Evaluating SaaS Companies
In the mad world of software, the valuation of a company is a topic that perpetually piques the interest of industry insiders.
The task of predicting the success trajectory of a SaaS startup (robinhood style) during the early seed phase is daunting and at times, pretty useless. There is no silver bullet. It will be extremely dificult to identify another Figma any time soon.
Yet there are a few back-of-the-envelope sketches one can do to get a "feeling" for a potential venture.
Now of course, I wouldn't apply what I am outlining here. SaaS evaluations are different for different industries. See this post as more of "rule of thumb" thing, rather than actual framework.
But when thinking about new SaaS or startups, I often think about a couple of different leading indicators or topics.
Most of the indicators overlap but we can put them into buckets:
1. Market Advantage
2. Tech Advantage
3. Competition Advantage
Obviously, there are way more buckets.
But at the crux of evaluating seed software companies, whether enterprise, licensed products, or startups - much lies in understanding their growth potential, market share and operational capabilities.
You want to try understand how X or Y can launch an MVP, maintain momentum, expand with partners and foster a culture of resilience.
Now this is more simpler said than done. Don't get me wrong. I am properly armchair quarterbacking sh*t around here.
But at certain breakpoints in the journey, you want to ask yourself - how well can a seed founder articulate the service or idea to a non-technical audience? What is the frequency and intensity of the problem such a company is addressing, and the willingness of future customers to pay for a solution?
These are the types of questions that keep investors and evaluators awake at night.
Metrics
When evaluating a SaaS startup, understanding and interpreting key metrics is pivotal. Metrics provide a quantitative lens into the company's performance and growth potential.
Something to think about upfront:
Understanding the Market
SaaS is an attractive business model due to its efficient, recurring revenues. We all know this. It's a become a lucrative market.
However, if a startup operates in a sector with slow SaaS adoption, such as healthcare (historically speaking) - well then, achtung!
So, when evaluating a seed it's crucial to map the potential market size, understand the problem space, and assess the competitive advantage. Get ready to do some heavy benchmarking and deep-diving here.
Total Addressable Market (TAM) of a potential seed and comparing it with other players in the field is crucial. Smaller TAMs often translate into fewer buyers and a limited pool of investors or channel partners for long-term consideration. In such cases, patience will be required to seek ROI.
Product-Market Fit (PMF)
Often founders know what their problems are, but not the underlying relative market positioning. To bring both worlds together is essentially what we refer to as "finding" Product-Market Fit (PMF).
However, there may be a case to shift the focus towards Product-User Fit (PUF) for early stage ventures. PUF is about surveying the extent of the problem space and the number of people willing to pay for a solution upfront and as early as possible. So, you kind of ignore some of the macro market dynamics and focus really on user need. Sometimes this can be a better indicator - depending on seed stage.
Do note, PMF is pretty much a continuous process here.
PMF cuts across many dimensions.
But notably PMF also helps identify if such X or Y startup or company have the capabilities to reinvent themselves further down the line. It helps carve out process gaps and highlights what future support mechanisms will be required to improve capabilities further down the line.
Vertical vs Horizontal SaaS
Now, the SaaS service in question might be exploring different use cases across various verticals instead of doubling-down on a single vertical.
So, the service might be addressing a specific business problem that cuts across multiple verticals, rather than focusing on a particular vertical.
There are pros/cons that one could argue about here.
Again, it's vital to try put a marker on the PMF positioning and understand this area thoroughly.
So don't underestimate this step. The distinction between horizontal vs vertical SaaS influences how products penetrate and expand within organizations, channels, and marketplaces.
Technical Evaluation
A pivotal breakpoint of evaluating a SaaS future readiness is the dissection of the tech stack.
Whether the startup leans more towards worflow productivity or infrastructure or API services, or whether it operates as a data app built atop a warehouse, functions as middleware, or some reconfiguration of an existing tool or even a new database - all these categories are of huge importance and its important to know which category fits and get the positioning right.
So at this breakpoint, you want to try decode the technical mystery that shrouds the service or technology component.
It's about discerning whether the service is robust enough to fend off competition and if the market is spacious enough to accommodate such a seed. This often involves a thorough cross-examination of business logic + stack execution.
Now, in the SaaS world, companies have the advantage of being developed once and distributed over and over again across markets. Business advantages that come from this characteristic include consistent revenue flows, gross margins of ~60-80%, and the potential to grow exponentially when network or scale effects occur.
I've heard very experienced people discuss billable versus non-billable and how margins can be amplified by understanding and positioning such capital flows.
