Up in the air: Key value drivers for sellers in the cloud and SaaS markets

Thought Leadership on Growth to Exit Strategies presented by Falcon Capital Partners, LLC.

Technology drives business innovation, and the last several years have seen businesses rapidly adopt innovations around cloud computing and software as a service (SaaS) technology.

Companies continue to move away from big infrastructure investments in favor of cloud-based systems. Last year, more than 40% of the respondents to a Computerworld forecast survey said their organizations will spend more on SaaS and a mix of public, private, hybrid and community clouds. In another recent survey of CIOs, CSC finds that IT leaders in government and the private sector continue to invest heavily in the cloud, with both private-cloud and hybrid-cloud management viewed as strategic priorities.

We are all running to the cloud, and that’s great news for SaaS software and cloud service providers.

Your company’s value drivers

So if you are a CEO of an SaaS or cloud firm, how should you measure company performance so you can drive revenue, margins and the right employee behaviors?  Let’s talk about some key metrics that drive value for these kinds of companies.

The four drivers of a company’s valuation are its growth rates for revenue, market share, margins and profits. Recurring revenue and customer diversification are other very important gauges. How well you are doing with these measures reflects on both the strength of the management team and the solution set your firm provides.

But what about more detailed metrics? What should a CEO measure at a more granular level?  Let’s look at the line-up of core SaaS/cloud business metrics CEOs should measure and incentivize their teams to achieve.

First up, recurring product revenue. Recurring revenue, or the repeating monetary value of a customer on a contract, is measured annually (ARR) and monthly (MRR) on a GAAP basis. Tracking this by customer is a must. Measuring the growth in ARR and MRR will provide an excellent indication of the health and momentum of the firm. One mistake people make in measuring recurring revenue is counting nonrecurring fees such as setup fees, consulting fees, training, etc. Don’t do this. The focus is on SaaS product or cloud service recurring revenue!

Another revenue metric is “total contracted revenue.” Total contracted revenue (TCR) is a significant measurement. It reflects the total financial commitments a customer has with a vendor for the life of the contract, which could be several years. Take note: Contracted revenue is different from annual revenue, which is governed by GAAP. Finally, total contract value (TCV) is a measure that includes the total value of the contract and, unlike ARR or MRR, includes the value of one-time charges for professional services, setup, training, etc. Growing TCV means you are delivering more value to your clients in the way of new features or options and, in return, they are paying you for it.

Secondly, billing are an excellent growth indicator for a cloud company. New and high billings mean that one or all of several (good) things are happening. New business, new customers, upsells, renewals — all these will increase billings. What’s more, billings can help you understand growth, whereas just tracking revenues can’t. ARR and MRR are recognized ratably and can show a very stable revenue stream that is simply working off deferred revenue or the billing backlog. Track billings, as they are an excellent forward-looking indicator.

Margins and the top line

Let’s talk about gross profits or gross margins. The above measures focus on the top line, and a growing top line is very good. Top-line revenue less cost equals profits. Profits turn into cash. Cash is distributed back to shareholders or back into the business to make the firm more productive (add employees, more assets, computers, systems, etc.). Your top line needs to be profitable. Therefore, costs need to be captured at a very complete level so you understand all of the cost-of-goods-sold (COGS) line items very well! Track gross margins by product line and customer. You need to shoot for 80% gross margins. A firm’s ability to grow and find economies of scale while maintaining high margins is extremely desirable to any investor, shareholder or acquirer, and will lead to very generous multiples.

Cash is king. However, for younger firms, burning cash is both a concern and part of the growth effort. The typical pattern is to raise capital, use capital to build the business, and then create positive cash flows before the capital runs out. Since SaaS and cloud-computing companies have high upfront costs and the revenue stream is on a delayed and back-loaded basis, managing cash and the burn rate is critical.

Customer: Lifetime value, cost and payback

Customer lifetime value (CLTV or LTV) is the present value of future net profits from a customer over the life or duration of the contract or relationship. LTV determines the value of a customer over time, and how much net value a firm generates per customer after customer acquisition costs (CAC).

Related to LTV and the burn factor are CAC and the CAC payback. CAC is the expense associated with signing up a new customer: advertising, commissions, sales salaries, overhead, etc. Including the CAC and any future growth capital needs, knowing the burn rate and exactly how much cash it takes to operate the business is critical information. CAC payback measures the amount of time it takes for your business to recoup the money spent on this acquisition. A CAC payback metric of 12 months is good, and it means that the company will be profitable within a year. Given the heightened importance of cash in a company based on subscription revenue, often distributed over a long contract term, the key value drivers of burn rate, free cash flow, CAC and CAC payback are critical.

These are just a few examples of key metrics for cloud and SaaS firms. As with any metric, data and detailed data capture are key. A CEO needs a granular set of accounting books, and excellent accounting methods and controls to be able to calculate metrics. Get yourself a good controller and an experienced external accounting firm that is knowledgeable with software and tech-service accounting rules and methods.

The total market cap of public cloud companies jumped from less than $25 billion in 2008 to nearly $180 billion last year. Private cloud companies are valued at $1 billion. This trend will continue.  Investors seek well-run firms where the accounting is GAAP, the numbers are clear and well documented. Strategic acquirers look to capitalize on the recurring revenue streams of a smaller company to boost their customer base with cross-selling opportunities. Measuring and understanding the key value drivers of your business is critical for driving your firm’s revenue, profits and shareholder value.

In summary, get your accounting grounded so you can capture data and calculate the metrics that will help you drive growth and shareholder value skyward.

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