Subscription Software versus Services Revenue

Many SaaS companies are concerned about their ratio of services revenue to subscription software revenue.   This was a constant discussion topic at Ariba, while I was there.  And it comes up in many board meetings of PE and VC-backed companies.

The thinking expressed by investors,and some CEOs, is as follows:  “Hmmm, subscription software revenue is valued by investors at 5x revenue and services revenue is valued at 1-2x revenue.  I think I would like more of the former and less of the latter.”  It is hard to argue with this as a mathematical proposition. To the extent the ratio of services to subscription software revenue is (legally) in your control, and all other things are equal, it is pretty incontrovertible.  But, of course, matters are never quite that simple and for most companies, focus on this ratio is misplaced.

1. It is best to focus first on the problem you are solving for the customer.  If you solve a real customer problem, you’ll find an investor.  (You may find an investor even if you don’t solve a customer problem–but you will not find a second investor!)  In addition, investor valuations can be pretty fickle–1999-2000 anyone?  March 9, 2009 anyone?  Work on customer fickleness before  worrying about investor fickleness.
2. Typically your customer wants a solution to the problem they face; they could care less about how you solve that problem–software, services, or Dark Arts.  The customer just wants to know you are going to own the problem and be responsible for providing the results.  You may need some “dreaded” services to solve the problem. For instance, W.W. Grainger probably does not want to find those parts you requested that are not in their catalog of 800,000 parts, but they will–to solve your MRO problem completely.
3. Sometimes, you will get lucky and only need a service to make the sale not to truly solve a problem .   A prospect will often be comforted by simply knowing you offer a service that they actually will never use.  Even if they use it, you maybe able to wean them off of the service with a better solution over time.  Warranties can be one example.
4. On occasion, offering an unattractive service is necessary to match a competitor in the sales cycle or shore up a strategic flank of your business.  (“Well, your competitor says they will do customer satisfaction surveys and benchmarking of our users and customers, but you do not offer this service.”)  If a competitor succeeds in making this service seem important, you may need to give in and offer the service to remove the objection.  (You just need to find a feature of your software you can return the favor with!)
5. If some of the services you offer are necessary because you have not yet automated the client’s recurring administrative processes (e.g. workflow), or built other self-service tools for your customers, then you are in trouble.  This is the worst kind of service–it shifts costs from clients to you, it is usually time-sensitive, and it is always low-value/margin work.  It’s a triple whammy.  Get rid of this kind of service revenue (or more likely cost) as soon as you know it is a recurring, common need.
6. Finally, remember why investors use a multiple of revenue as a valuation short-hand–and it is just a short-hand.  Investors use this metric because SaaS revenue is typically highly recurring and high in EBITDA margin.  In the long run, valuations should ultimately tied more to growth in EBITDA than revenue. If you have highly recurring services revenue, and these services are high margin, the “penalty” for having them may not be so bad.

Think of selling investors as selling a special form of customer.  Investors and customers are attracted to clean stories that solve a problem.  If investors are buying pure SaaS revenue, try to position your company as best you can that way.  Explain why you have the services you do and what customer or strategic needs they meet. I’m all for  positioning your company in the most favorable light, getting the most for every share, and raising capital when the market is favorable (now).  Just don’t let the investor sale become confused with the customer sale.  (More on that in the next post.)