This conventional sum-of-the-parts math lowballs the enterprise value of the company for several reasons. In general, it fails to give adequate credit for hardware sales because it fails to account for the impact of hardware on SaaS revenue quality. Specifically, it does not account for three revenue quality improvements of the hybrid business model over the pure-play SaaS model:

• Higher Gross Revenue Retention (GRR)

• Increased Customer Lifetime Value (CLTV)

• Reduced (offset) Customer Acquisition Costs (CAC)

We’ll dig into each of these in the following sections.

Improved Gross Revenue Retention

It is well understood that the architectural component of installed hardware increases the stickiness of SaaS services by introducing higher switching costs. The prospect of suffering these costs inhibits customers who might otherwise abandon a service more readily. On the surface this sounds like holding customers hostage, but it’s simply a reality of connecting physical things like buildings to digital services. Unless there’s a compelling case for making a change, most customers will try to get the most out of their sunk installation costs by keeping equipment in place for as long as it continues to operate. The same is true for other deeply embedded software deployments with high switching costs, such as ERP systems.

We can see this effect at work in the following chart, where retention rates for IoT type businesses (and others with high switching costs) exceed those of most other types of B2B SaaS categories.

Hardware-enabled-SaaS is clearly a top performer in Gross Retention. It shares this perch with other top performers such as ERP and Infrastructure that also have high switching costs. Notably, retention for this tier is significantly higher than that for SMBs, which is the largest cohort of the market for physical security systems. A few percentage points may not seem like much, but it has a huge effect on CLTV, as we’ll look at next.

Increased Customer Lifetime Value

Higher retention rates increase customer lifetimes, and their value goes up accordingly. 

This increase in value is not usually captured by the sum-of-the-parts methodologies, or those based on ARR multiples alone. ARR provides a snapshot of revenue generation capability at a given point, focusing primarily on current and near-term revenue streams. ARR multiples implicitly assume average retention and typical churn rates without explicitly capturing future retention or expansion potential. A company with a high CLTV may have a relatively similar ARR compared to its peers, yet possess significantly better long-term economics and growth potential. Investors relying solely on ARR multiples may undervalue companies with superior CLTV-driven retention, upsell, and cross-sell capabilities.

The impact of retention rate on customer lifetime value cannot be overstated. Consider an example for a revenue stream of $1,000 in ARR. Statistically, at 90% gross retention, it’s worth $10,000 over the lifetime of the customer relationship. At a 95% gross retention rate, it grows to $20,000 in lifetime value. In other words, a 5% improvement in retention results in a doubling of lifetime value.

To the extent that installed hardware (or other high switching costs) contribute to a retention increase of this magnitude, hardware revenue contributions are entirely undervalued at their typically low multiples. 

Offset to Customer Acquisition Costs

Acquiring customers is expensive. For pure-play SaaS companies, it can take a year or more for subscription gross margins to pay back customer acquisition costs. In the meantime, pure-play SaaS companies must consume working capital to finance each new customer they add to their platform. By contrast, the hardware-enabled-SaaS hybrid model usually delivers a healthy chunk of hardware-based gross margin upon contract signature. This upfront gross margin contribution can be viewed as an offset to CAC expenses because it delivers payback as soon as a sale is finalized and hardware has shipped. These margin contributions can easily exceed the CAC, which reduces the standard “CAC payback period” metric to zero. Thus, the combination of upfront hardware margins plus long-term subscription revenue offers the best of both worlds for both cash-flow and revenue. 

Conclusion

In addition to the three major effects described above, there are host of secondary P&L benefits due to higher retention:

• sales expenses drive growth rather than replacement of lost customers

• support costs decrease as customer longevity increases

• back-office expenses reduced for contracts, onboarding, renewals, etc

And all of this is before adding in the effects of Net Revenue Retention (NRR), which counts expansions, upsells, and cross-sells to the longer-lived customer base created by the stickiness of hardware underpinning a SaaS offering.

The security industry is currently embracing a major repositioning across many fronts: from prevention to enablement, wires to data, humans to analytics, and hardware to software. But we neglect our hardware foundations at our own peril. Far from being a discounting factor, hardware is in fact a measurable business model advantage we bring to the table over pure-play SaaS providers—and it should be reflected in the valuations we receive from investors.