The Vital Role of Revenue Predictability in SaaS Valuation

In the SaaS landscape, predictable revenue is very important as it has a significant influence on how investors and buyers perceive and value businesses.

 Before the advent of the cloud-based software delivery model, software was typically hosted and run through a local server or computer. The revenue model reflected this system by charging a (usually hefty) one-time license fee. The only way for software companies to make more money was through customer purchases of additional licenses, software maintenance fees, or services such as setup, training, and installation. These services boosted revenue, but their dependence on expensive human labor limited scalability and reduced margins. This, in turn, lowered the perceived value of both licenses and add-on services.

The rise of the cloud-hosted, subscription-based, software-as-a-service (SaaS) model had a dramatic effect on the way software businesses were valued. The predictability of the revenue eventually made buyers and investors value the companies on a forward-looking annual recurring revenue or ARR multiple. This is dramatically different than the P/E ratio or trailing EBITDA multiple companies had traditionally been valued.

Understanding Revenue Predictability

Let’s explore why revenue predictability has such an outstanding effect on valuations. At its core, revenue predictability is a company's ability to accurately forecast future revenue streams. This predictability is critical for buyers and investors as it minimizes risk and facilitates better strategic decision-making on an ongoing basis.

Predictable revenue typically stems from long-term contracts, subscription agreements, and/or a loyal customer base—all these factors help ensure the company can more easily grow over time.

In short, the more predictable the revenue stream is, the more valuable it is.

Types of Revenue and Predictability

Let’s dive into how buyers and investors perceive different types of revenue streams. Here is a summary of the types of revenue streams—ranked in order from most predictable (highest market value) to the lowest.

Recurring Revenue (most valuable):

This type of revenue provides the highest level of predictability and is therefore perceived as the most valuable. Recurring revenue is typically generated through long-term contractual agreements, such as subscriptions, with the expectation that most customers will renew monthly, annually, or ideally, over multi-year contracts. These long-term customer commitments maximize predictability and are therefore highly valued by buyers and investors.

Subscription revenue tends to be valued on a forward-looking basis using the latest monthly revenue (monthly recurring revenue or MRR) and is often annualized to be annual recurring revenue or ARR.

There is also a debate on how subscription revenue may differ from ongoing software maintenance revenue. Both are considered valuable recurring revenue streams. However, subscription revenue, a regularly paid, pre-set fee to access constantly maintained and updated cloud-based software is typically valued more. Whereas maintenance revenue, where the revenue is generated from providing ongoing support services and updates to a product, is generally valued less. Software maintenance usually entails lower-margin services.

It is important to tell the right story (qualitatively and quantitatively) to buyers and investors when explaining a business’s maintenance revenue streams to maximize value. A skilled banker can help here. For example, PEAK was able to help Agiloft earn a premium multiple on both its subscription and nuanced maintenance revenue.

Reoccurring Transactional Revenue (next most valuable):

Transactional revenue is different than recurring revenue in that it consists of one-time purchases. There is some grey area because some transactional revenues are more “reoccurring” than one-time in nature and is why we break down transactional revenue into two categories: reoccurring and non-reoccurring.  

An example of reoccurring transactional revenue could be fee-per-transaction where the transactions are frequent and relatively consistent, such as data pulls (e.g. background checks), data processing (AI inquiries), and payment processing revenue, amongst others.

Reoccurring transactional revenue is considered more valuable than other transactional revenue due to its, well, reoccurring consistent nature. Here again, telling the right story and framing transactional revenues the right way is essential. A skilled banker can help you tell the right revenue story to prospective buyers and investors. As an example, PEAK was able to help StrataPT with its 100% transactional revenue model earn a SaaS-like revenue multiple.

Non-Reoccurring Transactional Revenue (least valuable):

One-time fees like setup, implementation, training, or professional services tend to be less reoccurring, are lower-margin services revenues, and are therefore assigned less value. It is still very common for SaaS companies to have these type of transactional revenue streams. Cloud-delivered software almost always requires customer support, and charging for this support can be prudent, even if it is not valued as highly as, say, subscription revenue.

Having some, say 10% to 20%, of total revenues coming from these non-recurring sources is considered normal, but companies can be penalized if “too much” of total revenues are transactional.

Again, telling the right story is very important. To maximize valuation, a company should emphasize how these one-time fees and services support recurring revenue and/or enhance customer retention.