When evaluating software-as-a-service (SaaS) and recurring revenue services businesses, traditional financial due diligence may not tell the entire story.  That is why Maxwell Locke & Ritter approaches quality of earnings (QoE) analyses through what we call the Four Pillars of SaaS QoE. 

Together, these Four Pillars connect a company’s financial results with key operating metrics that are particularly important when evaluating SaaS, AI or recurring revenue businesses. 

What Are ML&R’s Four Pillars of SaaS QoE? 

ML&R’s Four Pillars provide a framework for evaluating the financial and operational characteristics of SaaS and other recurring revenue services companies during transaction due diligence. 

The Four Pillars focus on: 

  1. Validating live ARR versus contracted ARR 
  2. Analyzing customer churn and retention 
  3. Calculating and understanding gross margins 
  4. Evaluating key SaaS operating metrics 

Each pillar provides a different perspective on the business. Together, they can help investors look beyond reported revenue or adjusted EBITDA and develop a more detailed understanding of the company’s financial performance. 

Pillar 1: Confirm ARR/CARR – Rebuild MRR from the invoice line-item level and segment out any non-recurring revenue 

Valuations are often based on a multiple of a company’s annual recurring revenue (ARR), so rebuilding historical ARR using the target’s accounting source data is vital to our confirmatory diligence process.  Oftentimes a company’s pre-LOI ARR presentation is based on CRM data (rather than accounting system data), which may result in errors, discrepancies and/or timing differences.  

Our analysis of ARR begins with obtaining the most granular invoicing data available and working with the management team to segregate all recurring revenue streams from non-recurring and re-occurring services (i.e., professional services, implementation, etc.).  

Using invoice term data, we allocate revenue across the appropriate service periods and independently build an ARR/deferred revenue waterfall.  The ARR rebuild requires judgment and expertise because invoice term data is often incomplete or incorrect.  We reconcile our analysis to the Target’s ARR presentation to ensure any differences can be explained.  Differences typically arise due to invoicing delays and billing irregularities, so we ensure our presentation corrects any such anomalies.  

After the invoiced ARR rebuild is complete, we obtain any newly signed but un-invoiced contracts and discuss with management any known churn, upsells or downsells to incorporate into our presentation of contracted ARR (CARR). 

Pillar 2: Scrub gross punitive retention – Analyze invoice renewal timing to adjust unintended upsells and downsells in the dataset.  

A target’s ability to retain customers is a key value driver.  A common analytic used to measure retention is gross punitive retention, which includes churned (lost) customers and customers that have reduced their monthly spend (downsells).  

Positive customer testimonials and industry expert reviews can inflate an investor’s perception of a target’s product line, but gross punitive retention (aka gross dollar retention) helps an investor get to the heart of a product’s true growth potential and operational efficiency.  

We begin our retention/churn analysis by independently rebuilding monthly recurring revenue (MRR) from invoice data in the target’s accounting system.  Using that data, we remove any anomalies caused by early or late renewals and/or other invoicing irregularities (e.g., credit memos, out-of-period discounts, etc.).  Doing so helps “smooth” the monthly revenue data and eliminate the noise that may inflate upsell and downsell calculations.  

Once the monthly revenue data has been appropriately scrubbed, we calculate gross punitive churn over time to help the investor determine how “mission-critical” a solution is to its customers and the product’s ultimate growth potential.  

Pillar 3: Calculate gross margin – Utilize payroll data and job functions to correctly allocate costs to recurring and non-recurring cost of sales (COS). 

Gross profit margin is an indicator of a company’s overall financial health and ability to efficiently generate profits.  SaaS businesses have the advantage of scaling their costs as they grow their revenue, so a SaaS company’s margins may also be indicative of its potential investment return.  

Bifurcating total gross margin between recurring versus non-recurring gross margin is one of the most important metrics for an investor to carefully measure.  Getting it right helps an investor understand key cost drivers, forecast future profitability, and assess operational leverage.  

Our calculations begin with accurately determining which costs support recurring (SaaS) and non-recurring revenue streams (professional services, implementation, etc.).  Using our expertise and experience evaluating SaaS businesses, we assess each employee’s job function and allocate personnel costs to the appropriate cost category (i.e., recurring cost of sales (COS), non-recurring COS, G&A, S&M, or R&D).  Non-personnel costs are also carefully evaluated and classified.  

The resulting recurring gross margin metrics help investors identify potential issues and compare the target’s performance to SaaS gross margin benchmarks.  Further, accurate non-recurring gross margin metrics help an investor understand the true cost of onboarding new customers.  

Pillar 4: Understand key SaaS metrics – Insights from gross/net retention, momentum, LTV:CAC, CAC Recovery.  

Annual recurring revenue (ARR) and customer retention rates may be top of mind for SaaS investors, but other key metrics are just as important when evaluating an acquisition target’s operations.  In particular, customer lifetime value (LTV), customer acquisition costs (CAC), LTV:CAC, CAC recovery, and the Rule of 40 demonstrate a SaaS company’s overall operational effectiveness.  

