SaaS Investing: Where to start and how to do due diligence

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Digitisation took us from pens, paper and people to computers and machines. Account books moved to spreadsheets, bank tellers to ATMs, and cash to online banking. ‘Digital transformation’ is the next big shift. Software as a Service (SaaS) is leading the digital transformation movement. It takes us from servers and bulky hardware to cloud computing. In this space, opportunities are truly limitless. Naturally, investors are taking note.

The major difference between SaaS and older ‘IT’ products and systems is the power to replace. Although ATMs can perform the basic tasks of a bank teller, they can’t replace people in banking entirely. Kindles and online articles cannot completely replace the experience of books and newspapers. In the digitisation movement, products were sold as helping hands rather than challengers.

Transformative SaaS products have much more power to revolutionise the way we live and work. PayPal and Square's Cash App are now on a level playing field with bricks-and-mortar banks. Netflix competes with satellite TV networks. SaaS can be used by challenger startups to revolutionise traditional practices. It can also be embraced by traditional companies eager to adapt.

Before we look at where to start with investing in SaaS and how to do your due diligence, let’s look at the key advantages that make this asset class an attractive one:

SaaS tends to attract higher valuations in the stock market.

The reason for this is simple - almost all SaaS models are subscription based, as opposed to consumer technology, which is often a one-time purchase. This makes it much easier to forecast revenue.

The SaaS model carries a sustainable competitive advantage.

Many SaaS models are designed to be used holistically. Project management tools like Workflow and Asana, event management software like Cvent, and accounting software like Sage and Netsuite act as a ‘one-stop shop’ for entire businesses. An element of ‘customer stickiness’ gives companies a sharp edge, meaning once subscribed, business owners will be reluctant to endure the huge upheavals required to switch management systems to a different provider.

SaaS products are extremely agile.

The adaptable nature of SaaS decreases the need for business owners to shop around and switch. Any new features that might tempt a user over to competitors can be easily replicated and implemented within days. Much cloud-based software is also highly customisable, enabling businesses to build unique workflows. This means much higher customer retention rates than traditional IT products. Shopify Plus’s retention rate, for example, is estimated to be around 140% due to business customers both staying and increasing purchases over time.  

Due diligence with SaaS investing

With SaaS companies accounting for 25% of the enterprise software market in 2019, there is an ever-increasing number of opportunities to choose from. When selecting an SaaS opportunity, investors should look at three key metrics:

  1. Total Addressable Market (TAM). How broad is the ‘pain point’ the company solves? How many business types and industries can realistically use the service? Is it scalable, i.e. adaptable for big corps, SMEs, startups, and freelancers?
  2. Defensibility. Although SaaS companies carry sustainable competitive advantages (or ‘defensibility’) by default, investors should look for levels of both innovation and protection within the company that makes their product hard to mimic.
  3. Retention rate. Rate of user base growth is important to observe, as is revenue growth. But with SaaS, it’s useful to look at the annual recurring revenue (ARR). Most SaaS products are billed monthly rather than as one-off sales. ARR gives us a clearer picture of revenue vs. marketing and sales spend over time. Because of typically high customer retention rates, ARR should increase while marketing spend goes down.  

Adobe is an excellent example of both how SaaS can pose a formidable threat, and also how it’s never too late to join ‘em if you can’t beat ‘em. Adobe was incredibly slow to move away from its expensive, restrictive CD-installation model. When the 2008 GFC hit, businesses shrank away from big one-time investments. It was the eventual transition to the more flexible, more affordable cloud-based Adobe Suite that saved the company, which is now flourishing, with ARR growing to $8.4 billion in 2019.

If you’re sold on the merits of SaaS as an investing route, STAX provides access to a wide range of opportunities, and offers easy, direct investment via our online platform. Check out our latest investment opportunities here.

James Brannan

Director of Operations at STAX

All views, investment or financial opinions expressed are those of the author and do not necessarily reflect the official policy or position of STAX. The information contained in this post is not investment advice or a recommendation to buy or sell any specific security.

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