As inflation spikes and cheap money looks like a thing of the past, many are turning their attention to some of the sky- high valuations in the technology sector. Time will tell as to whether those valuations sustain or come crashing back to Earth as interest rates continue to rise. However, if recent experience is anything to go by, tech companies with robust balance sheets, reliable annuity revenue, and lower leverage seem to be faring well.

HopgoodGanim Lawyers act for many businesses in tech, big and small, particularly those in the Software as a Service or Platform-as-Service sector. For simplicity we will refer to both as SaaS in this article.

From our experience in that sector, there are a number of unique factors that drive and sustain the high valuation and multiples of SaaS businesses. Interestingly, these three factors really underpin what makes the SaaS or cloud space attractive to investors in the first place:

  1. a business model that prioritises what is deemed to be “good” revenue (i.e. recurring or subscription revenue), over “other” revenue (one-off or ad-hoc revenue);
  2. term-locked, rolling licenses which bundle the software licence with other associated services, support and maintenance; and
  3. a scalable service offering that is, by design, the same for each and every customer and not intended to be customised for each and every customer – this is what is commonly referred to as multi-tenanted application or platform.

All of these factors can create a robust, resilient, and highly scalable business. Yet, time and time again, we see businesses forgetting to ensure that these unique factors are actually translated into their contracts. The consequences on an exit or M&A event can range from receiving a sub-par valuation, to an entire deal falling over.

This article examines three key factors that can make or break a deal in the SaaS space, whether that be a capital raise or an acquisition.

1. Recurring revenue reigns supreme – but does your contract actually reflect this?

As noted above, a key reason for high valuations in the SaaS sector is because businesses in that sector are, or should, be underpinned by contracts which push all the value into a recurring service fee which is paid in regular (often monthly) instalments. This results in more regular, less-lumpy, cash-flow. From an investor or acquirer’s perspective, reliable cashflow in a term-limited contract is attractive, particularly in a business that has the capacity to scale up that model with rapid growth in revenue.

Despite this, it is common to see contracts for SaaS services which undermine the recurring revenue model and seek to fetter or split a higher recurring fee into many of one-off fees, together with broad termination rights (discussed further in 2 below), scope variations and delay cost clauses. This often can be driven by the customer’s preferred “standard form” contract, or procurement teams trying to squeeze a square peg into a round hole. But there are consequences for this – do not expect to receive the same high SaaS sector valuation for your business, at least from a sophisticated investor.

One-off revenue arising from custom development or lengthy implementations typically have lower profit margins, and are more prone to being eroded by scope creep, delay, and disputes. That is why many SaaS vendors seek to carve off that side of the business and refer it to third party implementation and integration specialists.

A properly drafted SaaS contract should attempt to define a clearly defined software licence scope, together with a clearly scoped maintenance and support services offering, all wrapped up in the same subscription fee. You may wish to consider drafting the contract so that it does not even contemplate the ability to pay for services on a one-off basis unless there is a very good business reason for doing so.

2. Term locked, rolling licences

The right to use the software and receive services should be bound by a fixed term or duration, and ideally rollover for future recurring terms. Further, there should not be any perpetual licenses to software or intellectual property (IP) rights in software.

In our experience, this is common where government framework agreements and standard form procurement contracts are utilised. Despite government framework agreements accommodating cloud services via specific modules, these are often poorly implemented. It is not uncommon to see perpetual licences to use the IP encompassed in broad definitions, such as “deliverables”. Granting a perpetual licence to a SaaS product is completely anathema to the business model and will do damage to your business if you are a vendor of those productions.

In addition, there should not be any rights to terminate for convenience or notice. This is because the cost of the various services and infrastructure wrapped up in a SaaS contract are usually spread across the duration of the contract and early termination could result in those costs not being recovered. Finally, a contract with a termination of convenience right in it will not entitle the contract value to be counted as revenue, which in turn adversely affects the valuation of the business.

3. Scalable and multi-tenanted

The final factor that is very important to remember is that the scalability and profitability of many SaaS business is underpinned by the simple fact service offering is, by design, the same for each and every customer and not intended to be customised. This enables a SaaS business to grow quickly as, in theory, customers can be efficiently onboarded with minimal customisation to the underlying core software and infrastructure. This in turn, leads to the ability to sign-up customers rapidly, whilst simultaneously growing your business.

From a contractual standpoint, SaaS vendors should be on the look out to ensure that clauses do not seek to undermine the scalable multi-tenanted nature of the product. For example, a clause which requires the SaaS Vendor to comply with specific technical or operational security requirements is unlikely to be practical, as the technical and operational security measures are the same for all customers.