Why Investors Continue to Bet on SaaS Revenue Models

PROPELR Growth is a Toronto-based growth equity firm investing in late-stage growth companies, with a preference for technology and software businesses. We provide periodic market updates to our investors including sharing insights into our investment thesis. The following is intended for a broader audience, beyond those who are deep in the technology investing sector.

Why Investors Like SaaS Revenue Models:

PROPELR has invested in several SaaS (software-as-a-service) businesses and continues to find these businesses attractive since they possess two key characteristics:

i) Scalable and asset-light business models

ii) High-quality revenue streams

i) Scalable and Asset-Light Business Model:

SaaS companies build software products that can be sold at a minimal variable cost. Compared with more traditional industries, software companies can produce higher gross margins (80%+) without intensive working capital needs or significant capex investments. Cloud hosting costs are often the main variable cost for software businesses, and are often de minimis – shipping code is cheaper than shipping hard goods or providing services.

Once we see that a company has established profitability on a per-unit basis, these models can justify significant growth investment behind sales and marketing and further scaling R&D. For growth equity investors, this results in high growth rates, limited need for subsequent capital vs. other revenue models, and a path to scale.

ii) High-Quality Revenue Streams:

Subscription Revenues, from customers signing multi-year contracts for access to software, provide high visibility into the timing and the quantum of future cash flows. The quality of these revenue streams can be diligenced and often these businesses have attractive annuity-like characteristics.

Rise and Fall of Software / SaaS Valuations:

For the reasons above, in recent years software companies have garnered meaningful attention from retail and institutional investors, with blue-chip SaaS companies increasing their valuation multiples significantly (the average EV / NTM Revenue multiple increased from 9x in 2019 to 23x in 2021). Technology investors have cashed in during this period, however, some have suggested that this trend is behind us, as valuations have fallen from record-breaking peaks of early 2022.

Several headwinds contributed to the decline in the valuations of software companies (e.g. geopolitical tensions, end of COVID-driven consumer demand, rising inflation and macroeconomic risk, etc.) with the largest contributor being the rise in interest rates.

Fundamentally, the value of any business is simply the present value of its future cash flows, so when the discount rate increases, the present value of future cash flows decreases. The U.S. 10-year treasury bond yield has increased from 1.3% in late 2021 to 4.7% today, and (as an example) over the same period, one of Canada’s greatest technology success stories, Shopify, has seen its market capitalization fall by over 60%.

Interest rate increases are particularly punitive to the software valuations because their business models are predicated on significant cash outflows in earlier years to fuel growth and positive cash flows coming years later, once the business has matured. 

Why We Think It’s Still a Great Time to Back SaaS Models:

At PROPELR, we believe the current investing environment once again makes it possible to back strong SaaS business, but now at attractive valuations. The current market conditions are as follows:

i) Valuations have reset, causing entry multiples to decrease

ii) Tightened capital markets are forcing businesses to abandon “growth at all costs” and pursue sustainable growth

i) Valuation Reset and Entry Multiples:

Valuation multiples have significantly decreased, with the average EV / NTM Revenue decreasing from 23x in 2021 to 6x today for software businesses. Over a 10-year period, the data shows the recent change in multiples is a reversion to the mean. Software companies have been trading between 5-10x EV / NTM Revenue over the past 18 months, which is directly in line with where they traded between 2013 to 2018.

At PROPELR, when we diligence an investment opportunity, a significant part of our effort centers on buying well (i.e. investing at attractive and reasonable entry valuations). As investors, we believe that valuation multiples are at reasonable levels today. The “reversion to the mean” helps us build conviction that companies will be able to exit at similar valuation levels, de-risking a key element of our investment math: the exit multiple.

ii) Tightened Capital Markets and the end of "Growth At All Costs”:

In early 2022, with fundraising slowing down significantly, companies in “burn-mode” had to re-evaluate their capital management and extend their runway. When the cost of capital was low and venture capital was widely available, sponsors encouraged portfolio companies to “grow at all costs”, so long as they could then raise fresh capital at higher valuations by showcasing their growth since the prior financing.

As VCs pulled back in early 2022 (average quarterly investment fell from C$4.1bn to C$1.9bn), companies discovered that raising new capital had become more challenging (e.g. fewer funds deploying, compressed valuations resulting in potential down rounds) and growth at all costs was no longer feasible.

Achieving or maintaining profitability then became the main priority. Companies ranging from tech giants (FAANG) to local Toronto-based startups reduced headcount and implemented hiring freezes. Today, we’re seeing a rebalancing underway with companies slowing topline growth to achieve or enhance profitability. Since 2021, the average SaaS company’s YoY Revenue growth declined from 43% to 10% and EBITDA margins increased from -16% to -10%.

As companies are returning to disciplined financial planning, investors are placing a greater emphasis on a metric known as the Rule of 40 (Ro40). The metric is derived by adding a company’s revenue growth rate to its EBITDA profitability margin. If the output exceeds 40, then the company is considered to have a healthy mix of growth/profitability (or burn). Today, public markets show that companies that can achieve Ro40 are rewarded with higher valuation multiples; (average EV / NTM Revenue multiple of 8x, vs 5x for non-Ro40 companies).

What does this mean for us? For investors, this is a positive development that will ultimately produce more fundamentally sustainable businesses that do not rely on perpetually cheap (or free!) capital in order to sustain themselves. We are already seeing this in our deal pipeline at PROPELR.

What is PROPELR Growth is Looking At Now?:

As buyers of SaaS tools look for ways to reduce spending, many have started by terminating non-essential tech subscriptions, with reports of organizations reducing budgets by up to 30%. With software budgets slashed, investors are looking for companies that have maintained strong retention rates and have held onto their share of customer budgets. A study conducted by McKinsey surveyed 50 CIOs (Chief Information Officers) on what they identified as key areas of software investment within their firms.

The survey concluded that CIOs were least likely to scale back spending in Cybersecurity and Data analytics, with over 50% of CIOs indicating plans to increase spending in these mission-critical areas. Investors should expect companies in these verticals to show stronger retention rates and greater revenue growth than, for example, Adtech (advertising tech) companies (40% of CIOs expect to decrease Adtech spending). Cybersecurity is a sector that PROPELR has tracked for some time, and in 2022, we invested in Field Effect Software, a cybersecurity software provider focused on providing holistic cybersecurity protection to SMB clients. You can read more about our investment in Field Effect here.

In short, we will continue to focus on SaaS models providing mission-critical solutions to their customers.

Conclusion:

Regardless of economic cycles, software companies will always attract growth investors due to their scalable business models and high-quality revenue streams.

We’re in a market environment where companies are trading at lower, more reasonable valuations than 2021 levels, which we expect will lead to exciting investment opportunities. PROPELR continues to seek opportunities to invest in leading Canadian growth-stage businesses with strong fundamentals.