With the large number of startups that have already announced layoffs this year, and the belief that more layoffs are on the horizon due to the economic downturn, there’s a second-order effect that will exacerbate the challenges for SaaS companies: reduced renewal rates. Most SaaS companies sell their solution on a per user basis, and a material number of SaaS companies sell to other venture-backed startups. When the customer comes up for renewal, even when they’ve had a great experience and received real value, now needs fewer users because they’ve downsized the team, they’ll renew a smaller contract. The SaaS company hasn’t done anything wrong, and likely has delivered a valuable solution, only to see the account shrink.
Reduced renewal rates then have several third-order effects. First, with additional churn, it’s harder to grow as more of the newly signed customers are required to offset the customers that have downsized. Second, with a lower growth rate, the valuation premium is reduced as growth rate is a major driver of the valuation multiple and the Rule of 40 score goes down. Third, budgets and annual plans have to be updated to reflect the reduced demand, and this often results in reduced hiring or layoffs, especially in the context of capital being more expensive and valuations being lower. It’s not a death spiral, but it is a serious change in the playbook.
Thankfully, SaaS as a category is still growing incredibly fast with public SaaS companies growing at an average rate of 35% annually. The growth won’t come to a complete halt, but it will be impacted. Ideally, the economic downturn would be temporary (12 – 24 months, hopefully!) as inflation is tamed and the normal creative destruction process plays out. Entrepreneurs would do well to know that their growth metrics, especially renewal rates, will likely be challenged for a period of time, and to plan accordingly.