Category: SaaS

Brad Feld wrote a great piece last month titled The Rule of 40% for a Healthy SaaS Company. The idea is that growth plus profitability should be 40% or greater once at scale (double digit millions of revenue). As an example, if a SaaS company grew 100% year-over-year, and had negative margins of 60% (burning lots of cash), then those combined percentages equal 40% (yes, they’re two different percentages, but the metric is more of a gauge rather than scientific). As for another example, if a SaaS company grew 20% year-over-year, and had EBITDA (profit) margins of 20%, then those combined percentages equal 40%, and hit the mark.

Here are a few thoughts on the rule of 40% for SaaS companies:

• For seed stage (under $1M run-rate) and early stage ($1-$5M run-rate), the percentage should be much higher
• Higher growth rates often equate to higher valuations (see the growth rate valuation multiplier)
• No growth, and profit margins of 40%, would still fit this 40% metric, but not be nearly as interesting to traditional venture and growth stage investors (unless they thought significant revenue growth was possible)
• As scale increases, maintaining high growth rates becomes much more difficult as the law of large numbers kicks in
• Mailchimp, a rare unicorn, has double digit revenue growth and greater than 50% profit margins

Thinking about growth rate in conjunction with profitability makes perfect sense as there’s always a trade off between the two. The Rule of 40% for SaaS companies provides a general metric that takes into account both growth and profitability.

What else? What are some more thoughts on the Rule of 40% for SaaS companies?

An entrepreneur emailed me recently asking for advice about his Software-as-a-Service (SaaS) business. After several years of working on it, and signing up hundreds of customers paying a small amount of money, it became clear that it wasn’t a viable business. That is, by all accounts, product-market fit was reached but no matter how hard he tried, there wasn’t a repeatable customer acquisition process that could scale it to a multi-million dollar revenue business and make it worthwhile. This is one of the most challenging cases: years have been invested, customers clearly want it, and there’s no sustainable business in its current form.

Here are a few questions to ask when a product works but a business doesn’t:

• Are there any adjacent markets or opportunities that can use the expertise developed with the first product?
• How excited is the team about the opportunity? Has any fatigue set in from the current product?
• Is the product a must-have or a nice-to-have? What would it take to make it a must-have?
• Can you sunset the product or wind it down such that customers have time to switch to a different product?
• How much effort does it require to keep it running while moving to a different product? Can focus truly be put on something else without worrying about the first product?

Products that work with business models that don’t actually happen more often than expected. Inevitably, some ideas aren’t economically viable even though they look great from the outside looking in. Even though it’s hard, sometimes the best approach is to stop throwing good money after bad and pivot or iterate into a better opportunity.

What else? What are some other questions to ask when a product works but a business doesn’t?

Earlier this week a friend sent over an executive summary and financial model for a Software-as-a-Service (SaaS) startup and asked for my advice in evaluating it. While he hadn’t been an angel investor before, he was thinking about becoming one and this would be his first investment. After looking through the two PDFs, I told him that there’s nothing to evaluate other than whether or not he loves the market and the team. The startup had no revenue, no customers, and was working on building a prototype. It was simply an opportunity to bet on a market and team.

Now, if it did have an operating history, even a modest one, there would be a number of different metrics to analyze. Here are a few items to look at when quickly evaluating a potential SaaS investment:

• Annual Recurring Revenue (ARR) – How much money would be generated if no customers were added and no customers left
• 12 Month Growth Rate – How does the ARR from 12 months ago compare to the ARR today
• Monthly Churn Rate – How many customers that started the month renewed for the next month and what has churn been for each of the last 12 months
• Cost of Customer Acquisition – How much money is spent on sales and marketing relative to a new dollar of annual recurring revenue generated in each of the last two quarters

While there are a number of other metrics to analyze, these four quick items paint a clear picture of health and opportunity for a SaaS startup. SaaS is an amazing business model due to recurring cash flow, gross margins, and predictability of the business. And, potential investments can be quickly evaluated.

What else? What are some more thoughts on quickly evaluating a potential SaaS investment?

A few weeks ago I was talking to an entrepreneur about his Software-as-a-Service (SaaS) startup. After three pivots they arrived at an idea that’s taken hold and are starting to scale. While they don’t have Saastr’s Initial Traction (ARR of $1M of more, ARR growing more than 100% a year, and more than 50% of new revenue from zero-cost marketing) yet, it looks like they’ll achieve that this year.

One of the great things about SaaS is that even with near initial traction, there’s a sense of inevitability that the business will be successful. Here are a few reasons why:

• Signing the first 100 customers provides enough use cases to feel confident that the next 1,000 customers will be signed up
• Engineering becomes more cohesive and stable with continued customer adoption and product development
• Starting the marketing engine is incredibly difficult (e.g. SEO, content marketing, etc.), but once it’s working, it keeps on giving
• Recruiting team members gets easier as the story and results are more developed

SaaS companies with near initial traction have an inevitability of success. While it isn’t guaranteed, with continued growth and high renewal rates, the chance is very high.

What else? What are some more thoughts on success being inevitable once a certain size and level of momentum is achieved?

