae method thatering for ease

pment process the internal ce without crea is running a m

transition prov

1 2012

1 2012

UISITION COS

of Software

Page 10

se of this, ar t revenue e of for rapid changes ating marathon.

ves

TS (SKOK)


Page 11

LESSONS LEARNED

Though a number of lessons learned are listed below, the overarching lesson needs to be highlighted upfront to accentuate its importance. Build for category leader status early or risk becoming one of the crowd. As the SaaS ecosystem matures and provides the necessary infrastructure (e.g. PaaS and IaaS solutions) to allow vendors to worry less about database development, OS and hardware permutations, SaaS vendors can focus on iterating the feature set of an application much faster than a traditional software vendor. This will lead to a more competitive environment, making category leader status harder to obtain but worth so much more.

Not meaning to diminish the importance of the technology offering, the above commentary makes it vital to place significant effort into developing the brand image and marketing it aggressively. As stated by more than one CEO of a SaaS company, your first hires better include a UX graphics designer and a marketing department.

NEGLECTING THE LOW END

Don’t neglect the small/mid business segment. There are examples within the public markets of SaaS vendors that have either intentionally or by chance moved their product to the higher end of the market, leaving behind the small and mid sized customer opportunities. The result in most cases has been two fold; it drives a need for more services offerings to placate the large users as they have become a bigger portion of your revenue, and it provides an opening for someone to develop a lower cost solution below you. Responsys and Demandtec serve as examples. They both built high end and sophisticated solutions but in both cases, relied on a set of larger customers set to grow their business, resulting in a product that required larger upfront sales support and more services to produce the anticipated value. By making a concerted effort to reach the smaller customer set, it forces the SaaS vendor to architect the product for simplicity, leveraging low cost implementations and pull type sales models. It lowers the barrier to experience and lessens the chances of competitive encroachment from below.

TOO PROFITABLE TOO EARLY

Gain comfort with the profitability of an individual customer. Develop metrics and controls in order to obtain this comfort. Once you recognize the LTV of a customer, you can scale your sales efforts accordingly. Your valuation is much more dependent on your competitive position and growth than it is on your current profitability. Too many cases demonstrate that focusing on profits rather than growth in the early phases will cause a wake-up call later on and a need for aggressive investment. Your current investors may not like the idea of added dilution and continued loss generation but it must be stressed that, especially in the SaaS marketplace, the level of success is dependent on competitive position.

BEWARE USAGE BASED PRICING

The best quality of a SaaS model is it inherently aligns the interests of the customer and the vendor. On the surface, usage based pricing appears to fit that but it actually exposes a future point of contention. Unfortunately, it opens up the door for too much discussion around value-add. It takes your discussion from a revenue enhancing, labor reducing method of gaining best practices to a pure cost negotiation as you have done the work of converting your value into a direct cost component of the customers offering. It will be hard to express value-add to the customer when they start asking for unit cost levels within an RFP.


Page 12

OVERAGES CAN CAUSE DISCONTENT

The wireless operators have moved away from this and so should you. Bill shock, lack of clarity of cost structure will only produce added work and pain. A SaaS vendor’s customers understand that a SaaS business is one that benefits from scale, so attempting to convince them that overages should cost them more is a tough negotiating stance. Wrap it in, become a partner where alignment of objectives is clear.

BEWARE INFRASTRUCTURE LOCK-IN

The development and deployment of application logic is becoming much easier with the introduction of Force.com, Azure, and AWS to name just a few. Through the use of these infrastructure solutions, startups can achieve a faster ramp to revenue utilizing a lower level of capital deployed. However, there is a cost: dependence. It is important to separate the strategy of building a product on these platforms versus building a company on these platforms.


Page 13

CONCLUSION

As with any company, the goal is to grow the customer base profitably. For a SaaS company, that desire is no less true. However, the characteristics of the model, the immaturity of the market, and the large size of the opportunity require a deeper level of understanding around that goal. The speed of evolution within the market and rapid innovation of feature sets combined with the high level of stickiness drives a need to accelerate market penetration. This penetration will come about through driving a lower barrier to experience and a low cost sales methodology, leveraging the ease of use and an increased focus on taking marketing efforts deeper into the sales cycle.

The opportunity is large and ripe for a SaaS approach. Given the large installed base of aging computing infrastructure, the dramatic changes brought on by mobile, social, and the cloud, and the recognition that internal IT departments do not have the time and resources to respond to these changes, the opportunity of the land grab cannot be sacrificed by the desire to drive near term profitability. The accounting of profits needs to be viewed on a longer timeline as the profitability of a customer is defined by the duration of engagement and the cost to acquire, not the ability to cover current year expenses.

There are few business models within the technology sector that allow for better alignment between long term value creation and customer success. The Software-as-a-Service model allows for a logical and disciplined approach to drive long term sustainability when operating metrics are appropriately managed. By paying attention to and accurately measuring the lifetime value and the cost to acquire a customer, executives of SaaS startups can refine their actions to drive optimal valuations.

A

GC’S EXPPERTISE INN SAAS

The Nextt Generation oof Software

Page 14


Page 15

IMPORTANT DISCLOSURES

This document is intended to serve as information only, and to suggest that further analysis and consideration may be warranted. Unless otherwise indicated, AGC does not believe that the information contained herein is sufficient to serve as the basis of an investment decision. There can be no assurance that these statements, estimates or forecasts will be attained and actual results may be materially different. Only those representations or warranties which are made in a definitive purchase agreement will have any legal effect. To learn more about the company/companies that is/are the subject of this commentary, contact one of persons named herein who can give you additional information.

The Next Generation of...

Documents

Transcript of The Next Generation of...