Why cloud businesses will grow faster and value higher
Foto von Martin Adams auf Unsplash
Subscription business model is the value driver
- Year 1: Licenses 25 M€, Services 25 M€, Support 50M€,
- Total Revenue 100 M€, Growth Rate 10% on new business
- Year 2:
Licenses 27,5 M€, Services 27,5 M€, Support 53 M€ (50 M€ - 2 M€ Churn + 25M€*20% =5M€ New Support)
- Total Revenue 108 M€, Total growth on 10% new business is 8%
- Year 3: Licenses 30,25 M€, Services 30,25 M€, Support 56,38M€ (53 M€ - 2,12 M€ Churn + 27,5M€*20% =5,5M€ New Support)
- Total Revenues 116,88 M€, Total growth on 10% new business is 8,2%
| New Business Growth Rate | Total Revenue Growth Year 1 | Total Revenue Growth Y2 |
|---|---|---|
| 10 % | 8 % | 8,2 % |
| 20 % | 13 % | 14,1 % |
| 30 % | 18 % | 20,2 % |
So it becomes even harder or more expensive to accelerate revenue growth. Let's have a look at the Cloud Companies and their typical subscription model. They are depending highly how subscriptions are priced. If you create a price model that has a 5 year comparable cost, the cloud subscription needs to be comparable to 100 € licenses + 5 years support at 20% + a cost for hosting the application of 100€ at the customer side = 300€ in total. Your comparable subscription would be 60€ per year to get in 5 years to 300€. A 3 year model will lead to 100€ license + 3 times 20% + 60€ for hosting and a comparable subscription of 73,33€ per year. This ignores the project cost for the moment. Traditional software companies have an on average spend for project services of 1:1 to licenses while good SaaS companies should have a minimum onboarding fee. That can obviously highly vary.
Any new software deal on a subscription based cloud business will generate 60-75% of revenue plus a minimal onboarding service fee compared to the licenses fees. Let's assume 60% for an example.
| Single Deal | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total Lifetime |
|---|---|---|---|---|---|---|
| Licenses | 100 € | 0 € | 0 € | 0 € | 0 € | |
| Services | 100 € | 0 € | 0 € | 0 € | 0 € | |
| Support | 0 € | 20 € | 20 € | 20 € | 20 € | |
| Total Revenue | 200 € | 20 € | 20 € | 20 € | 20 € | 280 € |
| Subscription | 60 € | 60 € | 60 € | 60 € | 60 € | 310 € |
| Onboarding | 10 € | 0 € | 0 € | 0 € | 0 € |
(The example is not taking price increases into account)
A good assumption is a customer lifetime of 8 years minimal, where the subscription business will outperform the license business by 40%+ and the revenues are more equally distributed across the lifetime, adding up quickly to the customer lifetime value.
To compare the standard software business model with the cloud subscription model, we need to look at the average deal size (the deal will most likely take a similar effort/cost to close):
Our company did 25M€ new license revenue in the example on the top. Let's assume the deal size on licenses will be 100k€ per transaction that would lead to 250 deals per year. While on the subscription side to a deal size of 60k€ per year:
The existing software company with probably 15 years of history has 2.500 customers in year 1 while the subscription business had 100 customers in this example. With the same effort in gaining 250 new customers per year and growing this at 10%, the subscription business is growing topline extremely fast if we assume the same churn rate of 4% which may be a little optimistic. In 3 years only, the cloud business will reach already 50%+ of the traditional software company in revenues.
| License Business | Year 1 | Year 2 | Year 3 |
|---|---|---|---|
| Deals / Support Customers | 250 / 2.500 | 275 / 2.675 | 302 / 2.870 |
| Licenses | 25 M€ | 27,5 M€ | 30,2 M€ |
| Services | 25 M€ | 27,5 M€ | 30,2 M€ |
| Support | 50 M€ | 53 M€ | 56,4 M€ |
| Total Revenues | 100 M€ | 108 M€ | 116,8 M€ |
| Cloud | |||
| New Customer Subscriptions | 15 M€ | 16,5 M€ | 18,1 M€ |
| Renewal of Subscriptions | 6 M€ | 20,16 M€ | 35,2 M€ |
| Number of Customers | 250 new / 100 existing: 350 | 611 | 889 |
| Total Revenue | 21 M€ | 36,7 M€ | 53,3 M€ |
So the growth perspective on the topline is already showing the strength of a subscription model. Here are the key value drivers:
A cloud business with 10 M€+ Annual Recurring Revenues (ARR) can be profitable depending on how much the company invests in new customer wins, so the sales and marketing spendings. Reaching the first 10 M€ ARR is a tough uphill battle but if you compare such a company with an even larger traditional software business, it will be growing faster and produce more cash on the long run hence higher company evaluations are right if you assume the same capability of closing new deals and winning customers.
SaaS (Cloud) companies are evaluated at 6-10 times ARR (Source: https://www.kalungi.com/blog/saas-valuations#saas-value) depending highly on company size and profitability - trending down since Q4 2022. Software Companies with the traditional business model are valued highly driven by growth capabilities and positive EBITDA at a revenue multiple closer to 3,5 to 5 times revenue. (Source: https://finerva.com/report/enterprise-software-2022-valuation-multiples/). The difference makes sense as the growth dynamics as discussed before are clearly in favorite for the Cloud (SaaS) business models.
Overall it can be rightly discussed if evaluations of beyond 20 times EBITDA will be paying back on the long run in a market with shrinking evaluations.
