This post was originally included in our Quarterly Letter to our LPs in Q4

2012, before Concur had been acquired by SAP for $8.3B.

During our numerous meetings with our Limited Partners, many often ask us
two questions: What is it that you like most about SaaS companies? and
How do we value SaaS companies? In regards to the first question we like
SaaS businesses for several reasons.
First, we like SaaS companies inherent annuity streams. In other words,
SaaS companies acquire customers that look like life insurance policies,
whereby each new customer presents a long-term recurring revenue
opportunity. Since the contracts are annual subscriptions, companies are
often more concerned with farming the customer over the long run than they
are with negotiating the initial contract. A good sales team selling a product
that works should be able to generate customer retention rates above 90%
and revenue retention at or above 100%.
Second, SaaS companies tend to have low churn and high renewal rates,
resulting in high customer lifetime values. This occurs for two primary
reasons. First, SaaS companies are built for strong customer service. Unlike
traditional software vendors, constantly searching for the next big win, SaaS
companies rely heavily on upselling and customer renewals for survival.
Thereby, poor customer service is not an option for SaaS companies. Also,
many SaaS apps require widespread user adoption throughout the
enterprise, which requires training and behavioral changes. The potential for
employee disruption doesnt justify changing SaaS apps simply to save a
few bucks.
The third reason we like SaaS companies are high gross margins. Gross
margins typically range from 60% to more than 80% with the primary COGS
being network and delivery costs, as well as services personnel (e.g.,
maintenance, training, implementation, etc.). As the customer base matures
and the company reaches scale, most SaaS companies should achieve gross
margins in the 75%80% range, depending on the level of professional
services required to deploy the solutions.
The fourth and final reason we like SaaS companies is they have much more
efficient R&D spend than traditional licensed software companies. In
general, R&D expenses (as measured as a percent of revenue) for public
SaaS cos are lower than traditional licensed software companies. Unlike
licensed software vendors, SaaS companies are not required to support
multiple technology stacks (i.e., operating systems, Web servers, databases,

etc.) or a variety of hardware platforms. Additionally, SaaS solutions are

typically version-less (all customers are on the same version) thereby
enabling critical R&D dollars of the organization to focus on the next version
and innovation (as opposed to supporting previously written releases). Some
analysts estimate that legacy licensed software vendors spend as much as
80% of their R&D expenditures on supporting old products. Analysts believe
the normal range of R&D for a mature SaaS company is 7%12% of revenue,
compared to 15%25% for a traditional licensed software company.
The second question investors often ask us is: how do we value SaaS
companies? In order to understand how to value a SaaS company, one
needs to understand a few important definitions.

Bookings: With a traditional enterprise software company, most

software that is booked in a quarter is recognized in the same quarter.
Thus, software revenue and software bookings (i.e., new contracts) are
essentially the same. However, for a pure SaaS company, evaluating the
income statement is like looking in the rearview mirror. Typically, software
bookings translate into revenue multiple quarters down the road. Thus,
bookings are a better indicator of future performance than revenue.
Free Cash Flow (FCF): Free cash flow is defined as cash flow from
operations less capital expenditures. Since SaaS vendors host applications
for the customers, capital expenditures are an ongoing cost of business
and important to monitor. In many instances, free cash flow is
significantly more than operating profits. There are two important things
that can dramatically affect cash flow in SaaS companies. First is the
contract length, in that customer contracts can vary from monthly
arrangements to multi-year upfront commitments, which can have a
material impact on cash flow and deferred revenue. The second is the
cash collection policy, in that some companies bill 30 days in advance,
some collect one year up front and some collect multiple years up front.
Many vendors have a combination of all three. All can have material
impacts on cash flows.

