A SaaS-y Story: Head in the “Cloud”
An attempt to understand Software as a Service
We debated internally whether to split this piece into one or multiple parts and whether anyone really wants to read long form posts anymore. In the end, we decided to keep it as a single-scroll post since nobody reads our blog anyways🤷
We’ve divided it into multiple segments though, so should some unfortunate soul stumble upon this corner of the internet, they can treat it as a “choose your own adventure”-style book rather than one lengthy blog post. Here’s the breakdown:
- Overview (Understanding “SaaS”)
- Industry Size & Landscape
- How to Analyze SaaS Companies
- Achieving Scale: Growth vs Burn
- Investment Trends (and Key Investors)
- Valuation Overview
- Closing Thoughts
Bear with us for this extensive piece. Let’s get started.
1. Overview (Understanding “SaaS”)
Why is everyone suddenly interested in “SaaS”? Turns out, it’s not all that sudden. While SaaS’ appearance on Indian Venture Capital radars may be a recent phenomenon, “Software as a Service” has been around for a while. Microsoft first referenced it all the way back in 2007 as (the admittedly less fashionable sounding) “software plus services.” Four years later, Marc Andreessen published his now-iconic “Why Software Is Eating the World” article. In it, he argued that unlike the dot-com bubble of the 1990s, many of the newer Internet-driven companies were building high-growth, high-margin and highly defensible businesses.
Andreessen (correctly) believed that not only had the technology required to completely transform industries finally arrived, but that it could be delivered at a global scale. In a fully digital world, internet/software companies would gobble up traditional businesses at a rapid pace.
Fast forward to today and software continues to chomp through the world and Andreessen’s predictions stand validated. Today’s largest companies such as Amazon or Google are essentially software companies. Their core capability is the software engine that powers the marketplace or the search platform. Technology’s growth has always been fast and software continues to disrupt, amplify and enhance (eat?) vast swathes of industries and sectors. Only now, software has moved into the cloud.
Enter SaaS. Simply put, Software-as-a-Service is a distribution method where the software is centrally hosted on a ‘cloud’ which enables consumers to pay for it like any other consumption-based service. Think of it as ‘on-demand software’ that is accessed via the internet instead of being natively installed on your device or at your office premises (aka ‘on-prem’).
From a customer standpoint, the benefits of such a model are obvious.
- No major hardware installations — leading to faster deployment, lower upfront costs and no capital expenditure requiring depreciation of assets on the balance sheet
- Automatic & over-the-air updates — always ensuring the most up-to-date and secure version of the software is running on your system
- Scalability — a flexible, “pay as you go” system based on your requirements/usage (e.g. number of users, the volume of data, the functionality required etc.) makes it much easier to scale
- Accessibility — as everything is on a cloud, it significantly improves accessibility compared to an ‘on-premise’ solution
Earlier, only large companies could deploy software at scale. But SaaS has “democratized” that process leading to SMBs and mid-market firms enthusiastically adopting SaaS. The advent of Covid-19 has accelerated adoption even further.
The growth of SaaS in India has been fueled by:
- Increasing broadband access, improving internet infrastructure and cheaper data and hardware costs
- Regulatory requirements requiring stricter data controls and higher security
- Increasing IT spends by companies and attempts to migrate from legacy systems. This push towards digitalisation was accelerated by the global pandemic
2. Industry Size and Landscape
SaaS in India is estimated to hit ~$50 billion of annual recurring revenue (ARR) by 2030 as per a report by Bessemer Venture Partners. India is currently estimated to have around 1,000 SaaS startups of which ~18+ are unicorns. Startups like Amagi, Yubi, LeadSquared, ShipRocket, DarwinBox, Uniphore, CommerceIQ and Hasura became unicorns in 2022. Thus far, there have been no new SaaS unicorns in 2023. In fact, other than Zepto, the Indian ecosystem has not seen any unicorns this year.
The same BVP report mentioned above also neatly classifies the Indian SaaS opportunity landscape into 4 separate categories with examples in each as shown below.
3. How to Analyze a SaaS Company
Given the tailwinds in SaaS, it would be prudent to study the business models in order to understand if a company is worth investing in. The key to analyzing any SaaS business would be to answer a few key questions, namely: (1) Is there a demand for you SaaS product? (2) Is your growth trajectory sustainable? (3) Is your growth trajectory eventually profitable? (4) Is the business operating efficiently? The below metrics help gauge answers to all of these and thus should be critical part of any SaaS company analysis.
Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR)
MRR is simply the average monthly billing value multiplied by the total number of customers for a month. Note the word “recurring” meaning it should exclude any one-time and professional service fees. This is a key metric because how quickly the MRR grows month on month (or quarter on quarter), is the most obvious indicator of your product-market fit. The better your product, the higher the demand, the higher the MRR.
