As an early stage SaaS company, you've worked hard to build a product that you believe in. But getting to the next stage in your business requires an injection of capital. When it comes to understanding how VCs value SaaS companies, it can feel somewhat like navigating a maze blindfolded. 

You're not alone. Many SaaS founders struggle with the challenges of securing the funding they need. 

Don't let a lack of understanding of venture capital keep you frustrated and missing out on opportunities for growth. At SVTech, we leverage our years of experience in Venture Capital law to help SaaS founders understand the VC perspective. 

Today, we will demystify the VC process and uncover the SaaS business model evaluation techniques that the biggest venture capital firms use to evaluate SaaS businesses for funding. 

Understanding What Drives Venture Capital SaaS Investment

In venture capital there is only one driver of investment - the promise of significant returns. 

For many VCs, one of the most profitable investment opportunities is in Software as a Service (SaaS). 

The high growth potential of SaaS companies, with strong margins, can mean significant return on investment. 

Venture capital firms look for companies with more to offer than strong products. They want businesses that can disrupt markets and generate exponential growth, ultimately dominating their market in the long haul. These qualities make SaaS companies a logical fit for investment. 

How VCs Assess SaaS Startups

So how exactly do they identify which companies to invest large sums of capital in? Below are some of the most common methods used by VCs to assess SaaS startup performance.

VC Investment Criteria for SaaS Companies

VCs will closely examine some key business metrics when evaluating a potential investment target. A strong performance in these key areas will garner the attention of investors:

• Average Contract Value (ACV) - Measures the average annual revenue from a customer subscription. Calculated by dividing the total contract value by the number of years in the contract. This number is heavily dependent on the specific industry, business model, and customer size. 

• Annual Recurring Revenue (ARR) - The predictable recurring revenue generated by a subscription based service in a year. Successful SaaS companies rank between 20-50% yearly increase.

• Monthly Recurring Revenue (MRR) - Recurring revenue is also measured monthly. A good MRR rate shows between a 10-20% monthly increase in recurring revenue. 

• Customer Acquisition Cost (CAC) - Measures the cost of gaining new customers. A low CAC indicates efficiency in marketing and sales. 

• Customer Lifetime Value (CLTV) - A predictor of how much revenue a customer will bring over the lifetime of their relationship with a company. A high CLTV shows a strong customer loyalty to the service. 

• CAC to LTV Ratio - The cost of acquiring a customer vs the lifetime value they bring. Used to gauge the sustainability of a business model. A strong CAC to LTV ratio is in the range of 3:1, meaning for every dollar a company spends to acquire a customer, they generate $3 in revenue. 

• Churn Rate - Measures the annual percentage of customer turnover, used as an indicator of customer satisfaction. A solid churn rate for SaaS companies is around 5%, meaning for every 100 customers, they lose only 5 per year. 

• Gross Margin - A measure of the profitability of the core service or product of a company. Measured by the amount of revenue generated, minus the cost of running the service. A solid rate is 70%, with top performers reaching 80%+.

A healthy performance in these key metrics is essential when seeking VC funding for SaaS startups. 

VCs will use these metrics together to evaluate potential investments across three areas: 

Product/Market Fit

Does your product solve a real problem? The most important criteria in SaaS business model evaluation is evaluating product and market fit. Investors must be able to determine if there is a market need for a product, and how valuable the service is in solving the problem for its customers. 

VCs will look at:

• USP/UVP - What is it that makes your product stand out? A unique selling proposition (USP) is what differentiates you from the competition, while a unique value proposition highlights the value your customers receive. Both of these are key aspects of how VCs value SaaS companies.

• Market Traction and Growth - Venture capital SaaS investors want a company with a  proven ability to acquire customers and expand their market share. Upselling existing customers is a key way of demonstrating growth. 

• Churn Rate - Evaluating churn rates helps investors understand the value of a SaaS product. Churn reveals whether customers are willing to pay for a product long term, or if an organization will be constantly seeking to replenish its subscriber numbers.

• Customer Testimonials - Lastly, VCs will gauge your product fit by evaluating customer satisfaction. A stable of satisfied customers shows VCs that your product has become a valuable part of their business. 