Neeraj Agrawal has an interesting article up titled The SaaS Adventure where he talks about the seven phases of go-to-market success for Software-as-a-Service (SaaS) companies that have gone public recently:

• Phase 1: Establish a great product-market fit.
• Phase 2: Get to $2 million in ARR (annual recurring revenue).
• Phase 3: Triple to $6 million in ARR.
• Phase 4: Triple to $18 million.
• Phase 5: Double to $36 million in ARR.
• Phase 6: Double to $72 million.
• Phase 7: Double to $144 million.

Of course, there’s much more nuance to startup success than hitting certain revenue targets (see 4 Startup Stages in 8 Words for the briefest example possible). Combine this with the Law of Large Numbers and Startup Growth and you can appreciate just how difficult it is to achieve that level of revenue growth and scale. See the Notes from the Marketo S-1 Filing to understand that the capital required to achieve the size and scale in that period of time resulted in investors owning 85.5% of the business, which is fine as long as that level of success is attained.

The next time an investor asks about revenue goals, tell them about tripling two years in a row and then doubling revenue year after year beyond that so as to go public in 6-7 years.

What else? What are some other thoughts on the revenue growth pattern of recent SaaS companies that have gone public?

Recently I was talking to an investor and he mentioned they were looking at a deal, liked the company, but were concerned with how much cash the startup had burned relative to current annual recurring revenue. For Software-as-a-Service (SaaS) startups, it’s especially difficult to get the business model going, and once it’s going, it’s especially cash-intensive to scale it.

Here are some example ratios to consider when analyzing funding relative to recurring revenue:

• Seed Round – 8:1 ratio of funding to revenue (e.g. $800k raised and $100k in new annual recurring revenue)
• Series A Round – 3:1 ratio of funding to revenue (e.g. $3 million raised and $1 million in new annual recurring revenue)
• Series B Round – 2:1 ratio of funding to revenue (e.g. $12 million raised and $6 million in new annual recurring revenue)
• Series C Round – 1:1 ratio of funding to revenue (e.g. $20 million raised and $20 million in new annual recurring revenue)
• Example Total: $35.8 million raised with annual recurring revenue of $27.1 million

Note: this assumes the money raised has been spent, while most startups haven’t spent all their cash. Startups that are doing great would see these ratios cut in half (e.g. they are twice as efficient growing revenues relative to money spent). There’s no exact formula for the ratio of funding to new annual recurring revenue, but this is directionally correct.

What else? What are some more thoughts on SaaS funding relative to recurring revenue?

One interesting aspect of Software-as-a-Service businesses is that most of the value creation is back-loaded. What I mean is that the majority of the valuation growth occurs in the later years, assuming the startup makes it there and has a rapid growth rate. Here’s an example five year trajectory with amount of recurring revenue and corresponding (hypothetical) valuation:

• Year 1 – $20,000 annual run rate with a valuation of $2 million (valuation isn’t based on revenue but rather based on the market for a seed-stage SaaS startup)
• Year 2 – $200,000 annual run rate with a valuation of $4 million (valuation is based on the market for a late seed-stage SaaS startup)
• Year 3 – $1,000,000 annual run rate with a valuation of $8 million (valuation is based on the market for a Series A SaaS startup)
• Year 4 – $3,000,000 annual run rate with a valuation of $15 million (valuation based on 5x run-rate)
• Year 5 – $8,000,000 annual run rate with a valuation of $40 million (valuation based on 5x run-rate)

So, assuming the startup is sold at the end of five years for $40 million, $32 million of that value was created in the last two years and over 50% of the value was created in the final year. In reality, value is created all along, but the premium paid for growth rate (even with modest scale) really emerges at the end as the revenue is ramping up.

What else? What are some more thoughts on the idea that SaaS companies create most of their value at the end before being acquired?

Several years ago I was biased against Software-as-a-Service (SaaS) startups offering consulting services. The previous thinking was that it was better for the startups to focus exclusively on recurring revenue and to hand off any consulting revenue to partners. Now, I believe the top priority is to deliver an amazing solution and make customers happy. While that can be done with partners, startups are better off doing it in-house for quality control reasons during the early years. Once the startup hits the growth stage ($5 million+ in revenue), incorporating channel partners becomes more important.

Here are a few thoughts on consulting services revenue in SaaS:

• SaaS valuations multiples aren’t affected by services revenue as long as it’s less than 20% of total revenue (e.g. a startup that’s heavy on consulting revenue won’t be viewed favorably, all things equal)
• Freemium products, which are self-service to get started, still have consulting opportunities
• Most technologies need a couple generations of refinement before they’re self-service (email marketing has reached it but marketing automation hasn’t)
• Productized services are a great way to deliver customer hand-holding
• Bigger companies are even more likely to pay for services, and often expect it, as change management is hard

Consulting services, and the corresponding revenue, are commonplace in the software world, SaaS or otherwise. SaaS startups would do well to ensure customer success and incorporate consulting services as needed.

What else? What are some more thoughts on consulting services revenue in SaaS?