Valuation of SaaS vs. On-Premise License Software
Market Insights - Q4 2014
Recurring revenues dramatically drive valuations up
No one would contest that investors pay more for businesses that generate recurring revenues, but nowhere is that truism more starkly evident than in the software industry. The transition from on-premise licenses to Software-as-a-Service (SaaS) over the past decade or so is not only remarkable in the amount of shareholder value it has unlocked, but also in how much difference selecting the right business model can make.
We here make conclusions based on US data from research firm Software Equity Group LLC to quantitatively support the strategic advice we give to our Canadian prospects and clients alike, regardless of their sector. This is particularly relevant in the context of them considering a potential exit in the coming years, and as they devise their strategic roadmaps to get there.
How big is the valuation gap, really?
Simply put, SaaS businesses are 2.0-3.5 times more valuable than on-premise license software firms. As shown by the grey line in the first two charts to the right, for publicly traded firms over the past five quarters, the ratio of median enterprise value (EV) to revenue and the EV to EBITDA multiples of SaaS firms vs. on-premise license firms were generally within that range, but peaked above 4.0 and bottomed at 1.7.
The third chart to the right shows that ratio holding steady in the 1.8-1.9 range for M&A transactions for which data is available. While the gap is lower in an M&A context (which indeed captures a more relevant set of circumstances for our readers), the discrepancy is still very much there.
This valuation gap is as clear as it gets in terms of evidence of what investors value—there is little doubt that any privately-held business (not just software) that can grow and defend a customer base that generates recurring revenues will be rewarded with higher valuations down the road if it chooses to explore a potential company sale.
Intuitively, it still seems like a big gap. Are there other drivers of value behind the ‘SaaS’ label?
Correct. And the answer is not SaaS businesses being more profitable. Rather, it’s high revenue growth that is rewarded, and it so happens that SaaS businesses on average grow far faster (25.8% TTM revenue growth) than on-premise license software firms (8.0% TTM revenue growth). At the high end of the spectrum, the valuations are truly eye-popping: SaaS businesses with more than 40% TTM revenue growth command a 10.7x multiple on average, and explain nearly all of the gap between revenue models.
The last chart in the bottom right corner shows this in more detail: valuations clearly increase as a function of TTM revenue growth, when they are plotted against one another. Not surprisingly, the ‘lift’ applies to both SaaS and on-premise license, but accelerates greatly for SaaS.
So, does it mean that privately-held software firms should convert all revenues to recurring and grow as fast as possible at all cost?
There is no question that a dollar of SaaS revenues is worth more than a dollar of non-recurring revenues. However, it is also self-evident that not all businesses lend themselves to recurring contracts, so our conclusion to the first part of the question above is “whenever possible”.
The second part of the question is far less ambiguous. Revenue growth is all that matters, in terms of exit values, for only a rarified set of private companies, primarily VC-backed ones. For the vast majority of privately-held firms, profitability is more important, and should be a strategic focus especially ahead of a company sale.