The current public market environment might look like a great SaaS crash for many people. In reality, it’s not a crash. It’s a leveling out from a period of explosive growth. As things appear to slow, how do we get back to the fundamentals, find the things that are great about SaaS that are measurable, and help people see the value in your business?
In this week’s Workshop Wednesday, Salesforce Ventures Investor, Jessica Bartos, shares the 5 metrics every SaaS company should care about in any market environment, especially the one we’re currently in.
Why is this market different than others? Because of the interest rate increase by the Fed. While this fights inflation, it also means that high-growth companies have prospects who see cash flow very far in the future and buy into the company’s future growth.
When the overall interest rate is higher, you need to discount those future cash flows to the present to understand the value of the company today. A higher interest rate means a higher discount rate. Future growth is less valuable today than it would be in a lower interest rate environment, so we’ve entered into a structural change thanks to the overall economy and interest rate change.
Growth Is Still Number One
Growth is still the number one metric, but it’s not the only one. Years before now, everyone was chasing growth. But now, achieving all 5 metrics that Bartos presents will attract capital to get fair valuations for your business.
The fundamentals make your business attractive. They’re simple but not always easy.
In today’s market, you’ll need to convince investors that you’re a worthwhile investment. To do this, you’ll need to show phenomenal growth, particularly at the early stage.
At the earliest stages, investors typically like to see you go from launch to $1 ARR in 12 months or less. From there, remember the acronym of T2D3 — tripling for 2 years and doubling for 3 years.
Growth is important because it drives strong metrics across all SaaS metrics and “solves” most other metrics problems.
Pay attention to your last month or quarter for companies raising at seed series A, B, or C, especially right now. It’s critical to show investors that you’re bucking the trend of many companies today that generate less demand and aren’t hitting numbers. You do that by showing momentum.
Net Dollar Retention Shows SaaS’s Best Qualities
NDR encapsulates SaaS revenues’ best qualities in one metric: the subscription-based model. It captures the predictability of SaaS revenue and built-in growth.
It’s much easier to sell something to a customer you’re already working with than it is to win them again and again.
To calculate your net dollar retention, take all of your existing ARR at the beginning of the period, add on any cross-sell or upsell, subtract out any churn, and then see the ending ARR.
This number should always be great than 100 and is typically measured as a percentage.
For enterprise-facing companies, great than 120% is a good number. For SMB-facing companies, over 110% should be your goal. If you’re below 100%, you must win new clients to stay in the same place. If people love your products, they should stick with you.
Low churn shows stickiness ingrained in customer behavior or mission criticality.
Gross Margin Is A Critical Driver Of Health
Gross margin is a critical driver of healthy unit economics. The beauty of SaaS as a business model is its asset-light nature, selling bits, not atoms.
Incremental sales cost nothing and should have high gross profit margins in the 70-80% range, which is entirely unlike other types of businesses like services that bring in around 40-50%.
Gross margin is the telltale sign of true SaaS vs. “fake” SaaS. Services or services delivered digitally where a human is necessary to deliver something means the gross margin is low.
High gross margin is the underpinning of SaaS’s high cash flow generation. That high gross margin flows down, eventually leading to high profit margins and cash flow. Higher margins impact all of your other metrics.
What does a good gross margin look like? Around 70% or more. If you’re really awesome, 85% is great.
When you’re calculating and sharing gross margin with investors, be real. Include customer success and support costs, plus any other services required to deliver your product on an ongoing basis.
Be realistic and be prepared to show your work.
The Rule of 40 Measures The Balance Between Growth And Margins
There’s a balancing act between growth and margins, and the rule of 40 measures that balance across all equities. How do you calculate the rule of 40? It’s the sum of the ARR growth rate or revenue growth rate plus free cash flow margin. The sum of the growth rate plus the profitability margin should be 40 or better.
This works for both early-stage and later-stage companies and doesn’t apply only to software. Multiples are often driven by those numbers to deem a healthy business, but SaaS can have a very high rule of 40.
Why does the rule of 40 matter? Because it can determine how fast you’re growing, which is something you need to highlight to investors who are going to be choosy in what types of companies they invest in today.
Burn Multiples Showcase Efficiency
Why do burn multiples matter in today’s market? And how do you determine yours? First, divide your cash burned by net ARR added. Lower burn multiples could signal a good measure of product market fit and go-to-market fit because if you’re getting a lot of ARR for how much you’re burning on sales and marketing, you’re doing something right.
Burn multiples are a kind of catch-all to show warts or problems for a company that is burning too much because the gross margin is too low, sales efficiency isn’t good, or you’re spending a lot in areas that aren’t worth it.
People like to measure it cumulatively, determining how much you’ve burned in your entire existence and then quarter-to-quarter and month-to-month to track periodic performance.
For companies, lower is better. For companies with less than $25M ARR, less than .5x is best. For those with $10-25M ARR, less than .8x is better.
The SaaS “crash” reminds us to drive our investing from corporate finance fundamentals. When things become more challenging in any aspect of life, go back to the fundamentals. Some of the key takeaways for SaaS companies in today’s market are:
- The basics of great SaaS businesses haven’t changed.
- Digital transformation is not going away, and software eating the world is not going away.
- You’re capable of generating a lot of cash flow because of the characteristics of a subscription relationship with customers — yes, generating cash, not just raising it.
Every Wednesday at 10 a.m. PST, SaaStr will hold live, interactive workshops on Zoom where experts in the community share their insights. Sign up HERE!
Published on February 14, 2023