New Metrics for Subscription Business Valuations

Why are SaaS startups trading at five times their revenue, twice the valuation of ordinary software companies? A report from Bessemer Venture Partners concluded that the subscription service pricing model featured by SaaS companies offers a more predictable picture of company’s market value than traditional software companies can for a number of reasons:

Subscriptions make future earnings streams much more predictable for at least the next quarter, and often the one after that as well (based on the length of their contracts). Churn is the biggest enemy of this.

Depending on growth can be risky for traditional sales models, but with a subscription service, businesses can simply continue to expand the reach of their services as their customers grow.

They interact with their customers regularly, usually monthly, for billing but also by email for updates as well. This makes it easy to present new services and other offerings to a captive audience. These companies can pursue growth by purchasing other service startups and upselling their current customers.

Traditional Valuation Methods

Conventional valuation methods estimate that a business should be valued at the net present value of the total future earnings that it can expect. Often referred to as “the market approach,” this method is favored by investors who value a business based on a multiple of past earnings. This can be problematic for growth companies that make market share a higher priority than net income or profits, which is a model most identified with Amazon.

Another common investment practice is “the income method,” which projects a valuation based on the present value of expected cash flows. Conservative investors tend to look on these expectations skeptically, though. There is a great deal that can go wrong and no business plans on failing. The other problem is that this also puts an emphasis on bookings, which makes sense for product companies, not recurring service-based companies. Because subscriptions are open ended, it’s impossible to tell at customer acquisition what their life-time value (LTV) will be. Bookings don’t tell you anything about upsells and service expansion.

A Better Metric

A different metric already exists that is better able to capture the actual financial state of the business: monthly recurring revenue (MRR). This includes both new accounts, increased price levels, reduced churn numbers and upsells in a single snapshot of the company’s current earning potential. It certainly takes more work, as MRR tends to vary significantly over the fiscal year. For greater accuracy, rolling in MRR with new accounts purchase orders and estimated churn creates Committed MRR (CMRR), a more realistic basis for the valuation of a subscription based business.

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