Scalability

The second key way VCs assess SaaS startups is by evaluating their scalability and growth trajectory. They want to see that a new business is poised to handle significant growth. These key factors help them with evaluating SaaS business models for scalability:

• Go-to-Market - For early stage SaaS businesses, Go-to-Market (GTM) refers to the organization's plan for getting its service to its target customers. It includes customer acquisition, marketing, pricing and sales strategies. 

• Scalable Infrastructure - Investors need to see that the technology platform can handle significant increases in traffic and data volume. Cloud-based infrastructure is preferred, providing excellent scalability for SaaS businesses. 

• Customer Acquisition - The ability to acquire and onboard new customers efficiently is a key indicator that an organization will be able to scale. VCs will look for shorter sales cycles, low CAC, and high Average Contract Value (ACV) as other indicators of scalability.

• Team Growth/Development - VCs will also want to see that there is a plan for scaling engineering, sales, marketing and other essential teams by attracting and retaining top talent. 

Current vs. Future Value

Lastly, VCs assess SaaS startups not just on their current value, but their future growth potential as well. This includes discussing potential exit strategies, such as a sale or IPO.

Some factors influencing future value that will be examined include:

• TAM - The Total Addressable Market (TAM) is a way of quantifying the estimated market demand for a product or service. A larger TAM shows higher growth potential. 

• Product Road Map - How a company plans for its products to evolve in 6 months, 1 year, and 5 years down the road. Demonstrates a commitment to long term growth.

• Competitor Differentiation - How a company makes itself stand out from the competition and creates a competitive advantage. 

• Where Value Can Be Added - VCs will want to know where there is potential for them to add value to the operation and help it reach its full potential. 

Other Factors That VCs Consider

Strong numbers and high performance in these metrics are vital, but there are other factors that influence how VCs assess SaaS startups.

• The Team - Investors want to see experience and expertise in the founders and the people they bring into the company. Passion for the business and a strong vision are prized. 

• Company Culture - Founders that build a strong company culture have an easier time attracting and retaining top talent. This plays a significant role in the willingness of VCs to invest in an organization. 

• Market Timing - Being an innovator is important, but so is capitalizing on existing trends and market opportunities. 

5 Common Pitfalls SaaS Startups Seeking VC Funding Must Avoid

We've discussed what the VC investment criteria for SaaS is, but it's also important to discuss potential pitfalls that can cost an organization their opportunity to secure their next round of funding. 

Some of the biggest potential hazards include:

1. Lack of Clear Financials - A crucial mistake many SaaS founders make is a lack of preparation with regard to financial projections. Projections that are vague or simply overly optimistic can cost you a deal. VCs will want to see a realistic and data driven look at your financial model. Prepare detailed projections, budgets, and cash flow statements. 

2. Lack of Clarity in the Business Model - You must be able to show investors how your business model works. Don't assume that VCs will innately understand the intricacies of your industry - they likely won't. You'll need to demonstrate who your target market is, how your business generates revenue, and how you plan to grow. 

3. Lack of Key Metric Data - We discussed the metrics that VCs will use to evaluate a business, and it's critical that you have that data to share with them. Your metrics must be accurate and up to date, and presented in a reliable and easy to understand way.

4. Unrealistic Valuation Expectations - You may have an idea in your mind of what your company is already worth, but that doesn't mean it will align with what investors see. You must make an honest assessment of your valuation expectations, and compare that to your competitors and market trends. 

5. Lack of Research into the VC - It's critical to understand the investment thesis of the VCs you approach. Tailoring your pitch to the VC's interests will increase your chances of securing the funding you need. Presenting an investment opportunity that doesn't resonate with their business motivations will only waste their time - and yours. 

Conclusion

Securing VC funding for SaaS startups is difficult, but understanding what VCs are looking for makes a huge difference. 

Ultimately, venture capital investment in SaaS companies is all about the return on investment they can achieve. VCs will pour over an organization's product and market fit, their revenue numbers, performance metrics, and plans for growth with intricate attention to detail before selecting the best opportunities to invest funding in. 

If you are an early stage SaaS startup in need of funding, SVTech Law Advisors can help you navigate the venture capital landscape and prepare you for success. SVTech has helped our clients reach their financial goals for over 25 years by delivering customized counsel and advice in seeking investment.   

Contact SVTech Law Advisors for a consultation to discuss your SaaS funding needs and let us help you formulate a winning strategy. Contact SVTech today.