In short, valuing SaaS companies is a challenge, and both investors and

analysts have many different opinions on how it should be done. Some
people focus on earnings (GAAP and/or non-GAAP) and free cash flow, while
others prefer to focus on enterprise value to revenue. While some investors
believe enterprise value to-revenue multiples are an unsatisfactory method
of valuing a company, it is clear that in the absence of meaningful
profitability, an avenue outside of earnings must be taken. Where earnings
are absent due to failed business models, it could well be argued that the
revenues generated by a firm may well be worthless since there is no clear
path to profitability or at least positive cash generation. In the case of SaaS

companies, earnings bases are typically negative, based not upon poor
financial structures, but rather upon high rates of reinvestment made to
support the accelerated growth of their valuable high-margin recurring
revenue base. Given the highly recurring, low churn revenue base, it is fairly
simple to calculate the net present value of the installed customer base
assuming the company was operating under a steady-state condition (i.e.,
not investing for new growth). Over the long run, the revenue bases should
evolve to support strong earnings bases due to significant operating
leverage.
This leverage comes primarily from sales & marketing, which is universally
the largest drag to operating margins and the largest expense as a
percentage of sales. Its important to understand that within the software
industry the sales and marketing function is often the most important and
most strategic component for growth. For SaaS companies, this expense is
exaggerated, as costs are recognized up front while revenue is deferred over
multiple periods. As a result, assessing the performance for a sales force is
challenging while many of the old rules dont apply, thus determining the
right sales force size can be difficult using only GAAP or non-GAAP metrics.
We use several metrics to measure the performance of sales and marketing
effectiveness.

Magic Number: The magic number is a metric that provides insight

into the effectiveness of sales and marketing spend in the context of
recurring revenue growth. This number provides a high-level view of a
combination of factors, including market saturation and competitiveness,
sales force effectiveness and retention, and up-sell and cross-sell strength
of existing customers. The magic number is calculated by dividing new
annualized quarterly revenue by S&M spend in the quarter. The key
insight is that if the magic number is greater than .75, it makes sense to
invest in growth because the business is primed to leverage spend. This
number can also help alert management and investors as to when
something may not be working. A number between 0.00 and 0.75 should
alert a company to take a closer look at their internal process and market
position. It could mean that market saturation is high, competition is
challenging on price, sales force is ineffective, or the market isnt growing
fast enough; all of which may justify a reduction in spending or
restructuring of the sales force.
CAC Ratio: The CAC ratio is similar to the magic number but provides
insight into the ultimate profitability of S&M investments. It is calculated
by multiplying new annualized quarterly revenue by gross profit and
dividing by S&M expense for the quarter. A CAC ratio of .5 shows that half
of the investment is paid back within a year, and assuming low churn, paid
back in full in two years.

Cost to acquire a customer CAC: This is calculated by taking sales

and marketing spend and dividing by the new customers added in the
quarter. This gives us a sense of how acquisition costs trend over time.

% Attainment: This represents the percentage of total sales capacity

that is actually generated by sales reps. It gives us the ability to
benchmark against other companies and determine how realistic our sales
force productivity model is.

Sales Performance (MRR): Defined as how much monthly recurring

revenue a sales rep on average is bringing into the company. If we
multiple this number by 12, we get annualized recurring revenue which is
a percentage of sales quota.
One way to understand the financial leverage, is to use an example of a
company that is a microcosm of the sector itself. To that end, weve decided
to examine Concur Technologies, a provider of SaaS based expense
management and travel solutions. The company has been public since 1998,
and currently trades at about the median multiple for the SaaS comp set we
discuss below.
Concurs financials are featured below:

Upon closer review of these financials, a few things should stand out. First, it
is clear that the largest operating expense line item is Sales and Marketing at
40.3% of sales vs. 16.8% for G&A and 10.5% for R&D. Concur is spending
over $186 million dollars on discretionary sales and marketing today, in order
to win long term, high gross margin contracts with its customers in the
future. Substantially all of Concurs revenues are recurring, and the
company has a 95% customer renewal rate. So, what might happen if
Concur pulled back its spend?
Concurs financials end up looking significantly different if they pull back the
throttle on sales and marketing spend. Due to the low 5% annual churn rate,
95% of customer revenue would continue to recur each year, but the
company could dramatically increase its profitability. In some ways, this
could be thought of as an annuity contract with 72% gross margins that
would decay at a rate of 5% per year. The stream of cash flows is indeed
highly predictable.

