On January 25th, the Next Generation Committee presented a panel about investing in the Software as a Service (SaaS) sector.
Among other things, the panel aimed to define the major trends in the evolution of the business model and distribution channels, to expose the elements of valuation that are misunderstood by investors, to state the challenges of companies in the sector and to discuss the impact of the entry of non-traditional investors in the sector.
Since the start of the pandemic, what do growth, number and quality of investment opportunities, size of rounds and valuation multiples, look like?
All of these topics were discussed with our panelists and our experienced moderator: Mia Morisset, Vice President of iNovia Capital, Mathieu Provost, Managing Director, Venture Capital and Technology at the Caisse de dépôt et placement du Québec, Samuel Nasso, Senior Vice President of Novacap and Nectarios Economakis, Co-founder and Partner at The PNR.
Excerpt from the panel
The 40% rule is generally used to evaluate the valuation of a company, which means that the sum of the growth rate and the earnings (EBITDA) should reach at least 40%. In the last year, there has been some movement away from the 40% rule to a single use of growth as a SaaS metric. Today, we are seeing the pendulum swing back. According to the speakers, we should have a more balanced model that is sustainable and profitable over the long term.
According to the panelists, the key metrics that are essential to evaluate a SaaS business in growth capital are:
- Profits;
- Potential revenue growth;
- Profitability;
- Net retention;
- Sustained growth;
- Sustainability.
A new benchmark also appears to be important according to our stakeholders, namely net retention. It provides more in-depth information than monthly recurring revenue (MRR) and customer acquisition cost (CAC). It calculates the percentage of recurring revenue retained from existing customers over time, taking into account cancellations, downgrades and suspension requests.
How fast does the existing customer base grow independently? If no new customers are obtained, what is the expected annual percentage growth for the company? When the answer is 15%, it’s a premium business; that’s the new goal.
On the VC side, it appears that investors have quickly adapted to the market and the industry. There are three aspects of SaaS investing that make it worthwhile: prospecting ability, due diligence and value-added monetization.
Indeed, there are no longer geographic barriers so we are seeing more competition in transactions. This is reflected in the influx of foreign investors, but also in the migration of traditional investors and development capital into transactions that were typically more related to venture capital funds. To stand out, you have to specialize.
In terms of due diligence, you need to be proactive and know the company before you even meet them for the first time so that you can start a strategic discussion early on. The processes are shorter and this means that companies require some expertise in their field from the funds. In addition, investors need to plan their cards just weeks after the close of the last round in preparation for the next one. For start-ups, it is now noticeable that more or less 50% of the primary rounds have a secondary portion, compared to before, when it was more around 10-15%. This makes it easier for them to get an exit.
On the value-added monetization side, we have seen a sudden growth in IPOs in 2021. There are even secondary rounds for premium companies, which is a completely new development. One thing is clear: the environment is constantly changing and that is why we need to focus on the core. We have to go back to the fundamentals, to the key metrics.
On the other hand, we must also be patient, careful and selective in choosing the company we want to support. Does it match our criteria? We need to be smarter and more disciplined in how we manage the pipeline. There are always funds that will pay more in the market, so it is essential to create a synergy with the entrepreneur in order to stand out.
Another new phenomenon seen in the market is the “grow into valuation”. People are paying for the future value of the company. This puts enormous pressure on contractors and limits their margin for error.
Since the start of the pandemic, assets that provide peace of mind have become popular. The SaaS sector, which is considered reliable, is no exception. As a result, there has been an increase in competition in recent months. Investors are willing to pay for higher valuations because these are safe and conservative assets!
Banks have been quick to rethink their investment strategies and are now much more market-driven. They use a different approach and try to better understand the business model of entrepreneurs. These new players are a nice addition to the current ecosystem and bring some balance to it.
It goes without saying that funds still have a competitive advantage because they bring much more than capital. They offer added value with their personalized support and expertise in the field. In this sense, debt does not replace the equity they need, but rather supports the funds’ growth plan.
What are the predictions for 2022?
Most will expect valuations to decline. Certainly, the gap between good and very good assets will rectify, except for the most coveted companies. Investors will have to stay on the lookout for opportunities more than ever and will have to act quickly when necessary. Finally, they will have to continue to adapt while accepting these new variables that are not about to be dislodged.
