In this article, I’ll discuss making your SaaS company attractive for investment, sharing the reasons why investors love SaaS and what makes a winning SaaS business, how to make your business attractive for investment, and mistakes I’ve seen and how to avoid them.
My name's Edward Keelan and in this article, I'm going to be talking about making your SaaS company attractive for investment. I'm an Investment Director within the Octopus Ventures team at Octopus.
I'm going to talk a little bit about:
- Why investors love SaaS,
- How to make your business attractive for investment, and
- Avoiding mistakes.
I'll be honest, it's a bit more things that popped into my head and thoughts I've had as an investor over the last decade of things that companies should look out for. It's probably not as much structure as this agenda suggests.
We've been around for 20 years now, we wanted to be a friendlier face of investing, that's been a successful mantra, we manage over 10 billion in funds under management and we do that from everything from renewable energy through to early-stage companies.
We also are known for our energy supply business, Octopus Energy, which has been born out of the back of a lot of the work we've done in renewable energy.
The team I work with is the Octopus Ventures team, and specifically on B2B software. We're looking at B2B software and with that, clearly, SaaS is a big part of it, really through all the different stages of growth and size.
Why do investors love SaaS?
We've been looking at SAS for a decade but I certainly remember five years ago thinking about annual recurring revenue multiples of four times and thinking that sounded very high. But like anybody trying to predict the market, that has just gone up and up.
One way street?
SaaS capital is probably one of the best companies at providing data around this and you'll see even in the pandemic year where many other industries were struggling, SaaS companies really did very well.
The reason why is there are two things that investors love, even at VC level, which are:
- Cash and generation of cash, which SaaS companies do very well, and
- A predictable and recurring revenue stream.
Two of the main things investors look for you find within a SaaS business.
Word of warning
My word of warning, anybody that pretends they can predict a market is a bit of a fool in my book. I don't think anyone can predict markets particularly well, especially not me.
But I do think from more of a qualitative level we may see valuations coming down.
The main reason I say that is not just because there's a bit of a bubble, but more I just think companies will look harder and harder at their IT spent around SaaS.
I'm already now seeing companies, for example, a SaaS company whose SaaS model is to look at the usage of other SaaS in the company. Their mantra is ‘the average large company will have 100 different SaaS products, and only half of those will be used’.
Therefore, you need their technology, pay for a SaaS license with them to tell you what other SaaS companies are doing within your organization.
I just think companies will get wiser and wiser and whereas before, that £5,000 SaaS license, people would almost be apathetic to renewing it every single year, I think they're going to get wiser to it and they're going to be much more concerned about the usage of it as that overall spend becomes bigger.
I think that will ultimately drive valuations down.
Winning SaaS companies
The real winners in the SaaS world will be those companies that are properly integrated into the processes of the companies and not just the widget-type software that are the 'nice to have' of key individuals within the organization.
How to make your business attractive for investment
There's nothing investors love more than a KPI and a metric. For some of you, you'll look at this image and say, it's pretty obvious. Of course, we know this and this is what we should be doing.
There'll be others that this might be the first time you've really thought that hard about your KPIs. We see companies right across the board, people that are very KPI driven, and companies that really are quite naive to their KPIs.
You can see some of the main ones above, and I've tried to bucket them as best I can.
Know your ARR from your CAC
MRR/ARR & CAGR
Clearly, the way we value businesses tends to be on an ARR multiple basis. To know your ARR, you need to know what your MRR is, ARR being a function of MRR times 12, and you need to know what your compound annual growth rate is. That's just the fundamentals.
LTV/CAC, Rule of 40, & CAC Payback
The next bucket - lifetime value over CAC, the rule of 40, CAC Payback, this is all about sales efficiency. Anybody can spend huge amounts of money acquiring customers but does that then pay for itself?
Lifetime value over CAC is what's the lifetime value of a customer divided by the cost of acquiring that customer.
As a rule of thumb, you usually expect LTV to CAC to be between around about three times so for every pound you spend on acquiring a customer, you should make three pounds from them.
Rule of 40
Rule of 40 is a similar thing, it's a bit of a rule of thumb but basically what this says is that our growth rate plus your margin should equal 40%.
For example, if you're growing at 20%, and your EBITDA margin is 20%, you've made the rule of 40. If you're growing at 100%, theoretically, you could afford a negative EBITDA margin of 60%.
What this is trying to give is a rough picture that you're growing efficiently.
CAC Payback is around how quickly you can pay back the cost of acquiring that customer. Again, a rough rule of thumb is generally around a year.
If your average annual value for a customer is £50,000, it costs you £50,000 to occur it so you've got a one-year CAC payback, that's about right.
Unit economics & gross margin
I think of this mainly for modeling and financial forecasting and why it's so important. Often you'll see a model where it will be, "We think we'll be at a million pounds revenue, and we think revenue is going to grow by 50% every year".
That's not how we want to think about the metrics, what we really want to do is go down to each individual license sale that you make and how much it's costing you to provide that license and think of it in that way.
