Risks and returns on investing in a SaaS start-up

COVID-19 made a historic impact on our daily work routines and everybody that could, switched to working from home. That has reflected on the global potential of the software as a service (or solution) market as the demand for SaaS hit an all-time high.

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The market prediction is that SaaS will reach approximately $272 billion this year, with a compound annual growth rate (CAGR) of 20,8% from last year. In 2020, European VCs invested nearly $12 billion into the SaaS sector primarily because companies were forced to change their daily operations to tackle ensuing challenges and the demand for tailor-made SaaS has skyrocketed.

Phillipe Botteri from Accel stated that if the current growth continues at this pace, the cloud solutions might overtake on-premises software in value by 2025 and the entire software market should be worth approximately $1 trillion.

SaaS is a subscription-based or pay-per-use model that user can access through online via web-browser. It has a significant lower upfront cost compared to a one-time fee for an on-premises solution, which is a large capital investment and has a lengthy (and often complicated) implementation process. The SaaS model decreases the financial risk as it is paid either monthly, quarterly, or annually and can be cancelled anytime, compared to a one-time fee for traditional software.

SaaS are attractive investments for several reasons:

  1. Predictable and recurring revenue – just like with any subscription-based software (Netflix e.g.), investors can count that the income stream will be secure, it can be grown by getting more subscriptions or increasing its cost, compared to a one-time purchase of a software (or movie for this analogy).
  2. Already in the modern consumer mindset – instead of having to buy one large and expensive purchase, the modern consumer likes to have options, flexibility, and more reasonable-priced products. A suitable market already exists for the SaaS business model, you just need to have the right product.
  3. Capital efficient – based on insights from Crunchbase, 49% of all SaaS funded by VC’s that made an exit, raised less than $10m before their exit.

 

On the other hand, there are certain risks of investing in SaaS’s:

  1. Governance – with scalability, as the company grows, the number of users that use the software grows as well, meaning, a lot of data is just floating around, and that data needs to be organised. Financially speaking, if a company does not know if their platform or apps are being used to its fullest, they are losing money. Companies that have well structured governance are reported to have almost 20% increased revenue than their competition. Connected with this, is also data privacy, where a company must be always aware that they are compliant with data privacy laws such as GDPR.
  2. Continuous development – the SaaS market is constantly evolving, with new services right behind the block. If the company is not agile in adapting to changes on time, it will be a sign of weakness and it will reflect on their value in the end. The SaaS market is extremely volatile, and if you are not ready for that kind of a “ride”, think again before you invest in these kinds of companies.
  3. Economic crisis and the big players – smaller SaaS’s, who are on the path of becoming profitable, face two more risks. The first one is if an economic crisis would occur, smaller companies do not have the cash reserves to withstand a serious market downfall, where the need for their services will rapidly decline.

The second is the danger of big players in the software market, where they can simply buyout the smaller ones or use their near unlimited cash reserves to create a rival SaaS of the smaller companies.

There are certainly ups and downs when it comes to investing in SaaS, with plenty of rewards if the investments are successful, but with risks as well.

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