5 Controllable Factors in the Pardot Story

One of my favorite questions to ask is “why are you an entrepreneur?” I like to understand the motivation and drive for the person. Also, I’m interested in entrepreneurs that want to control their own destiny (an answer that resonates with me!). Of course, you can’t control much of anything in the world other than the most important things — your attitude, your actions, and your behaviors.

Entrepreneurs that I meet with like to tell me they want to build the “Pardot of X” where X is some industry or type of product. I’ve come to primarily understand this to mean they want to build a SaaS company that doesn’t involve raising money and does involve selling it for a meaningful amount of money. While that’s a worthwhile goal, I like to share the controllable factors in the Pardot story.

Here are the five most important controllable factors from the Pardot experience:

  1. Employees-First –
    Our focus on culture was maniacal. Employees came before customers and all other constituents. Everything we did internally was focused on our core values of positive, self-starting, and supportive. The ultimate reason we succeeded was because of our people.
  2. In the Path of Revenue –
    Our product unequivocally helped our customers make more money. We showed return on investment. We showed value. Our product helped turn marketing from a fuzzy role to a metrics-driven role.
  3. Must-Have Product –
    Our product was the core of the majority of the B2B marketing functions. If you ripped it out, many of the marketing channels stopped working (email, lead forms, etc.). It was not a nice-to-have.
  4. Complementary Co-Founders –
    Adam and I are very different yet complemented each other incredibly well. We knew our strengths and weaknesses and built an awesome organization.
  5. Focused Solution –
    Our product delivered the most value with the best experience possible at the $1,000/month price point. We were focused on providing the most bang-for-your-buck in the SMB market, and we executed well. This was especially important as our market was so noisy.

Notice that timing is nowhere in these factors, even though it‘s easily one of the most important considerations. We didn’t know if we had good timing. We didn’t know when to start. We did know that by entering the arena, we gave ourselves a chance. And we got it right.

Control what you can control. Everything else is noise.

SaaS Valuations Holding Strong

While SaaS valuations have gone down a bit from their all-time highs, they have held up well in this era of global pandemic. According to the BVP NASDAQ Emerging Cloud Index, the average public SaaS company is trading at 12.7x their enterprise value to revenue. What gives?

Talking to a variety of SaaS entrepreneurs, I’ve heard everything from the pandemic isn’t going to affect our growth rate to we’re expecting a 50%+ reduction in bookings this year and a 30%+ increase in churn. One SaaS entrepreneur in the ecommerce area said while many customers had sales fall off a cliff, other customers are seeing Black Friday-like volumes making the overall sales across the customer base even better than forecast. This gives a hint as to why SaaS valuations have held up so well.

The global pandemic, while hurting growth for many SaaS businesses in the near-term, is believed to have accelerated the growth of SaaS over the mid and long-term. With so many layoffs across the entire economy, and a tremendous amount of working from home, companies are going to invest in making their current workforce more productive with greater urgency than before. Now, companies are more focused on metrics like revenue and profit per employee. Investing in SaaS is one of the best ways to improve a business.

Just look at how fast people adopted SaaS products like Zoom and Calendly as the pandemic spread. Virtual meetings were steadily growing, and now without in-person meetings, they’ve become the norm. Fully 25% of meetings scheduled on Calendly are for Zoom meetings.

Of course, SaaS adoption is going to take time. There’s too much uncertainty in the world, too much expense cutting, and tremendous fighting to hold onto customers. But, this too shall pass, and when it does, upgrading systems and tools is going to be high on the list.

SaaS is well positioned for long-term growth and the pandemic accelerates the shift to the cloud. SaaS valuations have held up well and should continue to do so, especially with a variety of government programs propping up the economy.

Churn, Churn, Churn

For years I’ve been telling entrepreneurs that a high net renewal rate (and net dollar retention) is one of the most important SaaS metrics. While net renewal rate is important, two people in the last week have told me gross churn — both logo and dollar — is more important. And I believe them.

Why is gross churn more important? Let me count the ways.

  • Black and White Value – With gross churn, the math is straightforward: how many customers (or dollars) are up for renewal at the start of the time period vs how many renewed. Pretty easy. Now, for net renewal rate, things get more complicated. Do temporary upgrades/downgrades count? What about deals with subsidiaries or related businesses? You could ask 10 different SaaS companies how they calculate net renewal rate and get 10 different answers. Gross churn calculations should always be the same.
  • Ability to Understand – Similar to the first point, it’s much easier to rally the team around a gross renewal rate since it’s easier to understand and calculate. Say we start the year at $10 million in annual recurring revenue and have 20% gross churn, we know directionality that we need to sign more than $2 million of new recurring revenue to grow (assuming no upgrades/downgrades). Now, if we can get better and only have 10% gross churn, we only need to sign more than $1 million of new recurring revenue to grow. Pretty simple.
  • Recurrence of Upgrades – People love talking about their > 100% net renewal rate, myself included. Only, it’s much more nuanced than upgrades outweighing churn and downgrades. Are the upgrades across every cohort or do customers primarily upgrade in their first year (implying they’re still rolling it out) and not upgrade after that? Do customers often downgrade in year two or three implying they finished a component of a project or transformation? Are the upgrades primarily from a specific vertical and has that vertical been tapped out? Net renewal rate can become less compelling with a more detailed analysis of the cohorts.

