Transitioning to a SaaS business model can create huge value for your business, but success depends on addressing six key criteria, says Lyceum Capital partner Martin Wygas.

It is no secret that the market is moving toward the software as a service model, with SaaS products encompassing every aspect of business services from customer acquisition and marketing to delivery and operations.

For the customer, buying cloud-hosted, subscription-based software in place of on-premise licences has several clear benefits: faster and more cost-effective deployment, always-on access, greater update frequency and integrity, more flexible usage and costing, as well as reduced infrastructure costs with improved IT security.

For software businesses, the rewards from adopting a SaaS model are equally compelling. Among them are higher quality recurring revenues with greater forecasting visibility; increased direct engagement with the user and better customer alignment; boosted sales, including cross and upselling; lowered customer churn; potential efficiencies in development and support; and an ability to scale faster.

However, simply switching to a SaaS pricing scheme won’t deliver a full SaaS transition. It requires you to review and change your business model and create a SaaS culture. This includes how you incentivise your sales force, the approach you take to development and how you track and report performance metrics. It also involves scrutinising how you communicate internally to ensure employees are on the same page, and, externally to stakeholders to explain how you are driving growth.

Therefore if you are an owner of an on-premise software business, you need to assess the impact SaaS will have in six key areas.

1. Size

As in other sectors, buyers pay for size. SaaS businesses of scale are scarce, and therefore attracting an enhanced premium.  You need to feel confident that a shift to SaaS will help you create a business with annual recurring revenues of well over £10 million.

2. Historical growth

Track record counts, with buyers willing to pay a premium for companies that can show year-on-year revenue growth of at least 20 percent. Our research indicates that businesses with mean historic growth of 27-35 percent are typically valued at a healthy 3-5x revenue or above.

At the other end of the scale, SaaS businesses that grow at less than 10 percent year-on-year are unlikely to achieve much valuation uplift.

Of course, the timing of your SaaS transition will impact revenue growth. Therefore your business will need to learn how to track growth metrics other than delivered revenue. Annual or monthly recurring revenue and bookings are the most frequently used lead indicators of future revenue growth.

3. Profitability

In addition to growing fast, companies attracting premium valuations also have a proven ability to deliver profit growth. A common rule of thumb is the so-called “Rule of 40”, whereby combined EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) and year-on-year growth figures equal 40 percent or more.

Undertaking a SaaS transition will naturally lead to some level of in-year revenue and profit compression and maintaining profitable growth throughout the transition can be a challenge. However, there are some measures you can take to protect EBITDA and cash flow during this period:

• Planning – Develop a clear plan that examines the impact on all aspects of the business and creates a clear pricing structure that includes minimum number of users and contracts term to ensure a floor to your SaaS pricing.
• Controlled and limited launch – Launch your SaaS offering across a limited customer set either regarding geography, vertical or product set. You can then build credentials while confirming market pricing for your product.
• Hosting – Carefully choose the right partner for your hosting needs regarding scalability and pricing structure.
• Cashflow management – Start invoicing annually in advance: when a customer’s environment goes live in your hosted environment and not at full customer go-live.
• Customer success – Offer tiered support on new sales and at the highest level, a dedicated, onsite customer success manager who will also be able to drive further upsell opportunities.
• Upgrades – Put in place a stratified approach for existing customers and a payback pricing plan to switch to SaaS (a 50% uplift on existing support is a standard target).

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4. Quality of earnings

Recurring revenue is key to obtaining a premium valuation for your business. Those with 75 percent or more of recurring revenue and new sales predominantly on a SaaS basis can expect an uplift in value. But, when assessing earnings quality, it is not enough to simply focus on the headline percentage of recurring revenue. Management must also examine the contribution from each revenue line. Businesses that do not generate a gross margin more than 85 percent on SaaS sales (taking into account all related hosting and other infrastructure costs) will not get the full benefit of an uplift in value.

5. Scalability

Your business must be positioned to grow in terms of technology and people. Its software platform and infrastructure need to be secure and able to scale in line with the growth of the business. This means fully embracing SaaS as a business model and not just a revenue model. A key component of embracing SaaS scalability is a focus on improved sales effectiveness. Starting to measure and manage against SaaS KPIs, such as customer acquisition cost (“CAC”) and customer lifetime value, will help illustrate the scalability of your business.

6. Growth potential

Businesses targeting a sizeable or fast-growing market support higher valuations. Adopting a SaaS model can counter the limitations of a slowly growing market by broadening market appeal through new verticals, geographies, and new product lines.

By delivering increased functionality and exploiting cross and upselling avenues, you can alleviate market pressures and grow by increasing average revenue per user from existing customers. A structured and well thought out approach to upgrading an installed on-premise product to a new SaaS offering can reap great rewards. And continuous focus on existing customers will promote another highly valuable SaaS metric:  negative customer churn.

Shaping a customer-centric SaaS strategy that addresses most of the above criteria is not simple and, as experienced software investors, we know that access to additional capital and a ready network of industry experts can be the difference between steady growth and the emergence of a market leader.