For most software executives, the ultimate SaaS business barometer is their company’s valuation. It drives decisions on corporate strategy, product development, brand positioning, hiring, investment, and many other facets of the organization.
In that regard, 2021 was a good year, at least as far as venture capital-backed companies are concerned. In its latest VC Valuations report for Q3 2021, financial data company PitchBook reported valuations are on the rise for companies ranging from startup to late-stage, across industry sectors. In many cases, to record levels.
Why are SaaS companies valued so high?
A software company can take advantage of the pricing models set forth by SaaS companies. SaaS companies charge recurring subscriptions for their services and add additional revenue streams through subscriptions for new services or features. This helps many SaaS companies grow rapidly. That rapid growth combined with recurring revenue is causing record-high valuations for software companies, begging the question, are you can taking advantage of this or leaving money on the sideline?
Could your software company be leaving money on the sideline?
Valuations on the rise is great news for software companies, but a deeper dive into the data reveals a wider-than-ever gap between valuations for software companies in the top quartile versus those in the bottom quartile. In the climate tech sector, for example, this gap was around $365 million—a greater than 20% increase from 2020’s record gap.
Clearly, some SaaS companies are seeing their hard work pay off big. Those outside the top quartile, however, are leaving a ton of money on the sideline.
The Relationship Between Pricing and Valuation
What characteristics separate the high performers from the pack? Of course, product quality, market opportunity and customer acceptance are critical, but a software company would be wise to recognize the impact of their pricing model. According to Garth Tebay of Value Defined, LLC , a nationally recognized leader in the field of business valuation, “In software firms, the majority of the firm value is comprised by intangible assets. This intangible asset value can be maximized by a process-based pricing model—integrated throughout the enterprise—that reflects and capitalizes customer and marketplace dynamics.”
An optimized software pricing model is sophisticated and fluid, using real data and competitive insights to align revenue generation with the value customers derive from using the software. It is structured to accommodate the full range of customer use cases and control discretionary pricing decisions. It is built to be completely defensible, including treating customers who buy the same set of products and services the same. In so doing, the optimized pricing model strengthens revenue and margins over the entire customer base.
Yet beyond this obvious benefit of greater profitability are several other factors of an optimized pricing model that contribute mightily to a higher business valuation:
Greater scalability improves future growth:
To a great degree, a company’s valuation reflects its future potential. The easier and faster a software company can scale, the more it is worth to investors. An optimized pricing model addresses many of these common obstacles to scalability:
- Overly complicated pricing models, with countless SKUs, tiers and variables.
- A lack of true data to really know how customers use the software to gain value, how that use changes as customer characteristics change and the real prices being paid for competitive solutions.
- Revenue leaks from flawed product packaging, discretionary pricing or barriers for deeper customer deployment.
- Loosely established, undocumented pricing processes that are dependent on single individuals or hard-to-transfer practices.
When built on an effective data foundation, the pricing model can also predict how potential pricing changes, such as a higher price, could sway revenue, and visualize how customers, industries and products would be affected, further enhancing the company’s ability to scale.
Less deal friction:
When sales velocity improves, revenue growth accelerates. When revenue growth accelerates, a business valuation increases.
A programmatic pricing structure—a key element of an optimized model—uses formulas to remove ambiguity from the pricing model. Discounts are earned according to actual purchasing behaviors, not discretionary or random deals, making it easier for the customer to understand future costs as their deployment increases.
Further, a well-conceived model reduces the complexity of the company’s pricing, making it easier for both customers and the sales team to avoid confusion that slows the sales process.
Synchronized product development:
Integrating the development function into the monetization process is a key attribute of an optimized pricing model. Doing so ensures that development attention is focused on the true value creators, thereby synchronizing their development plans to revenue. By analyzing purchase and use data, companies can determine, for example, features to be included to existing customers, those available only at a premium level, or those to be packaged into a separate product.
Over time, this will result in capabilities that generate better revenues for the software company and prevent the codebase from becoming bloated.
Adaptable pricing process:
Transferability—the ability to transfer an asset, independent of any single individual or existing environment, to another entity—is a core principle for valuing software companies. For this reason, the process a software company deploys to establish, monitor, refine and continually execute its pricing program is critical to its valuation.
An optimized pricing model establishes processes and tools to monitor performance and adjust accordingly. It eliminates blind spots to how the model performs as market dynamics shift, enabling quick changes that can prevent revenue leaks or take advantage of marketplace opportunities.
Higher investor confidence:
Venture Capital and Private Equity investors spend a lot of time assessing company management before deciding to invest. Why? To determine if existing management is capable of growing the company to its full potential, of course. A company with solid and experienced management will usually command a higher valuation than one without it.
The existence of an optimized pricing model—one rigorously developed that is based on data, aligns with how customers gain value from the product, accommodates all possible use cases, controls discretionary variables and is understood and integrated to all parts of the enterprise—testifies to the professionalism with which the company is managed. As Joel Lanik, Partner at the software-exclusive private equity firm Frontier Growth says:
“Software companies that apply real data analytics to their pricing model give investors a higher level of confidence in their business practices. It is an indicator of a much more mature business.”
Is it a good time to build a software company?
With record-high valuation levels, it is indeed a great time to build a highly valuable software company. But to fully capitalize requires more than just a great product, significant market opportunity and robust demand. The widening gap between the most and least valuable companies makes it clear: if you seek the highest valuation levels, your pricing model can help you get there.