SaaS entrepreneurs should focus on the gross churn rate and ensure it’s as low as possible (under 20% annually for SMB and under 10% annually for enterprise). The old saying that’s it cheaper to retain a customer than sign a new one has never been more true, and is even more important with SaaS.

Make fighting churn a top priority of the company.

When Debt is Better than Equity for SaaS Startups

Much has been written lately about the future opportunities for debt financing of SaaS startups. Of course, there are already a number of excellent debt options under the moniker of revenue loans. Personally, I’ve seen the upside and downside of debt for SaaS companies.

Let’s take a look at when debt is better than equity for SaaS startups.

When Debt is Beneficial

Limiting Dilution

Every entrepreneur hates the heavy dilution that comes with a round of financing. Revenue loans and other forms of debt often have no equity component, and when one is present, it’s minuscule (typically 1% or less). At Pardot, we never got on the venture funding treadmill and used $3M of bank debt to fuel growth while limiting dilution (most venture-backed startups only use debt as a safety net).

More Optionality for a Future Exit

Each up-round of equity funding also raises the valuation, and corresponding minimum target for an exit as investors often want to make a return of at least 3-5x the investment valuation. Debt provides a funding mechanism for entrepreneurs wanting to grow faster without changing any expectations as to potential exit outcomes. Generally, the less equity raised, the more optionality for a potential exit.

Ability to Reach a Value Milestone

In SaaS, there are certain financial milestones, like $10 million in annual recurring revenue, that open up a variety of new investors and exit opportunities (e.g. many private equity funds). Debt has the potential to extend the runway enabling the startup to reach a key value milestone.

Now, debt can be worse than equity in many ways as well. Here are a few of the more common.

When Debt is Problematic

Lack of Repeatable Customer Acquisition Process

One of the main tenants of SaaS is the predictable nature of recurring revenue. Only, a SaaS startup can have a number of customers without actually having a repeatable customer acquisition process. When debt is used in an attempt to accelerate growth, and customer acquisition isn’t repeatable, things are actually made much worse due to ballooning costs without the corresponding growth in recurring revenue. This is premature scaling, and funding it via debt or equity has killed many startups.

Inability to Fund Potential Growth

SaaS growth is terribly expensive (see Startup Killer) as costs to acquire customers are spent upfront while the new customers often pay monthly over an extended period of time. When signing customers faster, cash consumed increases. SaaS debt often maxes out at 3-5x the monthly recurring revenue, making it difficult to fund potential growth as cash is consumed faster than recurring revenue grows.

Covenants Constraining Cash Usage

Debt comes with strings attached. Capital providers often require covenants like one month’s cash on hand, gross renewal rates better than 75%, and sales to board-approved plan of at least 80%. When covenants are broken, a variety of penalties apply, which can force more limited use of future cash and tighter restrictions. Breaking a covenant or missing a debt payment can lead to serious challenges.

Conclusion

Debt isn’t the ultimate funding source but does work well for scaling SaaS startups looking to limit dilution, maintain optionality for exits, and striving to reach a value milestone. Currently, debt funding comes with a number of challenges, the biggest one being there isn’t that much debt available as a function of recurring revenue to move the needle. All said, SaaS startups should add a potential debt strategy to their plans.

5 Variables for a Quick SaaS Valuation

SaaS continues to be hot and shows no signs of slowing down. Of course, the strong gross margins, excellent recurring revenue, and overall predictable nature of the business model make it worthy of its praise. These same characteristics also provide the fundamentals for quickly assessing a rough valuation of the business as outlined in Premium SaaS Metrics Required for Premium Valuations.

After feedback and questions on that simple valuation, it’s clear there’s appetite for a slightly more complex formula whereby a couple additional variables are introduced.

The first variable to add: gross margin. As you can imagine, a SaaS company with 90% gross margins (extremely low cost of goods sold) is substantially more valuable than a SaaS company with 60% gross margins (high cost of goods sold for SaaS). A gross margin that’s 50% higher should be reflected in the valuation of two otherwise comparable SaaS businesses.

The second variable to add is much fuzzier: market sentiment. Sometimes SaaS is hot. Sometimes SaaS is white-hot. The fastest way to assess this market sentiment is through the public markets. Take the BVP Nasdaq Emerging Cloud Index and pull an easy-to-consume revenue multiple. That is, looking at all public SaaS companies, what’s the enterprise value divided by the revenue. This revenue multiple is the fastest way to gauge market sentiment. Today, that number is 12.6. Wow!

In the previous formula there was a generic 10x multiplier. This multiplier is better represented by the market sentiment.

