Our Quality of Earnings Transaction Services team has worked on hundreds of SaaS financial metrics and other recurring revenue generating target company transactions. Through this experience, our team has honed-in on key analyses that are critical considerations to valuation as well as long term success of SaaS companies. We refer to this as the Four Pillars of ML&R SaaS QoE.
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 separate 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 process 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).
A target’s ability to retain customers is a key value driver. A common analytic used to measure retention is gross punitive churn, which includes churned (lost) customers and customers that have reduced their monthly spend (downsells).
Great customer testimonials and raving reviews from industry experts can inflate an investor’s perception of a target’s product line, but gross punitive churn (aka gross dollar retention) helps an investor get to the heart of a product’s true growth potential and operational efficiency.
We begin our churn/retention analysis by independently rebuilding monthly recurring revenue (MRR) from invoice data from the target’s accounting system. Using that data, we remove any anomalies caused by early or late renewal invoices 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 activity.
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.
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 high gross 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. However, we often analyze companies that do not allocate (or do not allocate accurately) payroll costs to cost of sales, which results in inflated and inaccurate margins.
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 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 allow potential investors to 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.
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.
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 the deal. Our calculations begin with the raw unmanipulated accounting data from the target’s accounting and reporting systems to ensure the metrics are reliable and appropriately calculated.
The transaction advisory team at Maxwell Locke & Ritter specializes in performing QoE’s on SaaS and other recurring revenue companies throughout the US, Canada and EMEA. We serve private equity groups, lenders, family offices, and corporate entities on both buy-side and sell-side transactions.