Concur can also make a good acquisition target, given the recurring nature of
its revenue, and historically high retention rates. Key points for a potential
acquisition include:

Large acquirers (i.e. IBM, Adobe, Oracle, etc.) can acquire Concur and
plug the company into their massive sales forces, increasing sales
productivity
o

Concur currently has ~400 salespeople

Oracle has 30,000 salespeople

Large acquirers can cut duplicative administrative costs while

maintaining recurring revenue base, dropping savings to the bottom line

In our opinion, it is appropriate to apply a revenue-based multiple in

attempting to determine a fair market value for these companies. Given
gross margin structures and significant over investment in sales & marketing
to gain recurring revenue customer contracts, we think its obvious that once
revenue growth rates moderate, considerable profitability should be
achievable. Over the long term, SaaS companies of course will revert to
earnings-based and free cash flow valuations as their operating models
mature. With blended gross margins already routinely coming in at 70-80%
or greater, operating margins should mature to routine levels of 25-30% or
greater while exhibiting strong stability due to the companies highly
recurring revenue base. Under such a scenario, a premium earnings multiple
should be justifiable for SaaS companies to account for the strong
predictability and visibility the companies offer investors. In the interim
though, there is no clear answer as to what is the appropriate revenue
multiple for SaaS companies, as industry multiples have had large swings,
and as investor sentiment in the broader market has varied. At the best of
times, multiples of 6-8x trailing revenues were common, with some capable
of reaching higher into a 10x or better range. While in a soft market,
multiples for many have fallen to a 3-4x range for trailing revenues, with the
most pressured companies (with negative earnings bases and short track
records) proving capable of trading below 2x trailing revenues. The chart
below depicts the revenue multiples of 14 SaaS companies on a semi-annual
basis since 2008.
Based upon this data, it is clear that there is a trend here and that SaaS
companies have been valued off of high revenue multiples for a long time,
and their multiple expansion and contraction has roughly tracked the broader
financial markets.

Overall, our intent here was not to make a justification of SaaS company
valuations, but rather to highlight why SaaS businesses are good businesses,
why they often trade on multiples of revenue and why they make good
potential acquisition targets. In a nutshell, these businesses have high gross
margins, mostly recurring revenue, and the potential to be very profitable.
We believe that our strategy of investing in these businesses in the private
markets, while using structure to mitigate downside risk, is a sound path to
generating outsized risk adjusted returns moving forward. Most importantly,
we hope that this piece has helped many of our LPs who are less familiar
with the software sector understand why we believe these businesses are
attractive.

This post was originally included in our Quarterly Letter to our LPs in Q2
2013. LEC has made marketing SaaS investments in companies
like Bazarvoice,
Marketo,
Monetate,
Ensighten,
Kapost,
and
Spredfast. Clearly we have been bullish on the marketing technology space,
and in this letter, wed like to outline some of the reasons we have been so
fond of the market.
Reason #1: Marketing Departments have Budget
Selling into functional areas of enterprises can be a daunting task. When we
talk to salespeople at software companies we evaluate, they relay all of the
different pieces of pushback they hear from various constituencies. These
excuses typically range from the concrete; we need multiple sets of
approval from management and were not there to the completely
intangible; we need to figure out our strategic direction before jumping in
with a new technology. Through all the noise, however, the most common
refrain within functional groups is that they simply, dont have the budget.
Companies that sell into the marketing and sales departments of companies,
however, dont hear as much pushback around budget. The fact is simple,
sales and marketing departments drive revenue, which for most companies
is the lifeblood of their business. While other functional departments, such
as HR, finance, operations, etc. are constantly looking to cut costs, marketing
departments are becoming more empowered to leverage technology to drive
revenue especially as it delivers a clear ROI. They therefore have budget to
spend, which makes for the best type of customer. In addition, in most
corporations, they need to demonstrate organizational productivity, further
accelerating the need to experiment with new tools. Clearly this is not to say
that marketing departments never push back on pricing, but on a relative
basis we find that they are becoming much easier to sell into.