Taking it right down to the individual sale when then building up a financial forecast and not just increasing the headline numbers.
It used to be almost the de facto to say, "We call our customers every six months and make sure they're using our products". That simply isn't good enough now, customer retention is so important that what we would say is you should have KPIs around how much your product is being used and that should be integrated within your product.
If that goes down, or it's not where it should be, you should be able to do something about it. Because if you're not monitoring that product usage, and you're not making sure it's at a good level, it doesn't matter how many new sales you make, ultimately, you'll probably end up in a failing business.
TAM stands for total addressable market. Your market is never every company in the entire world, really understand what your TAM is, and what niches you play in.
Churn (logo, gross, net)
I'm going to go into a bit more detail but we often see a headline of churn, "Our churn is 10%", for example, but churn can be looked at in three main ways.
- Logo churn, which is just a customer by customer basis.
- Gross churn, which is looking at your revenue from the previous year and how much of that revenue is left this year. If all of that revenue is left from that customer, you've got zero churn.
- Net revenue, either net revenue churn or net revenue retention is about including any upsells within that number as well.
What does this mean in practice?
Churn by any other name?
This is an example of how you could look at churn whether it being 90% on logo retention, 69% on gross revenue retention, or 68% on net revenue retention.
The long and short of it basically is understand how these different retentions are calculated, what they mean, and why they're important.
Now, if you're looking for an idea around net revenue retention, and remember, net revenue retention is where you count your upsells so you're looking at both your down sells and your upsells when you calculate your retention metrics, it doesn't matter which source of data, it always comes up to being around about 100% net revenue retention.
What does that mean in practice? In practice, what it means is you should be upselling your existing customer base enough to make up for any customers that churn out. So, if you lose £10,000 worth of revenue for one customer, hopefully, your upsells will make £10,000 on the other side, and you'll end up with net revenue retention of about 100%.
It is important from an investment point of view, again, SaaS capital - a great resource for this type of information - for every 1% increase in revenue retention, the SaaS company valuation is likely to increase by 12%, after five years.
You can see maybe even increasing only by 3-4% in terms of your retention can have a massive effect on your valuation. I've seen other statistics that say it's about six times cheaper to retain an existing customer than it is to win a new one.
Again, we see a lot of focus on new business wins, where actually what I think makes a really good strong business is its ability to retain its existing customers. If it's not doing that first, then that should be a focus.
The sales funnel
A fairly basic funnel here but it's amazing how many companies don't do this. We really look at this when we're looking at pipeline and opportunity.
If you don't know how many leads you're generating, how many of those leads hit meetings, how many meetings hit trials, and how many trials hit sales, (and this is just a very basic pipeline, you can have all sorts of different categories here) then it can be very difficult to make changes.
One company I was working with recently was getting 1000s of leads, but they weren't converting into trials. Somewhere in this process, it's breaking it down.
Quite often we'll see a very broad pipeline, and it'll be a pipeline of hundreds of opportunities, everything will have a 50% weighting to it and then it'll equal a big number. But truly understanding the conversion rates between leads and meetings and meetings and trials and trials and sales, can then lead to understanding how long it will take you to close a deal and how forecastable for the next few years will be.
Some mistakes and how to avoid them
Again, this is as much as anything a bit of a brain dump from me about the mistakes I've generally seen, what I think entrepreneurs make as they are raising funding and particularly in SaaS.
The Valley of Death
I see a lot of companies raise their first rounds really easily, they go to their friends, they go to their families, they go to early-stage angels, and they sell them the dream and the concept of the business and they've raised a bit of money.
Usually what happens is they don't raise quite enough money to then get them through what some people class as 'the Valley of Death'.
I've seen the Valley of Death being categorized at different times, this is my own personal interpretation. It appears to be the seed round.
So once you're past those angels, friends, and family, and you're trying to get up to series A, and there's definitely a much bigger wall of capital around about 1 million ARR than there is at even half a million pounds worth of ARR although that number is coming down, and people raise not quite enough money to get them through that Valley of Death.
If you are an early-stage SaaS business, really think hard about how much capital it's going to take you to get from the early stages through to that million pounds ARR. If you are raising money, make sure you are planning that middle stage might be difficult to find cash as easily.
Product Market Fit
No article is ever complete without a good four-by-four matrix. This one by Adam Fisher from Bessemer Venture Partners is one of my favorites because I think product-market-fit is a really interesting topic.
I'm not going to go through each quadrant here but I wanted to touch on two, and two mistakes that I see customers make - vision down one side, customer engagement on the other.
The sexy story and in SaaS businesses in particular where I see this sexy story play out from the marketing teams is usually the conversation starts with "We are a machine learning AI blockchain company".
Using all the latest buzzwords, but there's no real customer engagement. It's all about the jazz and none of the actual real whether customers want this product or not. It's not necessarily tackling a real problem.
So it may look like a good vision, but do people actually want what you're trying to sell to them? If you do start your stories by saying 'AI and machine learning blockchain' then think really hard about that.
- Do you have customer engagement?
- Or is it just a really good story?