Non-billable components often find themselves under the umbrella of COGS, an unavoidable outlay. Ideally, billable data should be seamlessly incorporated into the very fabric of the product or SaaS offering, with costs (along with a profit margin) passed onto the customer.
I like this approach. When evaluating a SaaS try gauge what is billable vs non-billable and how might this impact longterm scaling effects. If possible.
Another leading factor for SaaS is that most if not all companies and startups own the code as IP, enabling them to build up robust tech moats longterm - if the positioning is right.
In parallel, it's probably a good idea to grasp how data is intricately woven and employed across a SaaS services or operations, and how this data is being harnessed for long-term benefits and eventually - the moat.
All this being said, there are many different approaches towards analysing the tech stack. But it is yet another area that should not be under-valued.
The goal is to analyse and identify to a certain degree of accuracy, which sub-system components within the tech stack are available to aqcrue value incrementally over time.
DIY Capabilities
In an ideal world, the SaaS or startup would have the right components across their tech stack to power real-time product needs as customers scale.
Moreover, how they expose such data to enhance the overall value of their service and whether they possess the technical capabilities to execute at scale is crucial.
No doubt, the DIY capabilities gain prominence as a SaaS startup scales and grows. Such considerations play a significant role in shaping future margins.
While COGS are an inevitable part of the equation, it's the internal capabilities that often tip the scales when it comes to longterm evaluation.
Balancing all these technical elements during the evaluation process can be like walking a tightrope and naturally, this requires a serious amount of objectivity and dicipline.
Evaluations also involve, as expected - a lot of transparent comms with engineering teams, and other key stakeholders.
Competition and Monetization
Understanding the competitive advantage of the startup within the problem space and building ontop of TAM is the next breakpoint.
Understanding the monetization options and the speed of customer onboarding is kinda super important and stuff.
Startups that can get their product up and running and secure the love and payment of the first 10 customers have a significant advantage when seeking investment.
So it's crucial to be aware of the Customer Acquisition Cost (CAC) and strive for efficient CAC paybacks below 20 months adjusted on a gross margin basis. You here these metrics quite often.
Longterm, you may want to think about partnerships, specially if you are evaluating an enterprise SaaS - so, which third-party ecosystem players or channel partners may such a service or company be able to tap into for customer expansion.
You also want to think about how such a company will play ball with the bigger players in the space. For instance, if you are working with an infrastructure SaaS, how might they compete with AWS? Would such a SaaS company also be attractive to such big players? Hypothetically, will a company like AWS want to buy the SaaS company under evaluation one day?
Open Source
The rise of the Cloud Native Computing Foundation (CNCF) and other Open Source Software (OSS) platforms underscores a shift in the technology landscape. Once sidelined, open source has undergone a transformative journey and is now pivotal to many SaaS marketplaces.
As it stands, the open-source playbook functions as-is: freely distribute the core code, attract a vast user base, engage developers, cultivate feedback, iterate, and finally, introduce premium features.
Although this might appear like a high-burn process, the dedication of users and the power of a vibrant online community can yield rewarding returns.
For budding SaaS businesses, embracing this strategy is not without risks.
On the outset, you are essentially providing their primary offering at no cost, with the hope that the value-added features or premium services will generate revenue.
But this gamble, while audacious, has borne fruit for many. Between 2020-2023, we witnessed remarkable developments and growth spurts in the OSS arena.
However, the key lies in discerning what to freely provide and what to monetize. And dhis decision matrix isn't always straightforward.
And then there's the domain of licensing, notorious for its intricate legal challenges. It's a maze that many SaaS startups wish to sidestep, fearing potential pitfalls. But given the current ubiquity of OSS, it's almost inevitable NOT to engage with it.
Innovations like the Business Source License (also known as BUSL), adopted by companies like HashiCorp, exemplify the evolving marketplace right now.
BUSL permits time-bound exclusivity for certain features before they transition into the public domain. It's a balanced approach that respects commercial interests while ensuring eventual contributions to the community.
But it's crucial to tread carefully here.
Leveraging the benefits of the OSS community without reciprocating or engaging in parasitic practices is detrimental. Authentic engagement and genuine collaborations are essential.
Therefore, for anyone evaluating a SaaS startup's future potential, it's vital to examine how they engage with open source. Exploring their strategies and interactions with the OSS community, especially if they aren’t inherently open-source, can be revealing. Analyzing the journeys of companies like Slack and HashiCorp, especially their "freemium" models and the succesful community collaborations, can provide significant insights.