the big key criteria for a great SaaS company

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1 Sometimes called cloud-based, web-based, or on-demand, Software as a Service ( SaaS ) is a way of delivering applications over the internet. Instead of installing software locally, you simply access it from the web. The provider manages security, performance, updates and infrastructure. 5 the big key criteria for a great SaaS company 1. Category leadership in a market with substantial headroom for growth 2. Really understanding what is driving its revenue and how that is changing over time 3. Add new customers efficiently 4. Deliver 24/7/365 operations efficiently 5. Generate good profits from happy customers An investor s perspective HgCapital has invested in more $100 million-plus SaaS companies than most European investors and we ve been investing in them for a decade. Along the way we ve learnt a thing or two about what makes a cloud business successful and how to identify real winners with the potential to become billion dollar companies. The heart of our approach is understanding how a business measures up against what we see as the Big 5 key criteria for a great SaaS company. In this white paper, we discuss these criteria alongside the associated metrics we feel the best companies should track and look to improve on their journey to success. We hope it s a useful guide for investors and managers alike.

2 01 Criteria: A category leader in a market with substantial headroom for growth Key Metric: Total addressable market (TAM) The Total Addressable Market is a measure of the maximum revenues a company could generate. Number of Potential Customers x Average Spend per Customer = TAM These are typically complex metrics to calculate so estimates based on competitor revenues or total spend within industry segments are also commonly used. MEASUREMENT Measuring TAM is typically something companies do early on. An estimate of TAM is a critical component of many business plans looking for initial funding. What can be lost as companies mature is that an understanding of TAM is important throughout the life of a business and remains key to driving value. In particular the remaining oxygen for a more mature but still high growth business is crucial. Unsurprisingly the most valuable SaaS businesses serve a large market: the larger the market the more room for growth, the larger the total revenue potential and the greater the value it will generate. Also critical is a deep understanding of the TAM and an ability to articulate it clearly. This starts with an understanding of customers; who they are; what is the value they see in the product and what is their potential spend to secure this value?...and INTERPRETATION Being able to tell a clear story of what truly defines a company s addressable market is a great starting point for thinking creatively about where to invest for growth. Is the defining characteristic of the addressable market vertical specialisation? Can different customer sizes be serviced with modified products or is the product really only suitable for one particular customer type or niche? Is the defining characteristic deep engagement with a certain size business and if so, does that engagement allow other new products or services to be developed which can expand the TAM into new areas? Does it make sense to look at new industries/geographies or are there barriers such as regulation or customer practice which make it difficult to cross such boundaries? A deep understanding of TAM is more than just a large number to impress potential investors (one of the most frustrating elements of ill-thought-through pitches give us a pound for each time we have heard we only need 2-3% of this $4 billion market ). For the best companies it is really used to understand their USP, to focus their sales and marketing efficiently and to drive strategic direction. Geographies Potential Current Original Original ADDING VERTICALS TO EXPAND TAM HgCapital invested in Achilles in Achilles provides a SaaS platform connecting buyers and suppliers, allowing them to exchange critical information. The Achilles platform was founded to provide these connections for Oil & Gas companies in Norway and was extremely well supported by its customers. We saw early on that Achilles had developed a unique product which greatly simplified the lives of large buyers dealing with a disparate universe of small suppliers. This industry set-up was the defining characteristic of an addressable market for Achilles and the potential of the business was clear: pretty much any industry in any geography would benefit from Achilles platform. The company has since expanded across more than five key industry groups including utilities, transportation, pharmaceuticals, automotive and FMCG as well as 22 countries in four different continents. Industries Current Potential