The other spectrum of that is on the revenue-centric area, which is sales team-driven and where we see this in SaaS businesses is where you get a consulting firm that is moving into the SaaS world.
Obviously, SaaS companies are much more profitable than consulting businesses for many reasons. And so consulting firms who have been maybe building products for their clients quite often pivot into a SaaS company.
But when they do that, if they've still got that consulting feel, and they're still sales team-driven, they may end up chasing the very big fish, big customers, they become very customer concentrated and end up building lots of bespoke software for their customers.
That isn't product-market fit, that's just an iteration of their consulting world beforehand.
If you have got that you must think about scale, you must say, it might not always be the best thing to go after that big fish customer that wants eight different iterations to your product. Because in the long term, you're not getting a wider level of different customers engaging within your product.
This is something we think about quite a lot, how do you go about pricing that product?
When you've got a physical product, usually you look at how much it costs you to make it, and then you put a margin on top of it, whatever that margin might be.
Some people look at the competition, how much are my competitor selling this product for? And therefore, what can I sell my profit for?
Certainly, within SaaS, I think these are really bad ways of pricing your product.
You should look at them and price them on value. There's a lot written about this. I've used here, the LeBron James card that recently got sold.
From a cost point of view that LeBron James card is probably worth about $2 Max, put a bit of a margin you could sell it for $3.
I know there are other cards out there, maybe they're $5-$10.
But that was actually a card that was sold for just over $5 million. Somebody thought the value in that card was $5 million, it had nothing to do with cost or competition.
When you are pricing, it can be a real disruptor. But disrupting doesn't just mean cheaper. Disrupting might mean because you're adding more, you're offering more.
If you're a CRM, for example, you don't need to just price yourself at a pound cheaper than Salesforce. What is it that your CRM brings that provides value that other CRMs don't have? Talk to your customers and what value do they perceive? That's how you should be pricing yourself.
Clearly, this is a whole topic of conversation. I think pricing for SaaS businesses is really, really difficult because you can't just do your cost plus margin, you have to think about value.
My alarm bells
Quickfire things that boil my blood when I hear it.
The CRO to fix all our problems
SaaS companies who are starting to struggle with growth, so they think we just need to raise a bit of funding to get a CRO that's going to fix all your problems.
Almost never does a new shiny CRO fix all your problems, it's usually because you need to talk to your customers and understand your sales pipeline and where it's getting stuck.
Not suggesting you shouldn't be hiring a new CRO, I'm just thinking you might look inwards first and look where their sales pipeline is getting stuck before you do.
The part-time CFO to “do a job”
There’s nothing wrong with a part-time CFO, some of the best CFOs I know work part-time - but it's not just to tick a box and do a job.
Your CFO should be somebody that is producing the KPIs I talked about and can help make decisions and drive your business.
CEO being head of the brand and marketing
CEOs that are in love with their company so much they believe they're the only ones that can brand and market it.
Just something we see, there are professional branding and marketing agencies we introduce companies to that do nothing else but this and they are better at it. But I think it's often the CEO founder in particular where the company's their baby, they want to be the ones that deal with all of that element.
Only needing 1% of a huge population
When people think about TAM, and they talk about TAM-ing the entire world and they only need 1% of the entire world, and therefore they'll be very successful.
This goes back to the unit economics point earlier - think from the bottom up.
- How much does it cost you to acquire each individual customer?
- How much do you make from an individual customer, etc?
Churn due to an individual in the customer
One of my pet hates is when I ask a company to explain why a particular customer churned and they'll say because we lost our sponsor, we lost our key individual that loved our product and bought it.
I think if you're losing customers because of specific individuals within companies, then your product is probably not integrated enough within that customer and you need to do more to make sure it isn't reliant on key individuals within the customer and is just part of their processes.
100-page deck and half done model
Probably the number one thing we see companies do when they raise investment that's probably wrong or misguided is they spent a huge amount of time putting a massive deck together - 50 page, 100-page decks with lots of pretty pictures.
We asked for the financial forecast and the financial model and they say it will be available in a few weeks.
To be honest, most companies shouldn't need a deck of more than 15 pages. But what we do or what our team particularly likes is a really well-thought-out financial forecast where we can see what's driving your company through the assumptions that are being made for the future.
Three parting takeaways
- Spend time on your financial model, your KPIs, and your unit economics and use that data in order to drive your business - make it a priority. The qualitative stuff is really important but if you don't understand what numbers are driving your business, then you're going to find it very difficult to raise investment.
- When you're pricing your product, really talk to your customers and understand the value they're getting and price to that value. Don't price to what your competition is necessarily doing. Disrupting in pricing doesn't necessarily mean just being cheaper it means finding the value you're adding and pricing to that.
- And in terms of SaaS valuations, I'm not sure we're going to be around forever but I do think the ones that are the true winners, the true SaaS products that will win will be those that fully integrate their products within a business's, a customer's ways of working and processes. It's really important you monitor that and you ensure your products are integrated within customers and retained and they're not just ‘nice to haves’.