  • LTV represents the total contribution margin generated per customer for a client’s entire estimated life as a customer;  LTV reflects what an average customer is worth.  
  • CAC demonstrates exactly how much it costs to acquire new customers.  CAC is calculated as the total sales and marketing spend for a given time divided by the total number of new customers generated.  
  • LTV:CAC reflects the lifetime value of a business’ customers relative to the total amount spent to acquire them.  LTV:CAC helps investors gauge the health and effectiveness of a company’s sales and marketing function.  A healthy business should generally have an LTV:CAC ratio of at least 3X; any lower, and the business should re-evaluate its marketing spend.  
  • CAC recovery (aka CAC payback period) measures the time it takes to generate enough gross margin to cover the cost of acquiring a customer.  Calculation of the CAC recovery period is another measure to help investors assess the efficiency of a target’s customer acquisition process.  
  • The Rule of 40 states that the sum of a SaaS company’s annual growth rate and adjusted EBITDA margin should exceed 40%.  The Rule of 40 demonstrates a management team’s operational discipline and how well it can maintain strong returns as the business matures.  

 Along with ARR and retention/churn rates, understanding the above metrics is vital to an investor’s valuation of a business and can sometimes make or break a deal.  Our calculations begin with the raw general ledger data from the target’s accounting and reporting systems to ensure the metrics are reliable and appropriately calculated. 

Why Do the Four Pillars Matter in SaaS Financial Due Diligence? 

Two SaaS companies with similar reported revenue or EBITDA can have very different recurring revenue profiles, customer retention patterns, gross margins, and acquisition economics. 

Those differences may be difficult to identify from financial statements alone. 

ML&R’s Four Pillars of SaaS QoE are designed to connect the financial records of a SaaS or recurring revenue company with the operating metrics that help explain its performance. 

For private equity firms, lenders, family offices, corporate entities, and other transaction participants, this analysis can provide additional information for evaluating the target company, testing assumptions, and identifying areas that may require further diligence. 

Conclusion 

ML&R’s Transaction Advisory team performs quality of earnings analyses for buyers and sellers of SaaS and other recurring revenue services businesses. Our Four Pillars approach goes beyond the traditional QoE process and provides a framework for examining recurring revenue, customer retention, gross margin, and other SaaS metrics alongside a company’s financial results. 

Key Takeaways 

  • ML&R’s SaaS QoE approach looks beyond revenue and EBITDA to recurring revenue, retention, gross margin, and other key SaaS metrics. 
  • Rebuilding ARR from general ledger invoice data helps ensure an investor’s valuation is based on validated recurring revenue.   
  • Retention analyses generated from the rebuilt customer cube helps investors gauge how important a SaaS product is to its customers and the product’s ultimate growth potential. 
  • Separating recurring and non-recurring gross margins helps clarify the profitability of the core SaaS offering so investors can model future profitability and growth potential.   
  • LTV, CAC, and CAC payback period help investors assess customer acquisition efficiency and the scalability of the SaaS product.  

Frequently Asked Questions About the Four Pillars of SaaS QoE 

1.What are the Four Pillars of SaaS QoE? 

    • ML&R’s Four Pillars of SaaS QoE are (i) validating ARR and contracted ARR, (ii) analyzing customer churn and retention, (iii) calculating and understanding gross margin, and (iv) evaluating key SaaS metrics. Together, they provide a framework for examining the financial and operational characteristics of SaaS and recurring revenue service businesses.

2. Why is ARR validation one of the Four Pillars? 

    • ARR is often the key component of SaaS transaction analyses. Rebuilding the recurring revenue customer cube using underlying accounting and invoicing data can help investors determine whether reported ARR is supported by financial records and identify potential timing or classification differences. 

3. Why is customer retention important in SaaS due diligence? 

    • Retention analyses helps investors understand how effectively a SaaS business retains its recurring revenue customer base. Reviewing invoice-level data and adjusting for billing anomalies can help distinguish actual customer behavior from timing differences in the underlying data. 

4. Why is gross margin and important metric for SaaS companies? 

    • Recurring SaaS revenue and non-recurring services can have different cost structures. Separating those activities can provide greater visibility into the economics of delivering the company’s core recurring offering. 

5. Which metrics are typically evaluated in a SaaS QoE? 

    • In addition to ARR and retention, a SaaS QoE should evaluate LTV, CAC, LTV:CAC, CAC recovery, and growth and profitability measures by revenue category. The appropriate metrics depend on the target company, the investors’ focus areas, the particulars of the proposed transaction, and the available data. 

6. How do the Four Pillars fit into a quality of earnings analysis? 

    • The Four Pillars complement traditional financial due diligence by examining recurring revenue and operating metrics that can be particularly relevant to SaaS and other recurring revenue investors. They help connect historical financial performance with the underlying drivers of the SaaS business.