Growth & Profitability in Software— Why Frothy Markets Create Bubbles that Pop
An analysis of the current software market and how a focus on fundamentals can lead to long-term success
An outlook on the current software environment
The latter half of 2022 illustrates an inflection point of a fundamentally evolving investment environment where a significant drop in valuations has caused many high-growth companies to rethink and refine their operating frameworks. This includes their customer acquisition costs, growing profitability, and future expansion plans. Many investors and founders have discovered that high triple-digit growth would not be sustainable over many years. When capital is cheap, companies take advantage of it and burn as much as possible to increase their top-line and delay efficiency much later into scaling. With less capital readily deployed, high-growth companies need to prioritize efficient means of growth; otherwise, they will need a longer runway to survive.
Payment processing company Stripe dropped about 30% in valuation from early last year. Buy now, pay later fintech Klarna has reported that valuation has fallen 85% despite its recent round of funding, according to TechCrunch. And it’s not only fintech companies — software companies of all industries have taken an enormous hit. Enterprise cloud company Snowflake was valued at an inflated 70.3x EV/NTM multiple end of last year and is now trading at a more modest 17.7x, according to Clouded Judgement. Even the recession-proof data observability companies from my analysis on “Drivers of Data Observability Software” (2021) have dipped in value because of market-wide multiple contraction. However, many resilient players still hold strong growth rates and margins. This time last year, public high-growth (>30% growth rates) SaaS companies were trading at around a 30x EV/NTM revenue multiple, and mid-growth (15–30%) SaaS companies were trading at 14.5x. Today, according to Clouded Judgement, both median EV/NTM multiples are 8.3x and 5.0x, respectively. Public software companies that haven’t been able to hit their growth goals and are also not achieving profitable margins are now suffering.
Despite the large drops in valuations, it’s essential to take a step back and realize that these drops result from unsustainable massive hyper-growth throughout 2021, where investors led rounds with inflated post-money valuations. Investors overlooked the long-term effects of negative EBITDA margins and healthy unit economics and solely invested in the growth potential. If we took 2021 out of the picture and compared the growth from 2020 and 2022 adjacently, we would observe a 56% increase in fintech funding from Q4 2020 to Q2 2022.
In his research, Jamin Ball — Partner at Altimeter Capital —analyzed the correlation between growth rates and revenue multiples. As expected, Q4 ’21 showed an R² of 59% correlation while Q4 ’22 showed an R² of 42%, signifying that valuation multiples have less to do with growth rates. Further, median customer acquisition cost (CAC) payback periods have increased from 25 months to 33 months, resulting in high expenses toward growth. This trend of repricing growth prevailing throughout the public software markets is already starting to trickle down to the private markets. Consequently, investors are asking themselves how to value companies with decelerating revenues.
The hypergrowth these companies experienced over the past few years has led to an exorbitant amount of hiring. This happens when companies over-employ during times like these and ignore planning for times of downside where margins may contract too thin if revenues drop. The correction in hypergrowth is an attempt to reduce operational debt.
With growing investor hesitancy, soaring interest rates, and a correction in valuations, amongst other headwinds, high-growth companies need to prioritize having sustainable unit economics rather than obsessing over costly growth vectors. Doing so can result in a longer runway, improved valuations, and better investor terms in the future.
Pressure for growth
While profitability is a key focus for public companies or companies seeking to IPO soon, it also matters for hyper-growth companies earning $25M ARR (annual recurring revenue), even though you could be far from it. But for an early-stage startup founder, growth is probably the only word you wake up to and sleep to daily — if you even sleep. Even at $10M ARR, growth is of the essence as a company carves its way into penetrating its serviceable addressable market after achieving product-market fit. However, when a company has about $25M ARR, the path to profitability should begin to play a role in defining operating frameworks and GTM (go-to-market) motions.
With a high threshold from investors for closing deals and a fear of raising down rounds, founders need to rethink how they are spending their money and how they can better position themselves for the future. This includes having healthier margins to reflect that they have a robust GTM motion and a sustainable and cost-efficient framework to grow while they scale.
