David Cummings on Startups

SaaS Valuations Driven By More Complicated Metrics

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David Cummings

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Andreesen Horowitz has a great new piece up titled Understanding SaaS: Why the Pundits Have It Wrong. The idea is that SaaS valuations are under intense scrutiny due to the recent run up and down in the public markets. In reality, SaaS companies have financial models and metrics that are more difficult to understand when compared to traditional software companies. With a traditional software company, you spend a ton of money, close a deal, and collect the majority of the lifetime value of the customer immediately. With a SaaS company, you spend a ton of money, close a deal, and then collect a small portion of the lifetime value every month for (hopefully) several years. Financial statements for SaaS companies look worse compared to traditional software companies, yet the business model is significantly better.

Some key points from the Andreesen Horowitz article on SaaS:

  • More growth requires more capital as money is spent to acquire and onboard customers, yet customer payments are spread out over an extended period of time
  • R&D is much more efficient for SaaS companies due to having a single code base as opposed to lots of different versions of a product
  • Metrics like lifetime customer value, cost of customer acquisition, churn, and billings are critical for SaaS companies, yet difficult to discern from financial statements

SaaS and subscription-revenue entrepreneurs would do well to read Understanding SaaS: Why the Pundits Have It Wrong.

What else? What are some other takeaways from the article and reasons SaaS companies aren’t as well understood?

Comments

4 responses to “SaaS Valuations Driven By More Complicated Metrics”

  1. Guillaume Lerouge (@glerouge) Avatar
    Guillaume Lerouge (@glerouge)

    One of the key insights from the article to me is the recommendation to look at billings and deferred revenue rather than only revenue recognised during the current FY. Combined with the churn rate, those are the best indicators of the health of a SaaS company.

    What’s not clear from the article however is the total duration of the initial investment period. For a company like Salesforce, investors have been putting money in the company for 12+ years and it’s still barely profitable? Maybe the horizon of investment is simply too long for most investors, which would explain why they don’t feel comfortable about SaaS companies.

    Reply
  2. anandthaker Avatar
    anandthaker

    One of the biggest challenges for the street is differentiating between companies in the ‘cloud’. Companies like Salesforce.com are lumped in with Rackspace or Amazon vs Facebook. There is much confusion in the basics and its challenging for investors to be educated with that kind of fud.

    As an investor for many years, Salesforce and Amazon are constantly building an ecosystem for customer retention. That takes investment and as Guillaume correct pointed out maybe a long a horizon for most pundits to talk about in a consumable TV segment.

    What do you all see regarding the confusion in the cloud ?

    Reply
  3. Jeff Mikes Avatar
    Jeff Mikes

    As usual, AH nails it. The VC community certainly understands SaaS economics – not sure why knowledge of the critical metrics hasn’t passed to Wall St analysts yet.

    I felt they glossed over the importance of keeping a close eye on R&D spend and its outcomes. Yes, SaaS R&D should be more efficient than traditional software. But sometimes it can churn through cycles of additional features and functions without really adding to the customer experience/utility – and sometimes even degrading it. Haven’t figured out a solid metric yet on R&D spend effectiveness in driving sales and customer satisfaction but obviously they’re linked.

    Another challenging aspect of SaaS economics not addressed in the standard metrics is the cost and success of implementation efforts. If done by in-house proserv teams this work can become a de facto cost (and revenue) center. I’ve seen implementation costs rolled into Sales & Marketing expense since you can’t get to the recurring revenue stream without them, but not sure this is the best way to track the effectiveness of the actual implementation teams in getting the clients up and running.

    Reply
  4. lanceweatherby Avatar
    lanceweatherby

    My thoughts are a little too long to articulate in a comment. TLDR version is costs are spread out more than what the AH article would imply and some of their assumptions seem off. Here is the longer version: http://bit.ly/RWi8ew

    Reply

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