by John Patzakis
Legal Tech software CEOs often grapple with two competing challenges: Growing revenue in a manner that supports how customers buy their products for their individual cases, while at the same time maximizing shareholder value by recording recurring revenue, which the investor community typically favors. Recurring revenue generally comes in the form of fixed annual or monthly subscription licenses.
However, eDiscovery software providers are increasingly aligning their SaaS pricing strategy with the amount of product usage their customers consume. Instead of paying a fixed rate, the pricing is based upon actual usage. The benefits of this approach include a shorter and simpler purchasing process and increased customer satisfaction and retention.
In the eDiscovery space, customers often prefer to pay by “matter”, i.e., per lawsuit or legal case. Law firms and service providers typically utilize eDiscovery SaaS software specific to an individual case on a pass-through cost basis, where their end-client ultimately pays for the services. In the case of corporate law departments, oftentimes the organization prefers to purchase annual subscriptions for eDiscovery and apply the license over multiple matters in the course of the year. However, such buying decisions vary by organization, with corporate counsel sometimes deferring eDiscovery workflow and tech decisions to their law firms, which favors a usage-based pricing model.
While tech companies with recurring annual term revenue will typically garner higher valuations, eDiscovery software firms with usage-based pricing models are now seeing similarly elevated valuations. Investors are recognizing the very unique economics and buying dynamics specific to the eDiscovery software space. But it is incumbent on eDiscovery software execs, their investment bankers, and board members to educate the broader market on this dynamic unique to the eDiscovery space. In some situations, investors new to this space attempt to apply a steep discount to usage-based SaaS revenue, as it doesn’t fit in with their “paint by the numbers” ARR models. Rick Weber, Managing Director of Legal Tech investment banking firm Arbor Ridge Partners notes, “while the usage model is not annual recurring, it is ‘monthly re-occurring,’ and thus projections and modeling can be made based on company history and industry norms and should be treated like ARR contracts.”
In fact, usage-based pricing is now gaining wider acceptance in the broader SaaS software market beyond legal tech. Cloud infrastructure providers AWS and Microsoft Azure are obvious examples of successful usage-based pricing strategies, but many startups and medium sized companies have successfully implemented the model as well. While usage-based revenue may seem less predictable compared to other pricing models, companies using this model are often growing faster, retaining more revenue, and valued at high revenue multiples. But again, this realization requires a closer look by investors and an intelligent education effort by the companies and their advisors.
One caveat for investors is to confirm that the value of the SaaS usage offering is mostly based upon proprietary software tech versus services that are dressed up as SaaS. Some eDiscovery service providers attempt to position their services as SaaS, without a true standalone propriety software component. An analysis of the cost of sales/gross margins and assessment of the actual proprietary nature of the software is determinative. Gross margins should be at least 80 percent. And while some services are often provided in conjunction with a SaaS usage-based offering, a qualifying factor is whether the software is also separately offered purely as a traditional license to end users without any services required, which is how many customers will opt to buy.
But for true usage-based SaaS offerings, the flexibility, simplicity and supporting of legal customers purchasing dynamics are key to rapid growth and customer satisfaction. As summarized by Weber, “many of the PE firms and investors that have made big bets on such companies in recent years seem to understand the nuance and opportunity while many still lag behind and simply need to think outside of their box.”