ARR is simply the currently recognized recurring portion of this monthly revenue, multiplied by twelve.
Gross Margin
Gross Margins are simply your sales less all direct cost including those related to hosting, data communication, direct customer service, credit card processing & any embedded third parties services. Most SaaS businesses enjoy margins as high as 70–80% so this is a quick and dirty indicator of the efficiency of your operations.
Customer Acquisition Cost (CAC) & CAC Payback Period
Customer acquisition cost or CAC should be the full cost of acquiring users, stated on a per user basis. This means you add up all the costs involved, from sales to marketing including any referral fees, credits, or discounts. While most companies take into account blended CAC [total acquisition cost / total new customers acquired across channels], this doesn’t given any indications of how well your paid campaigns are working and whether they’re profitable. So if you wish to go one level deeper, you could consider paid CAC [total acquisition cost/ new customers acquired through paid marketing i.e. excluding users acquire organically].
CAC payback period is the number of months required to earn back the upfront customer acquisition costs. A lower payback period indicates your ability to recoup your costs faster.
Customer Lifetime Value (LTV)
Lifetime value is the present value of the future net profit from the customer over the duration of the relationship. It helps determine the long-term value of the customer and how much net value you generate per customer. A common mistake is to estimate the LTV as a present value of revenue or even gross margin of the customer instead of calculating it as net profit of the customer over the life of the relationship.
Churn
Churn is viewed in terms of customers and revenues. Customer churn indicates how many of your customers drop away in any given year and thus when does any particular cohort completely exit the business. (e.g. a 25% churn indicates that your current customer base will be completely gone in 4 years). Revenue Churn is the loss of revenue from downgrades plus any lost revenue due to customer churn.
The predictability of your revenue is directly correlated to your churn rate making it the most important metric for SaaS.
Net Dollar Retention (NDR)
Net Dollar Retention is you ARR + all upgrades — all downgrades — any churn all divided by beginning ARR. A healthy SaaS business has net dollar retention over 100% because upgrades in the customer base are outpacing churn and downgrades. This is an important metric because it shows you how much growth a SaaS company is achieving regardless of whether they acquire any new customers.
A rule of thumb followed by VCs while investing in SaaS companies is to look for gross margins of ~80–90%, LTV to CAC ratio >3, CAC payback <9 months, churn rate <10% and NDR of 110%+.
From a VC/PE investment perspective, SaaS companies give better returns than their high cash burn B2C counterparts given their predominant B2B nature. They also have high gross margins and provide predictable, recurring revenue. But does this mean they can scale?
4. Achieving Scale: Growth vs. Burn
Achieving the first $1–2 mn may be (relatively) simple but scaling your company from there to $100 mn and beyond is incrementally more difficult. Neeraj Agrawal of Battery Ventures believed that breaking down the journey into distinct phases of growth lays out the pathway for scaling much more clearly. He called his playbook the “T2D3”.
“I believe there are seven key phases in SaaS companies’ go-to-market success. Most of the phases center around a mantra I call “triple, triple, double, double, double,” (T2D3 for short), referring to a company’s annualized revenue growth.” — Neeraj Agarwal, Battery Ventures
Applying the above and tweaking the company’s strategy at each phase (such as adjusting your sales process, growing your team strategically, expanding internationally etc.) can take the Annualized Revenues from $1–2 mn to $100 mn in 5–6 years. A $100 mn revenue should then be enough to earn a $1 bn valuation and achieve that infamous unicorn status (theoretically, before the SaaS meltdown).
The below chart shows select well-known, public SaaS companies, each of whom roughly followed this 3x-3x-2x-2x-2x curve to achieve stellar success.
Inevitably, most SaaS companies burn cash as they grow. They have to, as do most startups in the initial stages. But what is the acceptable level of burn? Sammy Abdullah has done a great analysis where he looked at the last 73 SaaS IPOs since 2017 to find out. His findings — given below — show that on average, SaaS companies have a Revenue-to-Burn ratio of 3.5:1. In other words, for every $1 of operating loss, these companies generate $3.5 of revenue on average.
Note that while the median is 3.5x, the average is materially higher at 5.5x.
Efficient growth is when growth in topline reflects the cash invested in the business. Companies can only justify higher burn rates if they also showcase rapid customer acquisition and significantly higher revenue growth rates. Finding the right balance between growth rate and burn will be ever-changing and potentially a life long endeavor.
The most obvious takeaway here is that a clear path to profitability with a focus on efficiency and other metrics can help drive a company towards sustainable, profitable growth.
