SaaS Valuations Driven by Customer Base

September 27, 2018

Harvard Business Review published an article last year describing a new method they dubbed the Customer Based Corporate Valuation (CBCV) method focused on SaaS valuations and subscription companies.

CBCV takes a “bottoms-up” approach to determining a company’s value, focusing on its customer base and the value of its customers.  By contrast, traditional valuation methods take a “tops-down” approach, starting with a company’s financials and projecting a forward-looking analysis of the company’s value over time.  That method doesn’t analyze the customer base that makes up the revenue and only makes high level assumptions about how revenue will grow.   Future projected revenues are based on trends of the past – a method everyone knows is faulty but has been used for as long as anyone can remember.

Customer Segmentation is Fundamental to Valuation

The CBCV method digs into well-known SaaS metrics like Customer Retention rate, and Average Revenue per Customer (ARPU), goes further to segment customers to see how many are highly valuable versus not so valuable.   The assumption is that not all customers are created equal or, not every dollar of subscription revenue is equal.  In other words, a dollar from a profitable customer who is likely to be retained, is more valuable than a dollar from a customer that is less profitable and/or is more likely to churn.

The way to understand which dollar is better is to segment customers into different groups.  Customer segments can be different in several ways. Firstly, different customer types may have different typical retention rates – for example, SMB customers tend to have lower retention rates than large, enterprise customers.  Secondly, different customer types have different appetite or likelihood of buying more or increasing their average contract value. And thirdly, different customer types cost different amounts to acquire, service and retain, leading to varying customer profitability.The HBS article:  Subscription Businesses are Booming:  Here’s How to Value Them goes on to show how public analysts can get at some of this information and do a better job predicting whether a public company will continue to be valuable or not than by just looking at traditional financials.  Every company, however, can do the same and better with full access to its own customer data.   As outside analysts get better and better at picking up on tell tail signs of customer value, SaaS companies would do well to build that analysis internally first.

Connecting the Dots Between Financials and SaaS Customers

If the first generation of SaaS was about moving to a recurring revenue model and everything that entailed from traditional, on-premises software licenses, and the second generation was all about Sales and Marketing, the third generation of SaaS (today) is about the financial value of customers.

We see companies focusing on these key customer metrics and managing to them.  We see investors doing due diligence on potential investments against the key customer metrics, and we see investors focused on improving customer metrics as part of the overall plan to improve enterprise value of portfolio companies post investment.In light of all this, SaaS companies and management teams focused on increasing company value need to do two things:

  • Connect the dots between their CRM and their financial systems in order to do proper analysis of segmented customer retention rates, ARPU and ARPU growth and varying customer profitability.
  • Ensure that management across the board is focused on key customer metrics like retention rates, ARPU and customer profitability and working to continually them. Management can only do that if they are getting the appropriate reporting, which leads back to making sure that the CRM and financial system are connected and a good BI tool is being used for performance reporting.

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