Growth at all costs has been replaced by measured growth as SaaS companies enter the age of efficiency. A new generation of SaaS companies are emerging that combine growth with efficiency for lasting success in these less certain times.
The economy has been in the longest bull market in history. This has been further amplified within the tech market, given that it is one of the fastest growing industries and SaaS is one of the fastest growing sectors within tech. In many ways, it's been a good thing for tech. It brings in a lot of money, a lot of companies and a lot of growth into the industry.
Fuelled by this buoyant market, companies have tended to put a big premium on growth and haven't necessarily looked at some of the underlying inefficiencies as much as perhaps they should have. The thinking was, ‘Well, I can go out and raise money as long as I keep driving significant growth and try to follow the T2D3 (Triple, triple, double, double, double) model that many VCs are focused on, then that will enable me to raise more money. And I can just keep going.” Obviously, there are other metrics and indicators companies and investors have been looking at, but I think the overriding mantra has been growth at all costs. And that's been used to define success and the key (and perhaps only) driver of the next round of funding.
We started to see some brakes being applied to the tech industry during last year. Some of the tech companies that went public struggled to gain momentum and deliver good returns to investors, withe valuations often falling short of levels achieved in their last round of private funding. These companies, such as Uber and Pinterest, were typically not pure software companies where margins and future profitability were being scrutinised. These cracks were further opened by the WeWork drama who were perhaps the poster child of the growth at all costs mantra; the company’s weak foundations were brutally exposed and their very existence is now in question.
And then the COVID-19 pandemic happened. This has massively further ramped up levels of scrutiny on resilience, efficiency and profitability - essentially building a healthy business.
This is not to say that growth is not important. In the world of startups, you have to grow because you’re trying to take market share and disrupt an industry. But the balance has shifted away from the ‘growth at all costs’ mantra, towards a more measured approach, with a much greater focus on efficiency.
With that in mind, I looked up the definition of efficiency:
“Efficiency signifies a peak level of performance that uses the least amount of inputs to achieve the highest amount of output. It minimizes the waste of resources while accomplishing the desired output. “
I thought that was a really nice way of phrasing it. To some extent, the relationship between inputs and outputs has been lost In the world of startups and venture capital. Lots of money was being raised to fuel tremendous growth but without enough focus on the underlying health of the business.
I started to think about what some of the key inputs are that we put into a startup and what they should be expecting to produce in return. Obviously, perhaps the most important one is funding. There's the total amount of funding that you've raised. With the analysis we've done, you should have generated at least half the amount that you've raised in annualised revenue (ARR). So if, for example, you’ve raised $10 million, you should have at least $5 million of ARR (and ideally more) and that starts to demonstrate what you've done with the money that you’ve raised in concrete terms.
An output from new funds raised is the runway, the burn rate, and where the company expects to be at the end of life-time of this capital. In the current times there will be more ‘haircuts’ applied to your top line targets and more emphasis on burn rate and the length of the runway. Investors will be looking for an extended runway so that you have the time to reach the next inflection point even if it takes longer than expected in these uncertain times.
The main way companies spend their funding is on people. It depends what type of business you’re in, but certainly more than 50% and usually more than 75% of your costs are your people, so looking at revenue per employee is another good test of efficiency. As a rule of thumb, we think that companies should be generating at least $50K but ideally more than $100K per employee which again is a good marker for the efficiency of your business. Typically an early Seed/Series A stage company will be at the lower end of the range but as the company scales it should be able to drive greater efficiencies.
Most of your costs and your people are deployed either in demand or supply related work. The main purpose of the demand side is to win customers and if you look at customers as an input a useful output is looking at when those customers become profitable. This is usually measured by CAC payback in a SaaS company. This is measured by looking at your customer acquisition cost and the gross margin that the customer contributes and calculating when that contribution ‘pays back’ the acquisition cost. This gets into the pricing, the gross margin and also the efficiency of the customer acquisition itself. If your payback time is longer than 18 months (and ideally closer to 12 months) it suggests one or more of these components is not optimised and is, therefore, going to take too much time and money to grow the business and reach profitability.
On the supply side the main purpose is to deliver a great product and the output of this can best be measured through dollar retained revenue (DRR). DRR is calculated by taking the total revenue generated by account expansion less the revenue lost through account contraction or loss. The profile of a company with a strong product is where the DRR is more than 100% and ideally more than 120% where the expansion revenues exceed the lost revenues. It should be higher in SaaS companies serving the enterprise having invested so much into acquiring and servicing those customers and lower in those serving the SMB market which is a higher volume model. But in either case it should always be more than 100%.
Lastly, looking at revenue itself as an input, there will be an increasing focus on the quality of that revenue. The best measure of the quality of revenue is the margin and this is the key output for revenue. A SaaS company should have upwards of 70% in gross margin and the majority of that revenue should be under contract and therefore providing the forward visibility.
Looking at the EBITDA margin, most venture-backed SaaS companies will be loss making but there’s much more focus now on when the company plans to be EBITDA positive. Investors will no longer be comfortable seeing this projected in several years time like a dot on the horizon. The rule of 40 does a good job of tethering your growth to profitability. It is calculated by adding your growth to your EBITDA margin which should come out to in the region of 40. So if you’re growing by 100% a year your EBITDA margin should be no less than -60% for the business model to make sense in terms of balance and sustainability.
To summarise the SaaS market should be putting much more emphasis on efficiency and making a more scientific connection between inputs and outputs. In this way you can be sure you’re building a healthy business and one that can continue to prosper even in these more challenging times.