Written by Tyler Newton, Catalyst Investors
Submitted by Catalyst Investors

The cloud computing market is one of the most exciting growth areas in technology today. In contrast to traditional enterprise technology, cloud computing reduces costs, increases accessibility, and can even improve functionality for end users of all sizes. Cloud computing and its relative software-as-a-service (“SaaS”) are important target sectors for us at Catalyst Investors. We have reviewed more than 100 of these companies over the years and have invested in several, including UK-based MessageLabs, which was acquired by Symantec in 2008 in one of the largest SaaS acquisitions to date. As an investor in these sectors I hope to encourage a movement toward a standard method of reporting and analyzing the financial performance of SaaS companies. I believe that potential investors would better understand the performance metrics and potential ROIs of the SaaS sector if its metrics were comparable to those of mobile telephony instead of those of the general technology sector.

SaaS companies are typically run by technology industry executives – folks used to hardware or software license revenue models in which the customer pays up front for products. SaaS companies, however, are recurring revenue businesses, akin to a communications business like mobile telephony or cable television. In a communications business, the company makes a large upfront investment in a network and in sales and marketing to win customers that spread their payments out over several years. Net income is usually a meaningless number for communications companies until they became very large, thus they are usually valued on the basis of earnings before interest, taxes, depreciation and amortization or “EBITDA”.

For SaaS companies, however, much of the investment in the product platform is expensed as research and development rather than “below the EBITDA line” as capital expenditures, which makes even EBITDA a meaningless concept. While SaaS companies may take longer to reach strongly positive EBITDA than traditional technology businesses, the stable nature of its recurring, long-term cash flow stream should be valued more highly than hardware or license sale revenue. SaaS analysts have thus relied on revenue multiples to assess the valuation of individual companies.

While we believe that the high revenue multiples of the industry are largely justified, a revenue multiple is a rather blunt instrument with which to compare companies that may offer vastly different products to vastly different end markets. When valuing a SaaS company, important drivers are intangible factors such as market opportunity and competitive positioning. When assessing tangible performance, however, the key creator of ROI is the spread between the lifetime stream of profits per customer (“Lifetime Recurring Gross Profit”) and the up-front cost of winning and installing that customer (“Cost of Acquisition”).

Read the rest at: The Catalyst Investors Blog

Tyler Newton, CFA, is Partner and Research Director at Catalyst Investors, a growth private equity firm based in New York. You can follow him at on Twitter (@tylernewton). He blogs about economics and the financial markets at www.tylernewton.com.