Retention as a Driver of Valuation

Retention is one of the most important metrics investors will assess when deciding whether to invest and what money they are willing to pay. Companies that prove they can keep acquired customers will be seen as more valuable by investors than those that struggle with high churn. A high churn rate is costly, not just because of the revenue lost from departing customers but also the additional expenses incurred in acquiring new ones. This not only impacts revenue but also signals weaknesses in the perceived value of the software. Companies that have high retention rates are typically ones that have proven the mission criticality of their software. For instance, event planning software may witness cyclical usage patterns and higher churn rates due to the sporadic nature of events, whereas a mission-critical cybersecurity technology will tend to have a more stable customer base. When a company has high retention, it has proven that there is a need that it is filling and capitalizing on in the market. To play devil’s advocate, there are many circumstances where investors will be less bothered by churn. For instance, if a customer churns due to M&A or if the target engaged in M&A and intentionally churned companies, then investors will assess the causes behind the churn; not all churn is created equal, especially if it is intentional churn. While a high LTV:CAC ratio typically indicates effective customer acquisition strategies, it may also attract customers who are more price-sensitive or less committed to the brand. In industries where market trends or external factors heavily influence customer behavior, companies may experience high churn rates regardless of their efforts to retain customers. Smaller customers (S&B’s) are more likely to churn on enterprise, B2G (business to government) revenue is often the most sticky. 

Revenue Construction and Gross Margin as Drivers of Valuation
While topline is the ultimate anchor of valuation for software and internet businesses, details on the financial profile are also key in the diligence process. Financial sponsors prefer to invest in companies that have predictable annual recurring revenue. Recurring revenue is more important than implementation and usage revenue (one-time-use revenue) since it is far more predictable and sustainable. As a result, companies receive lower multiples from their implementation and usage revenue versus their annual recurring revenue.

Gross margin is an essential metric for valuing a SaaS platform. It measures the sustainability of a platform’s business model. It can also determine if a SaaS platform is strictly software-based or offers other non-software-based services. High gross margins are often achievable in the SaaS industry since the cost of delivery is low, which makes such companies attractive to investors. The gross margin of SaaS companies is constructed of subscription and service margins (profits associated with one-time purchases). Comparing both metrics, subscription margin is more important than service margin and is often the primary method of valuation of fintech financial sponsors. Investors will often pursue multiples based on the annualized gross margin for lower gross margin businesses (often seen in payments and FinTech companies).

The sector in which a SaaS platform sways valuation significantly. Trends, macroeconomic factors, and sentiment can propel specific sectors to fetch higher valuations. As a result, companies operating in particular niches can be valued higher than other platforms, even if their growth and unit economics are inferior. For example, investors often pay more for SaaS platforms that utilize AI than other sectors due to the recent strides in ChatGPT and other related technologies.
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While there are set processes and methods to determine valuation, it is often more of an art than a science. Investors will push for the best deal and the best terms, while a company will push for the highest valuation and the least restrictions. The competitiveness of the raise and appetite on each end of the deal holds tremendous weight. Furthermore, some investors are willing to pay aggressive multiples, while others are more conservative. Some crowds are less sophisticated and don’t know what to pay, and often pay multiples far above what sophisticated investors will pay. This often creates problems in subsequent funding rounds and lacks scalability.

Investors will likely use a spread of comparable companies and precedent transactions to determine valuation (at a later stage, they will even perform discounted cash flow analysis, using the standard venture return as the discount rate). Even then, the price of any asset is what someone is willing to pay for it. Over the course of the last few years, our team has seen dissonance between what founders expect and what investors are willing to pay. While structure can be used as a bridge to narrow this dissonance, ultimately the motivation of the investors and company to consummate the deal will be the key tell in how it pans out.