Having survived the Great Recession, the Software-as-a-Service (SaaS) business model is entering the realm of mainstream IT buyers. SaaS has become the model of choice for most new software ventures. As we predicted in late 2007, valuation multiples of public SaaS companies declined to near parity with valuation multiples of traditional enterprise software (on-premise) firms during the economic crisis of 2008 and early 2009. In the past 18 months this convergence was broken as equities of SaaS companies rocketed forward with an average appreciation of over 44% during the past 52 weeks and some firms showing triple digit percentage gains. Several SaaS firms now sport Ev/Sales multiples of 11X revenue and greater. Taking a checkpoint on the SaaS scenario for the next 52 weeks and beyond, we believe there are several key questions worth examining:
- Are the current SaaS valuation multiples sustainable? Are SaaS companies overvalued? If so, which ones? Are any SaaS companies undervalued?
- What is the right valuation methodology for a SaaS company?
- Are enterprise software companies closing the valuation gap or are they destined to permanently trail behind?
- Will SaaS companies close the profitability gap relative to enterprise software, or is the SaaS business model inherently less efficient?
- What drives valuation of software companies (SaaS and enterprise software alike) today?
In a recent research report: "SaaS Valuation: What Price is Right?" we analyzed valuation and operating performance parameters of 103 publicly listed software companies, of which 19 can be classified as SaaS companies (and a few more would lay claim to being SaaS). We tallied the performance, operating efficiency and valuation drivers, and found some surprising results.
SaaS companies continue to hold a valuation premium to enterprise software companies. This gap has been driven by SaaS growth characteristics. However, enterprise software companies are presently closing the short-term growth gap. One could attribute this to a post-recessionary bounce or anything else, but the short term growth of enterprise software companies is now within striking distance of many SaaS firms. Despite narrowing the gap in growth, the valuation gap remains as wide as the Amazon during the rainy season. As of March 9, 2011, the average SaaS company commanded a Price/Sales multiple of 5.45, up from 3.15X in mid 2009. In comparison, the average Price/Sales multiple for enterprise software firms rose from 2.84X to 3.97X. SaaS revenue multiples rose by 73% from mid-2009, while enterprise software multiples rose by about 43% during the same period.
The single biggest driver of valuation multiples for SaaS companies appears to be revenue growth. Company size continues to matter for SaaS companies as larger cap SaaS names outperformed their smaller rivals. Profitability, efficiency and cash flow are mostly ignored by SaaS investors, at least for now. Given the SaaS growth profile, this may be fine, - as long as markets continue looking the other way and interest rates are low. Yet, lack of efficiency is typically something that stays with companies and is often part of the corporate DNA. To put it mildly, it will be pretty tough to change it if the economic environment sours or investor scrutiny sharpens.
Operating profitability of SaaS companies continues to lag. Given the impressive growth of SaaS firms, investor concerns, if they do exist, are seemingly taking a back seat to the argument for investing in growth and taking market share. Given the nascent nature and low adoption rates of SaaS, this idea still has legs. One could argue that SaaS companies do not become a meaningful business until they reach $500Mil in revenue and are till then, for all intents and purposes, publicly trading venture stage companies. Theory aside, history of the software industry shows time and again that delivering profitable growth is a management discipline learned at a young age. Businesses that eschew profits for maximum growth are often unable to deliver consistent profitability. Whether it is a management discipline problem or a business model flaw is difficult to determine, and beside the point for shareholders. There is no real reason why a $200 million software company cannot grow the top line 30% or more and also deliver a modest level of profitability.
In assessing all the data, it appears that relative to historical performance norms, valuation multiples for all software equities are stretched and look vulnerable in the short to mid-term, especially if Q1 2011 numbers and/or guidance come in light. Some of the higher multiple, low MGI-score SaaS equities like SuccessFactors and others, could be particularly effected by an investor pullback. At present, there appears to be little room for error in managing these high-growth, high multiple companies. We estimate that barring any exogenous negative events, SaaS companies have about nine to twelve months to get their act together with regard to profitabilty. In twelve months or less, we will likely see a fresh crop of social media companies with explosive growth coming public - companies like Groupon, Facebook, and Twitter. When they do, the high multiple torch and attendant investor interest will pass from SaaS names to the new investor favorites.
For content of the full research report on SaaS Valuation, visit our website.