“There are two key SaaS measures that every founder should know: growth efficiency and revenue efficiency, these are the most critical factors that influence valuation.” – Peter Weed, Mckinsey, speaking to Notion Capital’s family of SaaS founders.
Every founder we have invested in is different; their individual characteristics, the make-up of their teams, the problems they are solving.
But they do have three things in common:-
- They are all developing cloud delivered software solutions for big, painful enterprise problems;
- They are all building recurring revenue businesses; and
- Ultimately they all plan to lead a category and maximise their market value.
A critical area of competency that cuts across all of these is their ability to execute with strong economic viability: understanding cost of acquisition; gross margin; and fully absorbed payback in order to grow in a capital efficient manner.
Few people have spent more time exploring this topic, with more data at their disposal, than the McKinsey Growth Tech Practice, in particular Peter Weed. We were privileged to have a few hours of Peter’s time in the company of our top founders, this is a summary of his insights, though with my interpretation in areas.
We lead McKinsey’s knowledge development focused on growth stage SaaS/XaaS companies and investors. It includes a proprietary benchmarking effort for “growth stage” B2B SaaS players focused on best practices and performance targets related to 40 critical growth and cost structures related metrics (e.g., sales acquisition speed/efficiency, marketing return, churn).
Our insights are sourced from 200+ SaaS founders & 50+ PE and VC relationships; 200+ SaaS growth benchmark participants and 130+ growth projects. – Peter Weed, McKinsey Growth Tech Practice.
First up, growth matters. Not simply due to the impact of growth as a multiplier of value, but more fundamentally in terms of long term success. The simple fact is that when SaaS players with a >50% growth rate approach $100MM revenue, they are far more likely to go on to reach $1BN in revenue and deliver a return on equity greater than their slower growing competitors.
“Supergrowers”—companies whose growth was greater than 60 percent when they reached $100 million in revenues—were eight times more likely to reach $1 billion in revenues than those growing less than 20 percent.
But so does efficiency
Referencing the BVP Cloud Index, it’s interesting to postulate that investors have a bipolar preference between growth and efficiency, vacillating from growth at all costs, to capital efficiency as their pre-eminent requirement.
The simple answer is that SaaS founders must strike the balance between the two. Efficient growth matters but so to does free cash flow, as demonstrated in the chart below, and the combination of the two is highly predictive of valuation.
Efficient, high value growth is hard
The essence of the challenge for any SaaS leader is to maintain a 50% per annum growth rate (faster in earlier years), combined with best in class behaviours in four key areas:-
- Gross margin > 80%
- Fully absorbed payback < 1 year in enterprise and between 3 & 6 month in SME
- High levels of retention – demonstrated by low churn, <5%
- Expanding installed base revenues of between 15 & 20%
By obsessing about these four behaviours, SaaS companies are 1) building a product for which the vast majority of revenue is contributory (i.e. high gross margin); 2) generating free cash within a single budgeting cycle; 3) holding on to the new customers they’ve acquired; and 4) growing their revenues from within the installed base.
NB There is an interesting caveat to the last of these that if expansion revenue is more than 30% of overall revenue growth then it is indicative of a number of potential problems – the company is failing to price to value and selling too cheap or even more concerning is that they are either poor at new business or running out of new customers to sell to.
Within each of these four metrics, it is critical to maintain a focus on constant improvement and marginal gains. Small changes in any single one of these has a big impact on performance, and ultimately valuation. Taken together – all three improving in parallel – the impact will be profound.
Think of your SaaS business in two components
But we can make this even simpler. Every SaaS business needs to demonstrate the fundamental ability to grow efficiently over the long term, this is “The Growth Business”, at the same time as creating an annuity revenue stream that generates free cash, “The Recurring Business”.
1. The Growth Business is the engine.
The key metric is of the growth business is Growth Efficiency.
In essence, how much net new annualised recurring revenue can you generate with $1 in sales and marketing spend?
The calculation: new ARR generated in a given period (a month, a quarter, a year), divided by total sales and marketing in the previous corresponding period (month, quarter, year).
NB – based of course on the magic number, published back in 2008.
Magic Number = (Incremental Revenue in a Given Quarter])*4/Sales+Marketing Spend in the Prior Quarter.
NB At Notion Capital, we consider this number every quarter as an indicator of product market fit and fundamental readiness to scale, though it can tail off as the company increases in size.
0.75 and higher = effective sales and marketing spend.
2. The Recurring Business
The key metric is Revenue Efficiency.
For every $1 of recurring revenue, what % is contribution to fixed costs? This is about more than just gross margin, but capturing any variable cost associated with the sale such as support or customer success.
Calculation? MRR (monthly recurring revenue) less any associated COGS (costs of goods), and less attributed and variable COS (cost of serve / success) and any recurring R&D or G&A.
The SaaS business wins by keeping it simple
So two key metrics you need to know are Growth Efficiency and Revenue Efficiency.
If the growth business is the engine and the recurring business the endless supply of fuel, then the challenge is how good a driver are you?
Posted by Stephen Millard, Chief Platform Officer at Notion Capital.