01 May For Software – SaaS is King
As specialists in M&A for emerging and mid-market software and technology companies, we work with a lot of entrepreneurs. A frequent topic is Software-as-a-Service (SaaS) licensing models versus traditional perpetual licensing models. SaaS has become the preeminent licensing model for newer companies, while some mature companies have remained with the legacy perpetual model, or may be straddling the two models.
In this article, we will discuss why we think all software companies should switch to the SaaS model, how you can overcome the common objections to making the switch, and some pitfalls that you should avoid when managing a SaaS business.
It is no secret that investors, and hence tech M&A advisors, are strong advocates for recurring revenue subscription models. Valuations can be double those for comparable companies with traditional perpetual licensing models. The reasons for this are clear:
- Cash flow and stability – software companies that use a subscription model have more consistent and predictable cash flow. They don’t have to bring a major new product release to market every few years to encourage customers to buy the upgrade. Since subscription revenue tends to be significantly higher and more reliable than “maintenance” fees, R&D can be performed at a consistent rate, and staffing, workloads, and profitability can be balanced and optimized. An additional financial bonus is that working capital is significantly reduced.
- Higher total revenue over time – The perpetual model consists of the license fee, maintenance fees, and periodic upgrade fees for “major” releases. The problem is that customers may continue to use the software without paying maintenance consistently and may substantially delay upgrades to major new releases. This introduces significant uncertainty in revenue and cash flow for software companies and the delays reduce the total revenue that the company will see over time.
- Lower barrier to entry – The initial investment to begin using subscription software is typically lower than in a perpetual model which means that a customer needs fewer levels of approval and may sign up without waiting for the next budget cycle.
- Reduction in legacy support – In a subscription model, customers automatically get all upgrades. Upgrades are usually evolutionary (rather than “major”) since they don’t have to be crafted to encourage the customer to purchase an upgrade. This helps to move customers to newer versions of the software sooner than in a perpetual model and reduces the software company’s costs related to maintaining legacy product versions.
- Value – all other things being equal, a software company with a SaaS model can be worth double or more than the value of the same company with a perpetual licensing model. Entrepreneurs work hard to develop their companies and their products, why wouldn’t they want to get the best return for that hard work?
Frequent objections (excuses) for not switching
- Switching will be difficult – we have to change our pricing model, our billing processes, and our software development lifecycle (SDLC) – Well, yes. But the transition will be worth it. If you time the switch with the next “major” upgrade, then it should mean a higher rate of upgrades from legacy customers since the initial upgrade cost should be less. Billing processes will become more standardized and predicable. Your SDLC will take on a more incremental approach with continuous improvement, providing a more consistent demand for R&D staffing and R&D costs.
- Our customers like it this way – most major software suppliers have already made the switch and your customers have figured out how to work with the model. That you need to make the switch shouldn’t come as a surprise to your customers.
- Our revenues will suffer during the switch – Only in the short-term and even that is debatable, because with the old perpetual model legacy customers may delay upgrades for months or years. And the timing for new customer purchases is not guaranteed. A lower initial purchase/upgrade cost should encourage more customers to purchase/upgrade sooner, which should mitigate the change in the revenue model.
Pitfalls to avoid
- Cash basis accounting – failure to properly account for deferred revenue – If you are being paid in advance for software or services that are to be provided over a longer-term then it is critical to accrue the revenue in accordance with generally accepted accounting principles (GAAP). SaaS companies who operate on a cash basis may have a misleading impression of their cash position and may overspend or give premature distributions to shareholders. This can result in negative operating capital at the time of a sale.
The Austin Dale Group has many years of experience running and growing tech companies and conducting tech M&A and software M&A transactions. We also advise tech companies on strategies to achieve the highest value. We would be happy to talk with you about ways to achieve the most value in your business and accomplish your transaction goals, whether you are selling or buying in the near-term or planning for the future.