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The funding paradigm shift
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In 2021, there was a 60% increase in the number of SaaS companies that entered the public markets, as compared to the previous year. Clearly, investors love SaaS businesses.
Yet, it's not always rainbows, unicorns, and high valuation. In today’s tough business climate, buyers are taking more time to evaluate potential acquisition targets or investments. They seek to fully understand your KPIs, current valuation, and other metrics before making any funding or M&A decision.
So, what data must you track to capture the imagination of these buyers and venture capitalists? And what story would these subscription metrics unravel about your business?
On these topics, Younium recently held a panel discussion with the following Europe and US-based SaaS experts: David Reiling, Strategic Advisor, Former SaaS CCO; Jorge Fuenzalida, Managing Partner, JLA Advisors; Mads Kunov, Director, Ernst & Young, Aart Bijkerk, Director, Clearwater International; Cedric Notz, CEO & Founder, Float; and Johan Castevall, Chief Financial Officer, Younium & SaaS Investor, Partinc Capital.
And, in this article, we pick up excerpts from their discourse to understand the fundamentals of valuation, how to measure it, and the implication it has in the current economic situation.
The rising focus on profitability for better valuation
Subscription metrics are a moving target, according to Mads Kunov, a director at Ernst and Young (corporate finance), based in Stockholm. He said that 18 months ago the focus was very much on high growth and ARR to improve company valuation. But today, it's all about profitability.
“A renewed focus on profitability is always the case in downturn situations. More specifically, investors would like to gain visibility of Cash EBITDA. But ARR is still a very solid indicator. And if that's growing, investors would like to know about it,” he added.
Cedric Notz, CEO and founder of Float, a Capital-as-a-Service platform based in Stockholm, said that they have a laundry list of specifications when it comes to doling out funds. They only consider SMEs with an ARR of EUR 1/2 million to EUR 10 million, growth rate of over 30%, positive rule of 40, LTV:CAC greater than 3, net revenue retention (NRR) of over 100%, monthly churn much less than 2%, burn multiple less than 2, runway of at least 3 months (for debt financing), and revenue that isn't focused on just a few customers.
And since 2023 is still very much a risk-off market, he believes that companies need to be more focused on achieving break-even.
“However, there are different ways of doing this [reaching break-even] right. You could either cut costs, increase revenues, or do a mix of both. But what we've seen, in this market, is that the most successful SaaS companies raising capital are the ones that actually increase the revenues,” Cedric added.
This is a really important distinction to make because a lot of companies tend to be overly focused on cutting costs. When, in reality, an increase in revenues is what matters.
And one of the reasons, he adds, for the VCs' interest in improved revenues is that with a focus on growth, your business is able to maintain a very constant and uplifting work culture. This means, unlike in cost-cutting companies, employees are more motivated (and productive).
Gathering and validating key SaaS metrics
Everyone shares everything perfectly, transparently, and there's never a question raised about the validity of data. Said no one, ever.
Especially fast growing startups don't have the time to diligently monitor KPIs and track trends that are vital to gauge company health.
“For example, when you start looking at NRR, you don't want to look at only the last month or year but you want to see if it's going up or down. This is why you really need to have the foundation to drill down to those numbers and build a very good understanding of the performance,” said Aart, Director, Clearwater International.
So how can you ensure the accuracy and integrity of the data used to arrive at the performance/financial metrics that are in demand?
Aart thinks you could get one of the big four accounting companies to audit those numbers. But it can be quite expensive and time consuming, if the requisite groundwork was not done.
On the other hand, Mads is of the opinion that even if it's expensive, it is helpful to use third-party accounting firms to validate the performance data. “When you're looking to raise money or embark on an M&A, it's time to get your books in order. It helps to use a reputable third-party accounting firm to produce a data book - a bunch of Excel spreadsheets that puts all the numbers into a fairly standardized format,” he said.
Wondering what the need is for having data that is so structured, if your business is likely to raise funding or get involved in an M&A only once or twice in its lifecycle? The answer is simple: a common format or a common approach makes it possible for investors to quickly move to decisions and validations.
Today, many SaaS companies are conducting financial due diligence, in advance of going to market. Those who have a tech stack supporting their business model, including a subscription management tool, can validate their KPIs in real-time. This supports quick completion of the due diligence process.
The funding paradigm shift
Some of the uncertainty in the global markets from 2022, spills over into this year. There is also a decline in overall IPOs. Thus, there is an increased need for a very rapid and accurate representation of company valuations.
Johan Castevall, Chief Financial Officer, Younium & SaaS Investor, Partinc Capital, said, “In the European markets, cash flow has a significantly higher importance today than 18 months ago. As a scale up investor, growth is very important. But, so is the management team’s knowledge of the runway and having a 360o view of the company’s financing. What used to be the rule of 40s is close to the rule of 50s. And for a really attractive growth case you need to show beyond 50% YoY growth.”
Jorge Fuenzalida, Managing Partner, JLA Advisors, said that for smaller US-based companies that don't have that path to profitability it has been extremely challenging, unless there is support from a tier one VC.
“And if the VC is excited about the SaaS model, we are less likely to see an increase in those targets from [rule of] 40 to 50,” he added.
Jorge did highlight that different metrics are important at different stages. In the first stage, he said that is all about proof of concept, you need to focus on getting customer validation and growth. But very quickly and suddenly, the metrics that were ignored early on (sales efficiency, ROI on R&D and ARR) become important.
So, in today’s market, successful companies are those that understand which metric is important and at which point in time. You also must understand what's the driving force behind the metrics and how to use them to make impactful business decisions.
It will likely take an extra year or so to raise the funding, with such dynamics at play. So, it won't hurt for SaaS businesses to be a little bit more patient when fund-raising.
Want to know more?
Stay tuned, as in the next article, we will share insights into the future of valuation and what external factors affect your valuation.
We will also explore the best ways to turn your day-to-day financial metrics into information that investors and buyers easily understand.