Pre-IPO SaaS companies are under enormous pressure to grow fast or die slow. As our research on public software companies has shown, growing fast, really fast, is the key determinant of breaking through $1 billion in revenue and getting rewarded by the public markets. Specifically, public software companies growing more than 60% when they reach $50-100 million in revenue deliver a 4-5X greater return on equity over three years, and they have more than a 50% chance of reaching $1 billion in revenue.
The challenge, as one can see from Figure 1, is that SaaS revenue multiples have been highly volatile over the last several years and, as we know, private SaaS valuations largely follow public valuations. For a private SaaS CEO, growth with high cash burn puts her at the mercy of future investors, especially if the markets for raising capital become more constrained. In that environment she faces a tough choice—try to raise money in an unfavorable environment and potentially run out of cash, or scale back growth in a way that conserves her cash until the market turns more favorable, but might affect how future investors view the attractiveness of her company. This is a Catch-22: spend the money to grow and potentially run out of cash now, or conserve it and find it challenging to raise money later, or at a lower valuation.
So how do you know how much to spend on top-line growth? How do you know whether the underlying business is healthy enough to sustain itself even if you decide to dial down on the top-line growth rate? There is an overload of SaaS metrics one can wade through—the Rule of 40% or your CLTV/CAC ratio to name just two. The Rule of 40% states that a SaaS company is healthy if its free cash flow margin plus its year-on-year growth rate together exceed 40%. So if you’re growing at 100% per year, you can bear a yearly net income loss of 60%. On the other hand, if you’re growing at only 20% per year, you had better be turning a healthy 20% profit. This rule is sensible so far as it goes: it captures a well understood trade-off between growth and profitability. But it suffers from two flaws:
First, it is an imperfect measure of SaaS value. Not all companies that satisfy the rule earn the highest multiples; and likewise many companies that don’t meet the Rule of 40% criterion are still quite successful. (See Figure 2.)
Second, the Rule of 40% says nothing about how SaaS companies can create value. It does not offer any guidance about which particular choice between growth and profitability any given company ought to make. And while it’s useful to understand how investors tend to view the trade-off, that understanding says nothing about which operating levers to pull to achieve any particular growth or profitability objectives.
Other metrics are similarly flawed. We have previously written about how the CLTV/CAC ratio is difficult to calculate and subject to manipulation. (See: Does your CLTV to CAC ratio stand up? Does it matter?) That metric too, focuses on too thin a slice of the business. The same can be said of using CAC payback period or churn rate as the critical metric or other synthetic measures like the “magic number” or the “quick ratio.”
Instead we propose dividing your SaaS business into two parts to determine the underlying health of your business and the efficiency or robustness of your go-to market efforts. These two parts we call the cash engine and the growth engine. The cash engine represents the underlying economics of the business—how much free cash do you generate from $1 in existing ARR. The premise is that your existing ARR should largely generate positive cashflow as you aren’t investing in sales and marketing for this existing ARR. If it doesn’t generate positive cashflow the underlying health of your business is questionable and you don’t have the strong foundation for growth. The key metric of cash engine performance is the recurring margin—the gross margin minus G&A and R&D expenses.
The growth engine represents the sales and marketing investment needed to drive new ARR. We think the key measurement of the success of the growth engine is the efficiency of that process—how much net new ARR do you add per $1 of sales and marketing you spend.[1] The two measures of your business are linked—the cash engine funds the growth engine, outside of capital you have raised or expect to raise. The key is that your growth engine is controllable—to increase growth, you can both raise more capital and make your growth engine more efficient. Starting by increasing growth efficiency gives you more control over your own future.
We like this framework because it can easily be decomposed further into specific operating levers that you can then manage. Figure 3 shows what we mean: both the cash engine and the growth engine can be broken into their component parts, and then those component parts can in turn be measured, benchmarked, and, most importantly, adjusted to meet your strategic needs given the external market dynamics.
Growth efficiency, recall, measures your new ARR growth for every dollar of sales and marketing you spend. Net new ARR growth is a function of ARR from new customers and new ARR from existing customers. By breaking the growth efficiency engine into its component parts you can now benchmark your performance against your peers to understand how well you are doing. For example, are you in the bottom quartile of upselling? If so, what can you do to increase net new ARR coming from existing customers? You can also benchmark the detailed elements of your sales and marketing spend relative to new ARR to determine what levers you need to pull to increase the efficiency of your sales and marketing dollars. The levers we typically see as yielding the highest returns in your growth efficiency engine include pricing, customer success, acquisition efficiency and sales rep performance, all levers within your control.
Fuel by McKinsey utilizes this framework to help pre-IPO companies accelerate growth and take control over their growth engine. Underpinning this framework is our SaaSRadar benchmarking tool which provides companies and their investors with relevant benchmarks and insight into their sales and marketing operations. In later posts we will share more detail on specific drivers of efficient and effective growth. In the meantime, if you are interested in learning more or participating in SaaSRadar, click here.
(1) Mathematically, this calculation is: ((GAAP Revenue in period 3) – (GAAP Revenue in Period 2) x 4) / (Sales & Marketing spend in period 1). This metric is similar to the “magic number,” but is annualized and reflects the fact that sales and marketing spend often has an impact in the second and third periods after it is invested.