Venture investors deploy capital, dismiss profitability, and focus solely on driving growth engines. And doing so isn’t wrong; however, it creates a false narrative that early-stage companies should be burning huge amounts of cash to pursue growth at all costs. Investors commonly make deals with term sheets that outline a 1x liquidation preference, offering downside protection for themselves and getting paid out before any other equity holder on the capitalization table. These investors make their return either from their ownership stake or their liquidation preference multiple (or both if participating). For instance, when a company is growing from $3M ARR to $15M ARR over a span of 2 years, and their exit value, in turn, went from, let’s say, $30M to $150M, investors can see a return solely from top-line growth since these exit valuations are generally based on forward revenue multiples, not EBITDA. And when revenue determines exit valuations and the market rewards explosive growth, growth becomes second to none. As a result, many venture-backed companies have a laser-sharp focus on growing aggressively, and their tunnel vision often makes them lose sight of the fundamentals of a healthy and sustainable business for the long term.
The more inflated valuations become, the more bullish investors become toward lower-margin businesses
An ongoing cycle of pressure
The pressure founders face from investors to achieve high-growth trickles down to the different teams within the company, especially the revenue-generating sales teams. The sales team will aim for lofty revenue goals, while founders will worry about their competition if they don’t keep growing fast enough. As a result, founders may consider hiring additional sales representatives to enable desired growth. Doing so will ramp up costs and possibly shrink operating margin even more unless they can convert more leads into high-paying and retaining customers. This cycle of having heightened revenue targets would yield more cash burn.
Roots of hypergrowth
Let’s look at the different stages of a SaaS company, from $0 ARR to $100M ARR and beyond. Each stage consists of its highs and lows. We’ll look at the median benchmarks of other enterprise-focused SaaS companies surrounding growth and burn provided by Scale Venture Partners.
Early Building
There are prevailing patterns for software companies as they grow between $0 — $10M ARR. Within this range, we notice a decrease from the exuberant levels of growth since the very beginning. $1M ARR companies have median YoY growth rates of around 1000%, reaching the low hundreds as they approach $10M ARR. From $10M — $25M ARR, many companies grow about 75–100% YoY and can see net retention rates over 100%. Operating margins are generally always negative, although improving as they grow closer to $10M ARR. It’s important to realize that approaching profitability from $10M ARR would take another six years, sometimes five, for high performers.
Hypergrowth
Companies in the $25M-$100M ARR range are spending time hiring and building teams across product, customer success, engineering, and go-to-market. They are building momentum to try to retain very high growth rates and minimize loss of YoY growth. New customers will still drive initial ARR growth until they reach a quarter of a million, with expansion revenue playing a large part in ARR growth. Top-performing companies from $50M-$100M ARR may start to have positive operating margins, indicating some levels of profitability; however, the vast majority of companies at this stage are still under the surface.
This level of growth drives even more momentum as a company scales. It prevents management teams from taking a step back and considering the long-term consequences of hyper growth due to short-term successes. The management team would never feel satisfied and would constantly want to achieve the next significant milestone, and the constant pressure from external stakeholders ends up at a cost. As a result, pushing customers into buying your product(s) to get that acquisition may backfire as some customers may not be the right fit for your product. This will leave you with unsatisfied customers who will then churn. Additionally, the pressure can blur the focus on prioritizing projects that matter and cause one to lose sight of long-term goals.
The excessive growth, backed by ubiquitous private capital, leads founders to focus only on valuations instead of actual value creation. And the markets in 2021 were rewarding this behavior until the correction hit in 2022.
Focus on sustainable growth
For software companies to be successful in the long term, there needs to be a prudent balance between top-line growth and operational efficiency. Initially, penetrating the total addressable market is critical since having a growing set of customers is essential for sustainable growth. As a company scales, many of these customers will retain, and the company can become primarily dependent on the expansion revenue of these existing customers.
The rule of 40 has been a valuable benchmark to measure how well the company is growing and maintaining its margin. Ideally, the sum of the annual growth rate and the free cash flow margin should be at or greater than 40%, and many resilient companies have percentages significantly above 40%.
“Software companies with top quartile FCF margins in January of 2022 have since outperformed the broader software market by 10%, compared to companies with top quartile revenue growth who underperformed the market by 2%.” — ICONIQ Growth
Rethinking healthy unit economics
Healthy unit economics are the backbone of any software company. If it’s sustainable, then companies will be able to survive for a while. We can define these unit economics as how much it costs to acquire one customer and how much value we can realize while the customer is with us. Let’s break the two sides down:
Acquiring customers is expensive and generally requires a robust sales motion. Customer acquisition costs (CAC) include headcount (salaries) in sales and marketing (S&M), direct marketing, marketing software, and sales software, among others. Separating your CAC by customer segments is essential since acquired customers can vary in costs. Some can be paid customers sourced from multiple distribution channels, while others are organic. In recurring revenue models, these customers — from individual consumers (B2C) to enterprises (B2B) — pay every period (monthly or annually), which means seeing any value from a customer takes time. Actual value creation for customers is determined by how long a company can retain them. If the customer stays with the company for an extended period, it’s safe to believe that the company is effectively solving customers’ needs. Likewise, if the company retains a customer for an extended period, their lifetime value can exceed multiples of the acquisition costs, driving recurring revenue streams.