Reason #2: Marketing Tactics have become more analytical

Marketing departments have seen a significant shift during the digital age.
Once stereotyped as cost centers with minimal measurability, marketing
departments are leveraging technology to both enhance and demonstrate
success. To that end, their appetite for products that can help generate
positive ROI is large. Today, more than ever, these departments are also
being judged on their effectiveness. CMOs are empowered to make
decisions, but must do so based upon concrete, data driven strategies.
As marketing departments have shifted during the digital age, they have
purchased products to meet their analytical demands. Several of our
companies help marketing departments meet these goals. The analytics
each product offers can help to specifically drive both leads and conversions.
Reason #3: Marketing Departments have (nearly unintentionally)
embraced SaaS
It is our belief that SaaS is the way in which nearly all software will be
delivered in the future. In the here and now, however, the marketing
departments within companies both large and small seem to be the ones
that have most overwhelmingly embraced the SaaS revolution. This dynamic
produces a more knowledgeable customer base and therefore a shorter sales
cycle.
But why is it that this department is the one that has embraced this delivery
method? In our minds the answer is simple, it comes down to greenfield
sales vs. legacy displacements. As we noted above, in many functional
areas, new SaaS technologies have the difficult job of displacing existing
legacy application software systems. For instance, if a new vendor wanted to
come in and replace a companys legacy inventory management software
system, theyd be displacing a technology that might have been used at a
company for 25 years. Employees know all of the legacy systems quirks,
workarounds and troubleshooting procedures. Bringing on a new system
would require a new set of education and time investment on behalf of
users. In these cases, often times the old adage holds true, if it aint broke,
dont fix it. With that said, many legacy systems are in fact being disrupted
by SaaS models but that is a topic for a different letter.
In the case of digital marketing, no such legacy systems exist. Due to this
fact, marketers have needed to embrace new emerging SaaS tools almost
out of necessity. As SaaS tools grew in the digital age, so too did data-driven
marketing, and voila, in that perfect storm, SaaS was the only game in town.
Because the products were so easy to set up and required minimal onpremise integrations, marketers started circumventing the IT organization,

which historically had been the area that laid the red tape so many software
companies met during the selling process. The inertia has continued over
time, and marketers are more empowered than ever to purchase technology
on their own accord.
With the aforementioned empowerment, also comes the double edged sword
of rapid change. Buying cycles can be shorter, but you can also be removed
more quickly. Often times marketing departments will purchase SaaS
software as a trial or proof of concept, and convert to a deeper, broader
deployment over time or shut the software off altogether. Because the data
is hosted by the SaaS company, however, the SaaS provider itself has
excellent high level data around usage and logins, that would be otherwise
difficult to get if the software was installed on premise. This plays into our
favor as investors, as were able to track these companies over time,
watching smaller purchases convert to larger upsells. If there is an absence
of upsell data because the company is on the earlier side, were able to
evaluate logins, time spent in software, etc. to make a determination of how
likely customers are to both renew and expand their subscription.
Reason #4: Market Dynamics and Exitability
Despite all of the positive micro-based trends above, perhaps the most
important reason we like investing in the marketing software ecosystem has
to do with what we term, exitability. Observing the private equity industry,
weve concluded that numerous companies end up in a firms portfolio for
years that are affectionately the walking dead. Often times these
companies simply might not have performed to par. More frequently,
however, they are companies that have revenues and are cash flow
positive/breakeven yet arent growing and are not large enough to IPO, and
have a minimal acquirer set.

The thing we like most about the marketing software sector is that
historically the exit dynamics are advantageous, and have been proven out
over a long time period. The chart below depicts an acquisition taxonomy of
the marketing software sector:

The prior chart gives us comfort in the exitability of the companies in which
we invest. There are a few particular characteristics that resonate in
particular:
1.

Multiple Winners Most of these sub-markets are large, and can

support multiple companies with meaningful revenue streams. Given that the
market is not winner take all, not picking the winner can still result in a
favorable investment and enhance downside protection.
2.
Healthy Acquisition Multiples Many of the companies on the list
have been valued at significant multiples of revenue on exit. This shows the
strategic value the acquirers have continued to place on the sector. As a
reminder, in the Q412 letter we discussed in detail why strategic acquirers
are able to pay these multiples for these businesses.
3.
Large Companies Buy v. Build Most of the larger acquirers listed
on the bottom right of the chart have made multiple acquisitions in multiple
sub-sectors. Through this public data, along with our conversations with M&A
folks within these organizations, we feel that there is overwhelming evidence
that the big guys will continue buying in this sector.