SaaS continues to grow at a rapid rate. According to Gartner, the industry will top at £14 billion by 2015, up from £9 billion in 2012. The market is currently seeing a lot of activity as new trends rise, vendors compete for position and clients continue to shift IT strategies.

Despite the upward movements, many still question whether SaaS companies are actually successful or not. Because these businesses seem to have a high revenue growth and lack of profits, it tends to scare off some investors. However, SaaS companies cannot be valued with a simple income statement narrative. When it comes to SaaS, this way of thinking can lead to bad investment decisions.

Comparing SaaS to Traditional Software

Traditional software businesses like Oracle conduct business by selling licenses of their software and then upselling upgrades afterwards. Customers pay upfront for their license, and then pay recurring fees for annual maintenance. It is a simple business, and it has been successful for old-line software companies.

On the other hand, SaaS customers sign up to use the software on an on-going basis, as appose to purchasing a license. Now, even though the customer signs up a 24-month contract, the company does not get to report that revenue gain up front. Because of accounting rules, SaaS companies must recognize the revenue as they deliver their services.

In the mean time, the SaaS Company has just spent large costs in marketing, sale, developing, hosting, and infrastructure in order to acquire that customer. Most of these upfront costs do not get recognized over time in simple income statements. Revenue and expenses are not aligned. Additionally, the cash flow is also misaligned. Customers pay for only one month of their service at a time, but the business has to pay all of its expenses on the spot.

As a result, we cannot look at the income statements of traditional software companies to determine if SaaS ventures are doing good or bad.

So, is SaaS a Successful Business?

Once a SaaS company has generated enough revenue from its customers to cover the cost of acquiring new customers, those old customers stay for a long time.

These businesses have traction because the client outsources all software operations to the vendor, which makes it a lot more likely to receive higher cash flows. With time, we start to see the reverse of what was happening at the start of the company. All the cost of acquiring that customer was paid upfront, and now the company gets to harvest pure profits from the customers.

It is also very difficult for existing customers to change SaaS vendors if they are integrated into their workflow. SaaS manages all aspects of the software. In the license model, in-house IT usually manages the software and is more like able to afford a switch.

The real assessment we need to make is not whether current revenues are high, but whether the investments SaaS companies are making today will result in free cash flow in the future. We need to look at things such as customer acquisition costs, customer lifetime value, billings, and unearned and deferred revenue.

While not every SaaS Company is successful, there are definitely those that fit into that category. We need to see past the big headlines, and make sure they do not get in the way of the whole story.