5. Investment Trends (and Key Investors)
In line with global trends in SaaS and Technology, investments into Indian SaaS dropped ~81% to $635 mn in the first half of 2023 compared with the massive $3.4 bn seen during the same period of 2022. Moneycontrol reports that while the first half of 2022 witnessed ~147 deals, 2023 saw the number fall to less than half (at about 70).
However, investments do continue, especially in the early stage space. Some of the most active investors in SaaS are given below. Accel at one point had over 40+ SaaS or SaaS-affiliated companies in their India portfolio.
More recently, Avataar Venture Partners is a fund focused only on SaaS. As per Venture Intelligence data, Peak XV (earlier Sequoia Capital), Better Capital and India Quotient were among the top active investors in SaaS in the first half of 2023.
6. Valuation Overview: How to Value a SaaS Company
SaaS businesses are valued on a multiple of their revenue. In most cases, it is the projected revenue for the next 12 months (or NTM). As there are no pure-play listed SaaS players in India, we need to look abroad for valuation guidance. The USA is the most advanced market in the world for listed SaaS and serves as a good yardstick for valuation using a “trading comparables” approach.
The multiples shown below are calculated by taking the Enterprise Value or “EV”(market capitalization + total debt — cash & cash equivalents) and dividing by the average of the forward estimated sales i.e. the “NTM Revenue”.
The overall stats (as of September 15, 2023) show the overall median NTM Revenue at 6.0x and overall average at 6.5x
However, if the companies are bucketed by NTM revenue growth, wherein high growth >30% , mid growth 15%-30% and low growth <15%, we start seeing a stark distinction in multiples.
- High Growth Median: 12.9x
- Mid Growth Median: 8.6x
- Low Growth Median: 3.9x
This clearly shows that companies with higher estimated sales potential are rewarded with a higher multiple (~3–4x more) than those without.
Venture Monk Tip: Meritech Capital also has a great free resource for Enterprise SaaS cos valuation and other benchmarks which can be viewed here. In this, you’ll find KPIs (key performance indicators) and valuation metrics for 50+ public SaaS and cloud companies, updated regularly. (You’re welcome.)
Alongside multiples of listed SaaS companies, public SaaS acquisitions multiples are also another way to look at valuing a SaaS company. Below is the data for all public SaaS company acquisitions since December 2020, once again from Sammy Abdullah.
The businesses (as of August 2023) on average sold for 8.9x trailing twelve month (TTM) revenue of with YOY growth of 20%.
7. Closing Thoughts
The industry is expected to follow trends like in mature markets suggesting M&A being a more common form of exit for early investors. The current liquidity crunch is actually expected to fuel M&A activity. Indian SaaS is expected to provide attractive acquisition opportunities, given the high growth but tempered with capital efficiency profile of most domestic SaaS companies. In light of the subdued valuations, large capital efficient Indian SaaS companies are also likely to use the inorganic route to consolidate their market position and/or enhance their product capabilities.
There is significant amount of private capital also available in the market for SaaS companies (or at least there was until the start of the current subdued macro climate).
“There is significant dry powder build-up with SaaS-focused Indian VCs/PEs who had cut back on investments and moved focus to companies with strong unit economics. For Indian SaaS companies with a demonstrated path to profitability, this presents an opportunity to raise capital at favourable terms and double down on growth.” — Ernst & Young
Venture Monk’s view is that SaaS has secular growth trends both globally and in India. Companies will continue to outsource non-core IT activities to specialist service providers who can do it better. The key for operators would be to find emerging categories to play in and tap previously under-served sectors. For instance, Vertical SaaS and Mobile SaaS are two new growth areas where Indian companies can look to enter. With the rise in technology and use of SaaS, areas such as Cybersecurity and DevOps are also emerging. Technologies like AI could also play a huge role in the future solutions deployed by the IT companies.
Most SaaS companies looking to target the Indian SMBs face dual problems of finding the right product-market-fit and the inability of SMBs to pay. India is still maybe a few years away from being a lucrative market as customers are currently unwilling to pay. Until the ARPU catches up with the rest of the world, the GTM must remain a mix of domestic and foreign markets with a strategy individually tailored for both. However, to truly win in this space, product innovation is key. Any SaaS business needs to have people with deep domain knowledge. Pricing is not a long term moat in technology and will never be. The biggest strength of Indian SaaS is a big talent pool capable of developing globally competitive solutions. That they can do it at a lower rate (up to 15–20% lower!) is merely an added advantage and not a feature itself. Unless this talent is harnessed correctly, India will forever remain a secondary player in the Global SaaS markets.
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