The truth about SaaS exit valuations and the siren call of service revenues.
By Jessica Bartos
As investors, we often take it for granted that building a recurring revenue SaaS business is the summit to which every tech entrepreneur obviously aspires.
A conversation with an angel investor, just a year off of the very successful exit of his software business to an American giant, woke me up to how non-obvious that is when you’re in the thick of building a tech business.
So many headaches, so little value…
My friend reflected on his own journey. He and the team had come from a background consulting on tech to the insurance industry. They had come up with the idea for their software product in the course of a pub lunch. They managed to build the core code quickly over the next few months. Distributed from their respected IT consulting platform, the software found product-market fit rapidly - it met a clear need, got rave reviews from end-users and quickly added new enterprise logos.
However, the product was surrounded by an ecosystem that rewarded provision of IT services rather than SaaS software. As the software sales grew, so the services revenue crept in - first, some data warehousing to prep clients’ data for the software, then offers to bid to build custom trading platforms for clients, and, of course, run-of-the-mill implementations and configurations. As a result, several years on, while software licence revenues had grown to many millions, they were still only c. 30% of the revenues with the balance being services.
Bankers (me! back in the day) who managed the exit were clear: the software licence revenues will be valued highly - potentially 10x+, but the IT services revenues were worth c. 1x sales or less. Management, and my angel friend, expressed surprise.
Building the services organisation had felt a lot more challenging than building the software. The software had felt “easy”; there were only a handful of core developers to manage. But the services organisation was where the management had spent years wrangling with headcount and weeks negotiating with clients and it accounted for the vast majority of turnover. All those headaches for so little value!
Why software revenues are valued so highly
In a tech business, high growth software revenues are valued at double digit multiples for 3 reasons:
1. Software is recurring - Software sold as subscription is a steady stream of revenues, while services projects (e.g., consultations, implementations, configurations, custom builds, etc) are one-off events. With software, you win the customer once and charge forever. With services, the revenues end when the project ends. Frankly, if you performed the project well, the client shouldn’t need to bring in consultants again. Thus, you need to win new clients all the time, constantly refilling the pipe to just stay in the same place, to say nothing of delivering growth.
2. Software is scalable - just as you can sell once and charge forever, if you do software right (i.e, multi-tenant cloud, plug & play to the extent possible) you should build once and sell to everyone. This translates into massive operating leverage. By contrast, an IT services business requires headcount to deliver and projects are bespoke to the client. This model isn’t scalable because headcount grows linearly with sales and only a sliver of work for one client is transferable to the next (i.e., not “productised”).
3. Software is high margin - services require (expensive!) people to execute them, while code requires close to zero marginal cost to run. Mark-ups on man-hours charged to clients are highly negotiated. Offshoring, nearshoring and use of lower cost labour (graduates, etc.) are techniques that services businesses use to try to stretch these margins. But nothing will beat software for profitability. In my friend’s insurance software business, the gross margins on services were c. 20% while on the software they were >90%.
Don’t just take my word for it. Here’s Bessemer Venture Partners’, Byron Deeter:
“I’ll be very blunt: professional services revenue is bad for cloud businesses in most cases. It’s low gross margin revenue that slows down your implementations and can only scale in proportion to your services headcount. For these and many other reasons, Wall Street investors and your customers hate to see a large mix of services revenue in cloud businesses.”
The siren call of services
If software revenues are so clearly awesome and services revenues are a drag, why do tech businesses heed the siren call of services?
These are the top reasons (excuses, if I’m being ungenerous) I hear for the inexorable creep of services:
1. It’s revenue! (and profits!) When you’re a start-up pushing for that initial traction, all revenues look good. Services revenues bulk up the P&L and make you feel like a bigger business. And they are profitable (though at low margin) with £’s that come through immediately with each hour that you bill. These profits (and the early cash it brings in) help to cross-subsidise software revenues that are just starting to scale. That’s fine, but keep your eyes on the prize - recurring licence revenue.
2. Each client is a special snowflake “...but so-and-so is a massive customer and they insisted on such-and-such because of GDPR, crazy data policies, special legacy systems, cross-border...” -- insert generic client justification here. Clients, especially sexy blue-chip logos, will want bespoke implementations and special services because they are big, important and unique in their industry - special snowflakes.
Certainly, you want to be closely attuned to your clients. Sometimes services projects can provide deeper insights into your clients and you can feed that back to improve the product. But ultimately, you should be laser-focused on solving the problem your software is set out to solve. Focus on your comparative advantage in building software and leave the customisation services to systems integrators, who are built to deliver that kind of work. Avoid the “innovator’s dilemma” dynamic of listening so closely to incumbents that you miss the opportunity to create new markets, new categories and disrupt your industry!
3. We have more control if we implement it. From entrepreneurs, I also hear a fear of giving control over implementation and ramp-up of their product over to the client. They think the client (or the client’s systems integrator) can’t do it “right” themselves. This could translate into poor user experience and underutilisation or churn. This is a valid reason. I would urge entrepreneurs to be clear-eyed about what implementation services in this case are for - setting the client up for high adoption, low churn and thus a high LTV. Avoid getting dragged into interminable implementations and be strategic about offloading as much work as is appropriate to system integrators.
There are good reasons to have services revenues - but entrepreneurs need to look at these £’s with open eyes and understand how they will be viewed by the investment community.
Eyes on the prize
The conversation with my angel friend reminded me that ideas that are truism amongst tech VCs are often not as broadly known amongst those who focus on building tech rather than valuations all day.
It’s worthwhile to take a step back and recap what a “good” looks like in a SaaS business. If you’re a software entrepreneur, design your product to deliver a recurring, high margin revenue stream; be thoughtful about where you compromise; and be clear-eyed about what gets you the most value for your business. Keep your eyes on the prize!