Firms love companies using subscription model despite inherent risks
Updated with correction
Venture capital and private equity managers love subscriptions. But the model of selling products with a recurring fee is no guarantee of success.
Managers are still investing in subscription-model companies despite higher prices and the trouble that some, such as Blue Apron Holdings Inc., have had as public companies.
And investors appear to be on board.
Vista Equity Partners in March closed one of the largest-ever software funds, the $10.6 billion Vista Equity Partners VI, which started fundraising with an $8 billion target and no hard cap, according to a report to the Oregon Investment Council, a fund investor. Vista is focusing on high-growth software-as-a-service companies — or SaaS — with "high recurring revenues" as well as high customer retention, the Oregon report stated. SaaS companies license their software rather than follow the original model of selling it to customers.
The recurring-revenue model is a main feature of SaaS companies, which are prime investment targets for venture capital and private equity managers. Private equity SaaS deals grew 217% between 2010 and 2016, showed data from PitchBook Data LLC, a Seattle-based private equity research firm.
Vista's fund amounted to about 19% of the $56 billion in total capital raised by U.S. private equity funds in the first quarter, according to PitchBook.
Software touches many industries, and SaaS companies have attracted investor interest. Venture capital and private equity managers like the recurring revenue, which they believe make these companies less risky. What's more, recurring-revenue companies also sell for more on exit, which boosts returns.
"SaaS is a more predictable and reliable revenue stream than if you had to go out and sell the software — the perpetual license model," said Peter Fair, managing director in the San Francisco office of credit asset manager Golub Capital LLC.
Rohit Kulkarni, head of research at SharesPost Inc., a San Francisco secondary market private shares trading platform, agreed. "Any firm with recurring revenue is extremely attractive to investors," he said.
Typically, companies with recurring revenue models are valued much higher than companies without a subscription model, Mr. Kulkarni noted. He believes the higher valuations are warranted, especially for companies that have a captive base of customers paying monthly fees.
"The subscription model translates to greater visibility of revenues, less volatility," Mr. Kulkarni said.
In the first quarter, software companies using the SaaS model had revenue multiples of seven times, compared to 6.1 times for other software companies, according to a recent Golub Capital report. (Revenue multiples compare a company's enterprise value to its revenue, with managers prizing companies with the highest multiples.)
And the name of the game for private equity and venture capital managers is organic company growth. Companies with recurring revenues, especially in the software sector, make up one of the few areas in which private equity and venture capital executives see organic growth rather than growth through acquisition.
"If I had to think about what industry is going to generate organic growth, it probably won't be the car or airline industries, it would be software in its many forms," Mr. Fair said.
A shift in strategy
Venture capital, private equity and even mutual funds are chasing companies with some sort of subscription model, Mr. Fair said.
At the same time, private equity firms are starting to pursue investment in venture capital firms' portfolio companies. That is not something private equity firms would have done two or three years ago, Mr. Fair said. Private equity firms stayed away from companies that "are still burning cash," he said.
Now, private equity firms are having discussions with later-stage venture capital portfolio companies, especially those with recurring revenue models, Mr. Fair said.
But managers are learning that not all subscription companies have equal chances of success. A key metric for private equity and venture capital managers is how much the company spent on such things as initial low-priced offers to acquire the customer, Mr. Kulkarni said. Another metric is how long customers continue to subscribe.
That is where some subscription-model businesses, such as Blue Apron, which delivers ingredients and recipes for time-strapped cooks, are going wrong. If the length of subscriptions is declining, "then the business unravels very quickly," Mr. Kulkarni said. "That's what Blue Apron is struggling with."
Another question is whether SaaS company revenues will continue unabated in an economic downturn, said Stuart Blair, director of research at Newport Beach, Calif.-based consulting firm Canterbury Consulting Inc.
That is one of the reasons that Canterbury is advising asset owners with venture capital to invest more in the hardware side of technology and less in software and strategies with a high degree of consumer exposure, Mr. Blair said.
"Hardware is not getting as much attention from investors" and software is getting pretty highly priced, Mr. Blair said.
'Better measuring stick'
Even so, for private equity and venture capital managers, a SaaS model gives managers "a better measuring stick," said Michael Larsen, managing director in the Boston office of Cambridge Associates LLC. "These companies are moving toward more attractive, more readily transparent ways of selling products and they have attractive, meaningfully recurring revenues," he said.
Although the recurring-revenue model is hot, only a relatively small percentage of software companies in the U.S. are SaaS companies, Mr. Larsen said, estimating that only a quarter of the market is using the software as a service model.
However just because a company has recurring revenues "does not mean it derisks the company from failure," he noted. "I think what it does do is it creates a more intensely analytical and measurable way of determining how a company is doing," Mr. Larsen said.
Private equity and venture capital firms are hunting for younger firms that promise a steeper growth trajectory, which adds a degree of risk. "Higher growth (SaaS) companies are attractive … and they drive bigger returns for investors, especially in the early-stage companies," Mr. Larsen said.
One major attraction for venture capital firms are the higher exit prices subscription businesses obtain. SaaS companies can sell for two or three times more than non-SaaS software companies, said Robert Amen, a managing director in the San Francisco office of private equity firm Vector Capital.
But Mr. Amen said he is not sure the spread between the higher exit prices of subscription businesses and other businesses is warranted. "From my point of view, whether the company has a subscription model or perpetual (license model), what matters is whether the underlying company is a good business," he said. "I don't think the difference is greater than" two or three times the exit prices of non-subscription businesses.
Risk is relative, noted Kevin Campbell, managing director, private markets, at money manager DuPont Capital Management, Wilmington, Del., who started his career as a venture capital investor.
"I would feel better about the safety and growth potential of a company that is relying on multiyear customer contracts with built-in renewals, rather than waiting for sales," Mr. Campbell said. "They have predictability of revenue as long as the companies have low customer churn rates."