foresight-44_square_high-resSoftware vendors across the world are embracing the software-as-a-service (SaaS) cloud-based business model in growing numbers.  According to Software Equity Group, SaaS software revenues will likely represent about 25 percent of the overall software market in the next five years. Research firm Gartner estimated that global spending on SaaS will reach $22.1 billion by 2015.

Some software vendors are converting their software delivery and revenue models to SaaS, while others acquire SaaS companies to gain access to this market. SaaS mergers and acquisitions transactions grew 25 percent last year, and the median SaaS exit multiple was more than double that paid for traditional, on-premise software targets, according to the Software Equity Group.

While the majority of software businesses today — especially those catering to large enterprise clients — still generate most of their revenues from traditional, perpetual licenses and maintenance revenues, the valuations of SaaS companies are about twice those of traditional licensed software companies generating the same revenues (Software Equity Group, 2013 survey).

Traditional software companies have an average enterprise value of three times revenue, while SaaS companies trade at a much higher multiple of 6.5 times revenue.

What factors are contributing to high SaaS valuation? Here are five worth considering:

1. SaaS Companies have a higher percentage of recurring revenues

In order for SaaS companies to maintain profitable, accelerated growth, they must consistently generate higher recurring revenues (MRR) from the same subscriber base. It is easier to upsell additional services into an existing subscriber base: Salesforce and NetSuite are two examples of successful SaaS vendors following that path.

2. Cloud delivery is gaining ground with enterprise customers

Enterprise customers become more comfortable accessing their software in the cloud. As the global computing industry is becoming more diversified in terms of networking platforms and access devices, software delivery is slowly morphing into a subscription service that can be accessed anywhere, at any time, on any device. Users receive timely, automatic upgrades rather than having to wait for the next version to be released and pay an additional fee for maintenance.

3. SaaS companies are growing faster

Data released by venture capital firm Redpoint Ventures show that from 2004 to 2009 the average revenue growth for SaaS companies was around 25 percent. From 2010, SaaS companies started reinvesting about 50 percent of their profits in growth, and as a result average growth rates have increased to 35 percent in the past three years.

4. The SaaS business model is disrupting the traditional software cash flow

While recurring revenues are usually preferable to providers and investors alike, the nature of the monthly SaaS subscriptions — as opposed to a one-time transaction fee — shifts the emphasis to customer acquisition cost (CAC) and retention (churn) as keys to the survival and success of SaaS companies. High, upfront payments (with annual maintenance fees of about 18 percent to 20 percent) are substituted by a longer stream of smaller, periodic (mostly monthly) subscription payments. While this results in a cash 'squeeze' in the early period after the launch of a SaaS product, investors still prefer recurring revenues as they lead to higher lifetime value (LTV) per customer.

5. SaaS companies manage churn to a minimum

Churn, which is defined as the rate of subscriber attrition (measured as a monthly percentage, typically under 2 percent for a healthy SaaS company) is one of several key performance indicators (KPIs) that are closely monitored by investors, especially in early-stage SaaS ventures, where they serve as a precursor for survival. In order to sustain profitable growth, SaaS companies need to minimize churn, increase MRR and keep CAC down.

The SaaS segment of the software industry is still young and growing, so any empirical conclusions on valuation trends will have to go through a longer observation cycle in order to establish a solid pattern. SaaS companies will need to keep balancing ratios such as churn, MRR and LTV in order to keep their profitable growth and high valuations.

Efrat Kasznik is a Silicon Valley-based valuation expert, entrepreneur, speaker and author, specializing in intellectual property strategy and valuation. She has over 20 years of experience advising IP holders from Fortune 100s to startups. Kasznik is a lecturer on IP Management at the Stanford Graduate School of Business and is listed on the IAM 300 list of leading IP strategists.  She has been a startups co-founder, CFO and advisor to startups, incubators and venture funds in Silicon Valley, Europe and Israel.