3 02 Criteria: Really understanding what is driving its revenue And how that is changing over time Key Metric: Monthly Recurring Revenue (MRR) Monthly Recurring Revenue (MRR) is a measure of the current contracted revenue base of a business. It is a common measure of the current size of a SaaS business and the level of MRR and its growth rate are key drivers of value. It may sound obvious, but knowing where you are now is the starting point for driving your business forward. MRR is the most common metric SaaS businesses use to measure their current performance and value. Reported revenue is a lagging indicator for a rapidly-growing SaaS business. The SaaS model of a regular small stream of monthly rental payments means recent wins will have little impact on revenue in a given period. This remains the case even if the total value of these wins is potentially significant. MRR is a useful metric as it is a leading indicator. It captures the total impact of recent customer wins giving a clearer picture of the current state of a SaaS business and its likely performance over the coming 12 months or more. MRR is interesting, but the key to the value of a SaaS business is how MRR changes over time. Strong growth in MRR will drive value but not all growth is created or valued equally: it is vital that the drivers of growth are understood. Growth in MRR can be broken into these component parts: New additions (new customers won and added to MRR) + Growth from existing customers (the impact of existing customers buying more or less) Customers leaving = Net Growth in MRR It is possible to drive growth in MRR using combinations of the above factors, but different approaches will clearly have different impacts on value. Growing MRR by 50 through adding 100 of new wins but losing 50 of customers means the business has to work much harder than if it was adding 60 but only losing 10. It is clear which approach has the most value and will be potentially more profitable. In our experience the key metric in the build-up of net MRR growth is customer turnover, also known as churn. High customer churn is indicative of a product which is not delivering the value expected by the customer and is a warning sign of something wrong with pricing, product or support. It works against growth and will limit the scale that a business can reach. Strong performing businesses are as focused (if not more) on managing customer turnover as they are with driving new customer wins. This makes sense as 1 of maintained business is equivalent to 1 of won business and preventing churn typically comes at a lower cost. Or put another way, as we will see in section 3, it is usually way more costly to acquire a new customer than it is to maintain an existing one. We believe churn rates below 10% per annum should be targeted by the best SaaS businesses and levels significantly below this are seen in the very best examples. In certain situations businesses are able to enjoy negative churn. This occurs when growth from existing customers is greater than the rate of customer loss. These businesses see their revenue base growing without needing to win new customers! Effective cross- and up-sell and tight management of customer turnover can lead to this positive loop. Satisfied customers who increase their spend over time are indicative of a potentially highly valuable SaaS business. Customer retention (%) EFFECTIVELY MANAGING CHURN IRIS provides SaaS accountancy applications and payroll software to SMEs in the UK. HgCapital introduced several new managers to IRIS from salesforce.com (one of the world s leading SaaS businesses) in 2007 and they have helped to improve products, customer service and support. From 2009 to 2013, we have seen customer retention increase from 95% p.a. to 97% p.a. This increased customer satisfaction has boosted both organic revenue growth and profitability Figures are a weighted average of the IRIS business division. 98

4 03 Criteria: Add new customers efficiently Key Metric: Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLTV) Customer Acquisition Cost (CAC) is a measure of how much it costs to acquire every customer. It can be defined as: Total sales and marketing costs, on boarding costs and other costs required to acquire a customer that is revenue generating. Customer Lifetime Value (CLTV) is a measure of net total value flowing from a customer over their life with the business. It can be defined as: The sum of gross profit from a customer over the average life of a customer with the business. The rate at which customers are acquired is important and a significant factor in driving MRR growth and therefore value. It is also important that new customer wins are delivered economically and add value to the business. Throwing sales and marketing resource at a problem can drive new wins but the best companies track incremental CAC the marginal cost of acquiring the last incremental customer - and are able to identify where resources deliver the best returns and where best to spend their time and effort. A good understanding of CAC and CLTV are imperative to really creating value through customer additions. One simple ratio SaaS companies use to quickly evaluate the effectiveness of their sales effort is: monthly gross profit the CAC delivers CAC This gives a measure of how many months it takes the investment in sales and marketing to cover its costs. In our experience, CAC payback periods of less than 12 months are excellent and months are often okay, much greater and there are usually signs that the overall business model maybe questionable. Best-in-class SaaS companies demonstrate payback periods of under seven months but a too short payback could also be a sign that the company is missing out on the opportunity to grow faster (depending on the incremental CAC) as is it underinvests in sales and marketing. A similar ratio often analysed is: CLTV CAC This is effectively a measure of how much profit a customer delivers over their entire lifetime. This ratio can be used to guide how much can be spent on customer acquisition while still delivering profitable returns and may be used by companies which enjoy long-term customer relationships. In our experience CLTV to CAC ratios in excess of three are a sign of a successful SaaS business. Detailed analysis of the CAC payback period and CLTV to CAC ratio by different sales channels, products and markets gives a simple rule of thumb of where it may make sense to apply more sales resource in order to drive the greatest return (or where to slow things down if returns are disappointing). These are not hard and fast rules and are married with commercial objectives - lower payback periods may be acceptable when trying to enter new markets for example - but a firm grasp on these metrics is key to driving value from a SaaS business. DETAILED UNDERSTANDING OF CAC:CLTV HgCapital invested in the Danish SaaS accounting provider, e-conomic, in An element of the firm s attraction was its strong CLTV:CAC ratio, an excellent platform for investment into further growth. CLTV:CAC ratio General target Note: Fully loaded CAC includes proportional staff cost e-conomic

