Price-to-value dynamics is important in establishing pricing that optimizes sales acceleration and gross margins. Empirical research has amply established that price in itself means very little to a buyer. Price is a relational concept based on a buyer’s perception of value. The greater the perceived value a product or service has in relation to a price, the more likely a buyer will purchase. Said another way, the more perceived value exceeds the price point, the greater the willingness to buy.

But, perceived value isn’t always quantifiable. That’s why many focus on “return on investment” (ROI) in buy decisions. If a product or service can save money or make money that exceeds the cost to purchase, the value-to-price differential is easily understood. But not everything is amenable to value quantification.

Take vehicle pricing as an example. Advertising is driven by lifestyle and image messaging because perceived value is tied to a buyer’s emotional investment in their image. In any service or product offering, decoding the value calculus of the customer becomes the anchor point for pricing and product messaging. The more differentiated a product is from competitive alternatives, the greater your pricing freedom. Apple charges are premium because it has a differentiated closed ecosystem of hardware, software, and services that work seamlessly. It has leveraged its position as high-end technology that appeals to a sense of elitism. Whether Apple products warrant a premium as a function of utility, flexibility, and performance is debatable. Along this value perception line, business research supports the proposition that businesses starting with a niche solution targeted to a particular vertical outperform companies pursuing a broad solution/broad market strategy in early-stage phases. Arguably, a contributing factor (along with avoiding effort and resource dilution) is niche products solve a specific problem that is highly correlated to value in a buyer’s mind. In that case, paying to solve the problem (whether it is cost avoidance, better efficiency, more production, faster time to market, or greater profitability) has intrinsic value that exceeds the cost when properly priced.

SaaS (Software as a Service) & Its Rise. Conventional wisdom would point to cloud services, virtualization, and microservices architectures as the reason software as a service has taken hold. In actuality, it is a financial model enabler that creates more enterprise value. In the past, enterprise software was licensed with a recurring maintenance charge that ran in the range of 15% to 20% of the initial capital cost. This means a $100 software package license would include an ongoing annual fee of $15 to $20 per year. SaaS converts the economic relationship into an annuitized relationship with generally monthly fixed-period payments over a contract period. This approach amortizes what would be the cost of a product over a time recovery period plus the cost of service with a margin and is adjusted with a financing rate that should exceed the cost of capital. This method will produce significant margins over time especially after the cost of the product is recovered.

Let’s look at an example.

Acme Smart Appliance costs $120 to produce, configure, and provision, and Acme used to charge $240.00 plus a $40 a year maintenance charge. It cost of maintenance is an average of $10 per year per unit. Acme wants to change to a SaaS model because it can “lower the upfront cost” to customers with a “budget-friendly, low-cost monthly payment” offer. The average life of a customer is 3 years.

Conventional Pricing yields: $200 in total gross revenue ($120 + $40 in year 2 and $40 in year 3). Year 1 Profit = $120, Year Profit = $30, and Year 3 profit = $30.

The SaaS team takes a new approach. The total revenue over 3 years generates $200. They spread the upfront price over a 20-month amortization period. This yields an amortized monthly revenue component of $10/mo. to the projected price SaaS. The next factor in the $30 of maintenance revenue per year under the old model and convert that to a monthly price contribution rate of $3.00/mo. So, the total SaaS price amount is now $13/mo. They realize that it costs the company 10% for its working capital, and factor that in because they have to use capital to outlay the widgets upfront under the new model. So, they factor in 10% on the $120 cost to produce the widget over 20 months which is $16.16 in cost of money over the r3covery period, which equals an additional 80 Cents per month, So, now the total SaaS price with the cost of capital included is $13.80. But they realize there should be an arbitrage spread between the cost of capital and the implied financing rate to cover a discount to present value, so they add another 64 Cents representing another 8% per annum for a total implied finance rate of 18% per annum. This increases the price to $14.44. mo. Now, they make a market decision and decide that 14.95 is saleable in the market and leaves room for discounting for volume and other factors.

SaaS Pricing Yields: $538.56 in Total 3-year gross revenue, versus $200 under the old model. Additionally, in year 4 and beyond, the company yields $179.50 per year on annual costs of $10 per year, generating an additional $169.50 in gross income! And, the initial cost recovery period for the widget outlay is actually 8 months.

Valuation & SaaS. SaaS Valuation (and the Rule of 40). The rule of 40 isn’t a business rule. It’s a measure of beauty in the eyes of a venture capital. Its origin is credited to venture capitalists Brad Feld, of the Foundry Group, and Fred Wilson, of Union Square Ventures. More precisely it’s a measure of momentum from a prospective growth and profitability measure. The rule of 40 is simple:

Annual Sales Growth Rate % + EBITDA % ≥ 40%

EBITDA is checked against capital expense and free cash flow (FCF) metrics to account for nonoperating income impacts that may materially distort the financial picture portrayed by EBITDA. Depending on the type of business, GAAP income recognition can lag behind cash receipts, and this likewise would dictate using an FCF% instead of an EBITDA % baseline in the formula.

As matter of valuation, SaaS Enterprise Valuation (EV) multiples as a function of trailing twelve-month (TTM) revenue range from 8.0x -22.0x with the average being 12.0X for public companies. This compares to multiples in the 3.0x-5.0x range for conventional software businesses.

Enterprise Valuation (EV) Disparities. The reason for the disparity in valuations is simply a financial compounding function coupled with a lower. It is driven by (a) a second derivate function (the positive rate of change in sustained annual growth rate as measured against a prior period), (b) the qualitative value of earnings, and (c) asymmetric risk versus return. Said simply, if the business is on a rapid topline growth trajectory and its profitable, then it’s a good investment. But there is more than meets the eye. It is also a theoretical comparatively de-risked investment because the baseline revenue is annuitized unlike a conventional sales transaction business where new sales must be generated largely anew each period. This concept is easy to appreciate if compared to durable goods like kitchen appliances. Once a unit is sold, the business must look for a new customer, whereas in a subscription-based business, the customer is buying month over month providing a steady stream of high-margin cash over an extended period. This translates into an asymmetric risk to return investment profiles because the annuitized revenue base de-risks the dependency on forward-looking sales execution.

SaaS Business Models from the Business Owner Perspective. SaaS-based business models are very attractive but shouldn’t be solely driven by investor attraction when the nature of the product or service is not readily conducive to being sold by subscription. Understanding how the target market buys goods and services and how funds are sourced matters. For example, government sector customers may be less likely to desire a pure SaaS offering as may be other customer segments that are highly protective of their operating budgets. These customers may be more capital expense-driven or rely on grant-based funding that drives more conventional transactions. A business limiting itself to a SaaS model may inadvertently limit its addressable market and slow rather than increase sales velocity. Further, a SaaS-based offering carries reputational risk when applied to a traditional market space. This is evidenced in the right-to-repair backlash where closed software systems and strict licensing is seen as holding customers economic-hostage. For some technology businesses, it might simply be the case that multiple forms of purchase financing should be offered to maximize market opportunity