SaaS Business : The Hidden Compounders

            I have  seen lot of eyebrows raised by Indian Investors when some SaaS company gets valuation of 10-15 times sales and making losses. Not only novice investors but even reputed investors raise the concerns that venture capitalist gone mad, they will burn their fingers. Where is EBITA margin, ROE, ROCE or cashflow?  Don’t VC love to make money? Are they doing charity by valuing SaaS companies so high? Defiantly, they will lose money in some but will make extraordinary return in some. Indian investors are not able to understand power of SaaS business model with annual recurring revenue and having some growth in customers and negative churn rate. Yes, negative churn rate is possible even if 4-5% customers leave your product. SaaS companies archive negative churn rate when 4-5% leave but existing 95% gives more than 5% growth in variable charges.

I am attempting to explain SaaS business model with annual recurring revenue with example where Indian investors will get some connect. I am explaining with real estate rent in commercial building with long term lease.

Let’s assume a businessman gives 100 cr each to his son and daughter and ask them to invest in annual recurring revenue (ARR) business model.

Son choose to invest in real estate rent in commercial building while daughter choose to invest in a SaaS product with ARR.

Our accounting standard captures capex of old business properly but not new business-like SaaS product with ARR. Dad asked son to follow same accounting standard as his sister going to follow. It will show unform picture.

It means all the capex will be treated like expense and it will not be shown as asset under balance sheet.

Let assume some conditions in business

•  Commercial rent yield was around 8 to 8.5% before pandemic. Let’s assume son is able to earn 10 yield on current market price of commercial property.
•     Inflation is around 6-7% and market value of property is increasing with CAGR of 7%. Market value is getting calculated previous year value + 7% of it + This year reinvestment.
• All the ARR (Rent) spent on reinvestment for purchase of new commercial real estate.
•  Accounting standards allow to put commercial property under asset in balance sheet but remember what dad said “follow accounting standard similar to daughter’s business”. Dad has given money can’t go against him.

Now, check how P&L Account will look for 20 years.

 

Last two rows not available anywhere in P&l , Balance sheet or cash flow . It was not ready made available to investors.

Son contacted some investors after two year to sale his business. Investors who invested whole life based on P/E, P/B , cash flow , ratios , margin looked at balance sheet and p&l accounts . They said, you don’t have positive EBITA margin, loss making, negative ROE & ROCE, burning cash and nothing is balance sheet. You have revenue of 11.70 crores. We will give max 0.5 times to revenue or rounding figure 6 crores. Will son except this offer? No. He is aware about last two rows of above screen shot. He knows market value of property is 137 crs.

Same happened after even 20 years, still company making losses (6 crores) . No investors were giving required valuation. They offered just 100 crores. Now, he approaches a VC which is big player in SaaS but open for other business as well.  VC figure it out that general commercial rent yield is around 8-10% . So, asset behind the scene (without looking last two rows) should be 10-12 times. He offered him 197.48 * 10 = around 2000 crores which is close 2310 – accumulate losses. Should he accept that deal now? It is pretty close; he can negotiate some for future growth factor and make deal. Finally, they made deal at 2100 crores. Is the story end now ? no .

VC invested to make money and not for charity. He decided to reinvest only 20% and rest 80% distributes as dividend. Now, P&L will look like below.

After year 3 he came for IPO. Will the investor will complain no. It will be high margin business with margin more than 70% , high ROE & ROCE , no debt , light balance sheet.

Paying dividend more than profit even after investing for future growth. VC decided valuation of 20 PE. Market cap will be 20* 211 = 4220. He paid only 2100 but after business achieved scale, he reduced re-investment and he made another 2x in 3 years.

Now, you try to calculate daughter’s SaaS business with ARR. It is similar to it but defiantly there will differences. e.g. Re-investment rate in real estate was 100% that can’t be in SaaS business but that will be compensate by higher yield. SaaS business is going to have much higher yield than 10%.

• 30% growth in ARR
• 70% reinvestment 
• 30% other expenses 

 

P&L

 

If she able to sell this business at 20 times PBT then valuation will come around 30000 crores to 40000 crores which was making losses till 20 years .

I hope everyone able to understand why SaaS business with ARR are valued on revenue multiples of 8-20 times or even more. Please note term ARR, even SaaS business doesn’t have 100% ARR there is always one-time components in revenue of SaaS business. If it is less than 10% then also, we can apply revenue multiples else need to do some adjustment.

I don’t know exact revenue of HighRadius(promoted by NRI Sashi Narahari) but as per my understanding it is around $230 to $250 million. It is valued at $3.1 billions in latest funding which is 12.4 to 13.5 times revenue. Do you still think that is too much?

There are very few SaaS player is listed space  and none of them is the pure SaaS player. E.g. Intellect Design has some portion of revenue from SaaS . I don’t want to name a tiny smallcap as SaaS Player to spoil generalness of this article .