5 Gross margin for a SaaS business is a measure of the cost of delivering a service to the customer. This typically comprises hosting and connectivity costs, software licences, tech support etc. It can be defined as: cost ( Revenue per sale of sale ) Revenue Gross margin is a traditional financial metric looked at in many sectors. We flag it here as it is not often the central focus of many SaaS businesses but it can be a useful indicator of current business performance and longer-term profitability and cashflow. The key operational difference between a SaaS business and a traditional software business is that you are providing a service. Provision of this service brings with it costs associated with delivery ranging from hosting servers to software licences. It also carries risk you are responsible for IT security, data management and security and 24/7 operations if the service goes down or data is lost, stolen or corrupted you are on the hook. In the traditional old software model where you supplied a licence and the customer installed it on local servers the software house transferred most of these operational IT responsibilities to the customer s in-house IT department. Stepping back and looking at total gross margin is a good rule of thumb for how efficient a SaaS business is at delivery. In our experience most SaaS businesses should deliver gross margins of over 70% with the best reaching 80%+. Low margins can indicate a number of issues: IMPROVING GROSS MARGIN Epyx provides a private electronic marketplace serving vehicle fleet operators in the UK. Epyx s services enable customers and suppliers to reduce costs and increase efficiency across multiple business processes, via a marketplace which connects the UK s vehicle fleet operators and 9,000+ suppliers (such as car servicing businesses) to these fleets. During HgCapital s investment, Epyx increased its gross margins from 95% to 98%. While this sounds like a small increment, the effect was to increase EBITDA by over 7% over two and a half years independent of any benefit from revenue growth (which also doubled over the period!). 25 A poorly architected product requiring significant effort to run; Expensive reliance on third party components; and/or A complex environment requiring large numbers of support staff. Efficient operations can lead to very high profitability from new customer wins, as the incremental gross margin contributes almost 100% to the bottom line. An efficient set of operations gives a growing SaaS business more options on where to invest and develop its business. 100% 99% 20 98% 97% 15 96% 10 95% 94% 5 93% % Gross margin A SIGN OF POTENTIAL Revenue ( million) 04 Criteria: Deliver 24/7/365 operations efficiently Key Metric: Gross Margin & customer satisfaction

6 05 Key Criteria: Generate good profits from happy customers Metric: Net Promoter Score (NPS) Good profits are the ones you make from delighting your customers. These are generated by giving them a positive experience with real value-for-money which causes them to want to buy more and recommend you to their friends. These are long-term sustainable profits. Unfortunately, all too often, the high-pressure world of investors (especially private equity) demands short-term performance and businesses don t focus on good profits. Instead they generate bad profits by squeezing customers on price or cutting support and service measures that can often be successful at boosting profits in the short-term but rarely create enduring and positive customer relationships. HgCapital is a big believer that to create true industry champions businesses that can prosper over years or more it is crucial to focus on long-term customer relationships and good profits. So far our key criteria have focused on financial metrics: data that can be extracted from sales and accounting systems and which all businesses should be able to obtain. The final of our key criteria is focused on something softer but which is key to the success of a business customer advocacy. We have looked at available market; managing a revenue base through churn and up-selling; adding new customers at low cost; and delivering efficient operations. In our experience however, strong performance against all of these metrics becomes much easier if you deliver great value to your customers and they are strong supporters of your business. Companies with happy customers enjoy lower churn, have lower Customer Acquisition Cost (word of mouth is the cheapest sales channel) and are best placed to move into new areas to sell more to their strongly supportive customer base. In our experience, a strongly positive customer base is the ideal foundation from which the best SaaS companies grow and create significant value. Our preferred measure of customer advocacy is used across many industries. Net Promoter Score (NPS) is a measure of customer advocacy and it is specifically based on a direct question: On a scale of 010, how likely is it that you would recommend our product to a friend or colleague? Promoters are those who respond with 9 or 10, detractors are those who respond with 0 to 6. It s a tough measure! NPS is: % of customers who are promoters % of customers who are = detractors NPS A positive NPS and strong performance against peers is a strong foundation for any SaaS company. It is understood that recommendations from personal contacts carry significant weight in purchasing decisions and an engaged promoting customer base can be an important channel to accelerate business performance and drive value. NPS as a metric is best used relatively; comparing your score to competitors or to the historic performance of your own business. We have found that building NPS depends on a number of factors including: Effective employee engagement; A culture of service excellence; Solid engagement and communication with the customer community; and Active response to complaints or suggested improvements. Driving NPS is a long-term challenge requiring full buy-in from the whole business and continuous engagement with customers. A positive NPS and strong performance against peers is a strong foundation for any SaaS company. MAINTAINING MARKET-LEADING LEVELS OF CUSTOMER ADVOCACY IRIS and Visma both adopted NPS around 2011, significantly ahead of their peers, to understand levels of customer advocacy and identify ways to further add value for customers. Since its adoption, IRIS has achieved and maintained industry-leading NPS scores of >50 (industry average is 24*), enabling the company to continue to reduce customer churn and develop new products and services to sell into the existing customer base. NPS (%) % industry benchmark 54% IRIS 2012 *Source: Satmetrix: Software & Apps NPS benchmarks 63% IRIS 2013

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