Now, here’s the slightly expanded formula:

Market sentiment x

Annual recurring revenue x

Growth rate (use trailing twelve months) x

Net renewal rate x

Gross margin =

Valuation

Let’s take a look at an example using today’s market sentiment multiple of 12.6.

12.6 x

$3M in ARR x

70% TTM growth x

100% net renewal rate x

80% gross margin =

$21.2M valuation

Naturally, for an imperfect market with a limited set of buyers and sellers, this valuation formula is merely a directional number as each startup is unique. For entrepreneurs wanting to understand how to think about SaaS valuations, this basic five variable equation is immediately valuable.

Premium SaaS Metrics Required for Premium SaaS Valuations

When talking to SaaS entrepreneurs, inevitably the topic of valuations come up. Right now, public SaaS companies are trading at all-time highs, so entrepreneurs expect those valuations to apply to their startups. While the valuations of public and private SaaS companies have a direct correlation, it’s important to understand that not all SaaS revenue is created equally, regardless of public or private markets, thus valuations as a function of revenue vary wildly.

As expected, premium SaaS valuations are driven by premium SaaS metrics. Here are a few of the most important ones:

  • Annual Recurring Revenue – The annual run-rate is the most talked about SaaS metric. Ensure that it’s contracted, recurring revenue as different from other revenue sources like services revenue and payment processing revenue.
  • Gross Margin – The money left after the cost of goods sold are taken out. SaaS company gross margins vary dramatically from the low 60s to the high 90s. Anything below 60% gross margins isn’t SaaS (startups masquerade as SaaS but often aren’t). A SaaS company with 90% gross margins is 50% better than a SaaS company with 60% gross margin, and correspondingly much more valuable per dollar of revenue.
  • Growth Rate – The year-over-year growth rate reflects the potential to continue growing fast, and ultimately achieve a much greater scale in the business. Investors pay a huge premium for high growth.
  • Net Renewal Rate (also Net Revenue Retention) – The gross renewal rate plus upsells and cross-sells represents how the annual recurring revenue will change assuming no new sales. Investors pay a huge premium for high net renewal rates.

Directionally, the simplest formula for SaaS valuations is as follows:

  • 10 x
  • Annual recurring revenue x
  • Growth rate x
  • Net renewal rate =
  • Valuation

Here’s a quick example:

  • 10 x
  • $5 million in annual recurring revenue x
  • 50% growth rate x
  • 105% net renewal rate =
  • 10 x $5,000,000 x .5 x 1.05 = $26,250,000

So, a $5M SaaS company with good growth and good net renewal rates would be worth a bit more than five times annual run rate.

To make it more complete, you’d add in gross margin and elements to reflect more nuanced variables like the potential size of the market (e.g. a valuation premium for bigger markets).

One SaaS company might be worth 15x run-rate (due to high growth rate and high net renewal rate) while the next one might be worth 2x run-rate (due to no growth and high churn).

Premium SaaS metrics are required for premium valuations. Look at the entire picture, not just annual recurring revenue.

Compounding Revenue’s Value in the Future

When talking to entrepreneurs about revenue growth, I look to emphasize the value of compounding revenue now and how it plays out over an extended period of time. It’s easy to think that it’s no big deal that we missed our sales number for the quarter or had a lower renewal rate than expected. Only, when you really dig in, a lost dollar today translates into many lost dollars of revenue and enterprise value over the long run. Similarly, an extra dollar of revenue sold today translates into much more revenue and enterprise value over time.

Let’s look at an example. Say you were able to beat the sales plan and the net dollar retention plan adding an additional $1 million in new recurring revenue in a calendar year. With an extra $1 million in recurring revenue:

  • Year 1 after exceeding goals
    • Extra ~$800,000 to grow the business (assume 80% gross margin)
    • Hire two additional sales reps and increase marketing spend (assume 50% of the extra $800,000 goes to sales and marketing)
    • Add $1M of new annual recurring revenue from the new reps (assume the two reps each have a $500,000 quota and hit it)
  • Year 2
    • Extra $1,600,000 to grow the business (year 1 gross margin plus the gross margin added by the new reps assuming 100% net dollar retention)
    • Hire four additional sales reps and increase marketing spend
    • Add $2M of new annual recurring revenue from the new reps
  • Year 3
    • Extra $3,200,000 to grow the business (it keeps layering on the previous year!)
    • Hire eight additional sales reps and increase marketing spend
    • Add $4M of new annual recurring revenue from the new reps

In this example, by the end of the third year after the year of an extra $1M in annual recurring revenue, the business has added $8M of new annual recurring revenue. $8M of annual recurring revenue pays for dozens of employees and adds $40M – $80M of enterprise value in today’s market (assumes 5-10x run rate multiples).

The next time someone questions the importance of renewing an existing customer, or signing a new customer, remind them that $10,000 of recurring revenue today is worth up to $800,000 of enterprise value after three years. Every dollar counts.