Why are high growth Subscription companies often unprofitable?
High-growth recurring revenue-based companies are often unprofitable, yet financial institutions value them highly. The median net income for Public SaaS companies is negative 4.5%.
Yet, despite these losses, the Price to Enterprise Value ratio for SaaS companies is 7.3x compared with 3.2x for Software companies, according to a 2014 Software Equity Group report.
Investors are looking beyond profitability. They see the value in SaaS businesses that isn’t reflected in traditional GAAP-based financial statements. That value is the ongoing revenue stream, which provides future value (and profits) not shown by GAAP financials.
We need a quantitative method to assess the outlook for SaaS companies that takes into account the value of future revenue against the cost of rapid growth. These financials should show the underlying profitability of the core business separately from the cost of growth.
Why doesn’t GAAP show the value of Subscription companies that investors see?
Product companies realize their revenue when the product is sold. SaaS companies realize the revenue as the product is used; it generally takes approximately three years of SaaS subscription revenue to equal the revenue from a product sale.
GAAP gives no
What makes Subscription companies successful?
The objective is to augment GAAP with additional metrics that reveal the actual long-term value of the recurring revenue stream relative to the cost of obtaining these revenue streams. There are three primary drivers of very successful SaaS companies:
1) Growing revenue
2) Growing the long term recurring revenue stream annuity
3) Growing efficiently
The key 3 metrics that matter in assessing a SaaS company’s growth are:
1) Retention Rate – keeping the customers who were so expensive to acquire
2) Recurring Profit Margin – making money to fund new sales after taking care of customers
3) Growth Efficiency Index – having a prudent cost of Revenue Acquisition relative to the cost new revenue
By excelling in these three key metrics, SaaS companies can grow efficiently increasing their aggregate Customer Lifetime Value of their customers, which is a significant driver of the company’s value.
So when will Subscription companies become profitable?
For the successful SaaS company, the answer is “when they want to be.” Grow faster with low profits or even a loss. Grow slower, boost profits, but potentially lose the market opportunity.