Smart technology investors understand that SaaS businesses must incur high upfront costs to attract and keep customers long before they profit from those new clients. So, when attempting to find funding, it is fundamental for SaaS startups to responsibly handle a burn rate and stay on a long-term runway. However, the situation for such startups is becoming more challenging, given that the stock market has verified the projected value of mature SaaS companies. As a result, it is highly essential to consider if SaaS startups may attract more value regardless of cloud giants’ devaluation.
That said, is the SaaS-acre primarily about declining valuations or validating SaaS startups’ business models? To properly analyze the challenges that SaaS startups face, it is crucial to understand how “SaaS-acre” turned into a catchphrase in the tech world.
What is the SaaS-acre?
“SaaS-acre” refers to the significant decline in SaaS valuations from their peak in late 2021. Cloud stocks have been hit hard since then. The BVP Nasdaq Emerging Cloud Index (EMCLOUD) has fallen by approximately 40% since its peak in early November 2021. And what is symptomatic, this significant decline has been experienced even though cloud companies are still showing solid fundamentals.
The cloud industry has experienced a remarkable boom in recent years, driven by the growing demand for cloud-based services and solutions. It has led to many cloud companies achieving sky-high valuations, with investors eager to get a piece of the action.
Following the trend, some startups are developing cloud-based technologies or at least building on them and attracting investors to put their money in. Also, this decline in SaaS companies’ stocks may seem like a bad predictor for startups. But when we look at longer-term historical averages, it becomes clear that the fall is more of a normalization than a catastrophic event.
Burning money as a consequence of the SaaS business model
One of the most powerful advantages of SaaS is its ability to scale quickly. As the number of users grows, SaaS vendors can simply add more servers to handle the increased load. It means that SaaS vendors can efficiently serve both enterprises and startups, regardless of their size. This scalability also means that SaaS vendors can quickly add new features and functionality to their software, which can be a significant advantage in a competitive market. The technology itself introduces several novel opportunities that may be advantageous to clients who pay as they go.
However, a cloud-based software provider must cover cloud infrastructure costs, which are not transferred to a single client as with on-premise solutions. To pay infrastructure costs, SaaS companies must attract a considerable number of clients before generating a profit. Furthermore, the paradox of SaaS technology is that the more active users there are, the higher the costs.
So, on the other angle of this profit vs. cost equation, for a SaaS startup, it means that before building traction and making money on a subscription-based pricing model, it requires significant investment to develop and keep a software product infrastructure is usually quite costly. The profit may come later with mass users growth paying their subscription fees. Before it happens, SaaS startups will burn money, as it’s called, and this is quite natural in this business model.
How do rising interest rates affect SaaS valuations?
Before the pandemic, SaaS multiples were already high, and the pandemic only exacerbated the situation. The hyper-low interest rate environment of 2020-2021 only fueled the fire, resulting in unprecedented valuations for many SaaS companies. Now that interest rates are rising and the pandemic is easing, it’s not surprising that SaaS valuations are also declining.
Although cloud-native technology appears to be a permanent trend, the market warns that many were overvalued, and the SaaS business model may also be considered unsteady. Furthermore, as interest rates rise, stock investors become less willing to bid up stock prices, making SaaS company valuation growth less likely and, as a result, keeping startup investors hesitant.
Will VCs be likely to burn any more money at challenging times?
So, what does it all mean for the future of SaaS valuations, including startups working in that field? It’s unlikely that we will see a rapid reflation of revenue multiples anytime soon. However, it doesn’t mean that SaaS is less valuable or relevant as a business model. It means that the market is returning to a more rational state after a period of unprecedented growth.
As previously said, one of the oddities of SaaS organizations is that the quicker they grow, the more money they burn. It may be unusual, but it is an inherent truth of the SaaS model. From the perspective of VCs, it makes SaaS startups burn much more money before reaching the break-even point. And in a challenging financial environment, funding in such companies is more complicated.
The important finding for the startup landscape is that SaaS startups may have difficulty securing funding at lower valuations. Still, on the other hand, established enterprises may have an advantage in acquiring some of them at more reasonable prices. Ultimately, the winners will be those who can navigate the changing landscape and adapt their strategies accordingly.