Earlier this month, the CrowdStrike system corrupted update affected 8.5 million computers, marking the largest IT outrage in history. This raises the question – how can a software company trigger such a widespread “butterfly effect” on systems worldwide? The “leverage” effect stems from the “Software-as-a-Service” (SaaS) model: As a SaaS company in the cybersecurity industry, CrowdStrike offers cloud-based security solution, major clients of which are involved in critical services, amplifying the economic and social impact of disruptions.
This is a vivid example to illustrate the key differences between SaaS and traditional software. Though may offer similar functionalities, SaaS providers have greater ability to exert influence on clients’ systems: An essential feature of SaaS is its “cloud-hosted” nature, where system upgrades and maintenance are managed entirely in the cloud. This eliminates the need for local installation and updates on users’ computers, a departure from the traditional on-premises software model.
Take Microsoft 365 or Apple Music as examples – users do not “own” the software, but rather subscribe to access the content and services online. This subscription-based revenue model, contrasting with the installation or implementation fees typically charged from traditional software, is the second characteristic of SaaS.
The cloud-centric and subscription-based nature of SaaS grants providers a higher degree of centralized control. This allows SaaS companies to have a more widespread impact, as seen in the MSFT-Crowdstrike IT outage incident, in a way that on-premises software vendors cannot easily replicate.
Key metrics of SaaS companies
1) Annual recurring revenues (ARR)/ Monthly Recurring Revenue (MRR)
Imagine a SaaS company signs a new 2 million contract worth. Within this contract, 0.8 million is a one-time project implementation cost, and 1.2 million is the annual subscription fee. In this scenario, the company’s Annual Recurring Revenue (ARR) would increase by 1.2 million, and the Monthly Recurring Revenue (MRR) would increase by 100,000 (ARR = 12 * MRR).
By aggregating all the company’s contracts, you can calculate the total ARR and MRR at any point of time. This allows for a clearer understanding of the company’s recurring revenue streams over time.
2) Net dollar retention
The net dollar retention is an important metrics for valuations. A net dollar retention rate exceeding 100% indicates that clients are enhancing their services and investing more on the SaaS products compared with the previous year.
Given that the net dollar retention rate significantly influences the cash flow visibility and sustainability of a SaaS company, a higher retention rate translates to a higher valuation multiple for SaaS companies.
Valuation of SaaS company
Usually, SaaS companies have higher visibility of cash flow thus enjoying higher valuation than the on-premises software. Moreover, valuation gaps exist across different geographical regions. For instance, leading SaaS companies in the United States are valued at 13x-15x Price-to-Sales (P/S) ratios whereas top SaaS firms in China are valued at 3x-4x P/S ratios as of July 25, 2024, as per data from the S&P CIQ database.
1) High growth period
The common valuation multiple would be Enterprise Value-to-Sales (EV/Sales) or P/S. For SaaS companies, the contract revenue will be distributed over the contract period, while R&D/development costs are invested upfront. As a result, in the early stage these companies rarely show profits on their financial statements, leading to cash flow deficits. Additionally, SaaS companies generally have low debt levels, which allows the market to take the P/S ratio as a proxy for EV/Sales in their valuation assessments.
In addition, if a company is transitioning from traditional software to SaaS business, Sum of the parts (SOTP) valuation will be applicable which uses Price-to-earnings (P/E) to traditional software business and P/S to SaaS business.
2) Stable stage
At this stage, the mature SaaS companies would have stabilized 60%+ gross profit margin and 0%-20% net profit margin. As cash flow stabilized, the discounted cash flow method would be applicable to SaaS companies in mature stage.
Why It Matters
- Crowdstrike incident reminds us that SaaS/software services play an important role in our daily lives, nurturing huge markets for different vertical players. A strong SaaS software implies a high-margin business model as well as high valuation multiple than traditional on-premises software business.
- Curious about your company’s valuation? Contact BonVision today for a comprehensive valuation analysis and see how we can help you unlock your company’s true value.