How the Predictability of Revenue Influences Valuation in SaaS
- The difference between recurring, reoccurring transactional and non-reoccurring transactional revenue
- How to frame your revenue data and its predictability
The SaaS subscription model changed the way software businesses are valued. While valuations were once based on P/E ratios, EBITDA, and other profit margin concepts, SaaS businesses trade off of multiples of revenue or ARR (annualized recurring revenue)—a paradigm that has allowed fast growing businesses to achieve premium outcomes.
Why is this the case? The answer is because recurring subscription revenue:
- Is more predictable
- Is easier to grow (i.e. doesn’t start at zero each year)
- Offers greater lifetime value to displace acquisition costs
While revenue-based valuations are common in the software industry, it’s important for founders to know that valuing a company is more than just applying an arbitrary multiple to their total revenue. That’s because not all revenue is created equal.
In fact, there are different classes of revenue, and each is treated differently in terms of valuation. Consequently, a key aspect of valuing a company is appraising its various revenue streams and classifying them into three primary categories, listed below:
- Recurring revenue (most predictable)
- Reoccurring transactional revenue (moderately predictable)
- Non-reoccurring transactional revenue (least predictable)
Why is this distinction important? Because predictable revenue is valued higher by buyers and investors. Consequently, framing the predictability of your revenue streams in a positive and accurate light will have important implications for maximizing your multiple.
Below are clarifications of the differences between each type of revenue, as well as some insights about how an experienced investment bank can help you position your revenue in a way that best highlights predictability.
Recurring revenue is a fixed amount that customers have contractually agreed to pay, such as through a monthly or annual contract.
The recurring model is by far the most desirable type of revenue to investors/buyers, and therefore most likely to attract premium valuations. It is also the most cut-and-dry category of revenue: either revenue is contractually recurring or it’s not. As such, when presenting your business to prospective buyers/investors, you should emphasize what percentage of revenue is contractually recurring (especially if the percentage is high).
While telling the recurring revenue story is fairly simple, your approach to positioning transactional revenue will also present a great opportunity to improve the outcome of your transaction.
Transactional Revenue (Reoccurring and Non-Reoccurring)
Transactional revenue consists of one-time purchases that are not contractually obligated and therefore may or may not occur again.
The default perception of transactional revenue is that it invariably:
- Is not predictable
- Requires ongoing sales efforts
- Often has lower profit margins
These perceptions aren’t always true—transactional revenue can be highly predictable and profitable with minimal sales efforts. But if you don’t actively frame the story of how your transactional revenue is earned, the default perception can limit your valuation.
Put another way, if transactional revenue predictably reoccurs, you need to make sure to frame that story so buyers/investors understand and value your company accordingly.
Consider an example of a software company that provides background checks on a transactional basis (i.e. pay per background check). If this software integrates directly with other solutions that are regularly running background checks as part of a broader, predictable process, then this revenue more closely resembles recurring revenue than it does transactional, and therefore warrants a higher valuation.
Compare the above example of predictable, reoccurring revenue to non-reoccurring transactional revenue like implementation costs, service fees, or professional service costs. This type of revenue will never be reoccurring and should represent a low percentage of your overall revenue (less than 10%). If higher, you’ll be discounted when trying to represent your revenue as recurring.
So in the case of purely transactional revenue, the key is to defend why those activities are important to sustaining recurring revenue. For example, they may create more stickiness, help customers leverage the software, or aid in upsells of recurring revenue.
The generally accepted gold standard in software revenue models is highly recurring. But there are cases where, in fact, a sticky transactional model that predictably reoccurs is more attractive than a strictly recurring model because customers are more willing to pay more per unit consumed than they would for a flat rate subscription. This buyer behavior opens an opportunity for a model we refer to as SaaS+.
The Opportunity of SaaS+
In a SaaS+ model, the software company charges customers on both a recurring and transactional basis.
Specifically, customers pay a baseline subscription fee with additional fees based on usage or performance.
The beauty of this model is that it provides a foundation of sticky, predictable recurring revenue with an added layer of transactional income that provides a greater share of wallet.
While the transactional portion of this revenue isn’t technically recurring, the unit economics can look similar to that of a pure recurring model with retention rates and gross margin. These aspects can be grouped together when looking at customer dynamics.
Additionally, there is space to make the argument that customers who transact more frequently, such as via month-to-month payments, are deriving high value from the product and are therefore less likely to churn.
Transactional payment models that can supplement recurring costs include: per lead, by add-on service or product, or through individual transaction fees. Despite not being fully recurring, companies can see fairly consistent and predictable results.
Additionally, customers who pay as they go see the benefits and ROI as they go—and they’re often willing to spend more. This growth potential combined with predictability is one reason investors value reoccurring revenue. In fact, in pure SaaS, you want growth rates of around 30%, but with a SaaS+ model, it could grow by more than 50%.
Crafting the Revenue Story
The most important step you can take to craft the story about the predictability of your revenue streams is to collect data. No matter how you plan to move forward with your business, it pays to track your revenue by customer data. It not only gives investors the information they need to make a strong case to their investment committees, but it gives companies information that helps them continue to improve their businesses from within.
When you do decide to execute a deal, it is critical to control the messaging around your retention rates and revenue by customer file. It helps the founder get a better deal, and it’s beneficial to the investor who’s going to use it to build the business better. This data will help you answer questions like:
- How many of our customers renewed?
- Why did they renew?
- Why didn't they renew?
- How can we get more share of wallet?
- How can we layer in additional revenue streams?
If you’re not collecting revenue data, start as soon as possible. It will help you get more money in the sale of your business and, in the meantime, help you manage your business better.
Learn more about the pillar metrics of SaaS that influence valuation.