And, of course, retaining customers comes at a cost, but not as expensive as acquiring customers. Retention requires continued engagement with customers, a solid end-user experience to go beyond solving customers’ needs, and a consistent investment in product innovation. It’s critical to consider costs other than CAC when retaining customers. These COGS are:
- Direct costs to serve customers day to day (i.e. server costs)
- Customer success headcount (salaries)
- Customer success software
Since LTV is a proxy of revenue, customer success and other direct costs to retain customers are necessary for accurate unit economics. Without accounting for these costs, a company’s LTV may be overstated at a 3.0x LTV/CAC rather than a valid 1.5x LTV/CAC. This difference can either make or break a company in the long term.
Many founders have attempted to ‘hack’ these metrics by using investment capital to subsidize the price of their products in the hope of increasing the number of bookings and annual contract value. In the long run, this strategy isn’t sustainable as it will lead to higher churn. The 2021 frothy market, unfortunately, rewarded players who are ‘succeeding’ at face value in the short term, and as a result, many companies have tried to do whatever it takes to get there.
It all goes back to unit economics when determining investments in S&M. Nonetheless, seeing how much juice you’re getting out of your investments in S&M when you’re burning cash is also important. For every dollar spent on marketing, how much is your top-line increasing? And because it takes some time to see the fruits of your labor, it’s wise to compare the invested dollars from the previous quarter and see the net effects of the top-line in the current quarter. This is called the Net Magic Number:
A number above 0.8 is excellent, and there should be further investment in S&M as necessary since those expenses are driving enough substantial top-line. This metric is far more telling than just straight-up S&M as a percentage of revenue because, most of the time, a higher S&M is needed for sustainable growth. What the percentage of revenue doesn’t tell us is how efficient our investment behind S&M is, and that’s what the Magic Number tells us.
Identifying sustainable growth models
Product-led growth —as opposed to sales-led — is a bottoms-up strategy where the product sells itself over time, making it the largest source of growth, from acquisition to retention. Having a customer — be it a consumer or enterprise — wanting to buy more into the product(s) as a result of the personalized experiences offered to them means a scalable way of snowballing while having a low customer acquisition cost. Product-led growth can also serve well for software companies looking to sell upmarket into the enterprise as they can leverage satisfied end-users to advocate products into companies as a pipeline. Selling to enterprise customers requires special attention to understand their complex buying journeys and product requirements while also being able to cater to the different decision-makers. This level of advocacy requires constant engagement with end-users and allows software companies to not have to rely on top-down sales-driven growth for enterprise accounts.
Another sustainable growth model is being niched enough and dominating a vertical segment. Being a player in a vertical segment only gives you so much opportunity from a total addressable market perspective, which means being able to move upmarket is critical for additional growth. Additionally, expansion revenue from upselling or cross-selling other products becomes even more critical for vertically-focused companies. It can help sustain growth since core products won’t generate enough revenue in the long term when they mature.
One component that can grow revenue without increasing costs is pricing. Constantly evolving and adapting a pricing model is critical to ensure you’re maximizing revenue from offerings. With TAM being smaller in vertical markets, consistently adapting your pricing model allows you to grow revenue, shows value to your customers, and may also encourage upsell and cross-sell if done carefully. Having multiple tiers in a pricing model is important as it offers a more personalized set of offerings that give customers choices for their needs. This kind of price anchoring helps increase revenue through consumer behavior. Additionally, such engagement with end-users will help retention as your company scales over time.
Enabling cross-functional collaboration
Especially important in product-led growth companies, having alignment between different teams — sales, marketing, customer success, engineering, and design — is necessary for sustainable growth to build products users love and want. Having a rigorous set of objectives and key results and focusing on outcomes instead of delivery is just one piece of the equation. Staying nimble while using a consistent and proven process to reach these objectives is necessary as a company grows. Providing a delightful customer experience that keeps net revenue retention in the triple digits is a byproduct of ensuring that all teams are on the same page.
Building an incrementally improving operating framework
As a company grows, management teams need to constantly update their operating framework to adapt to the changing needs of the customers they serve and ensure they grow at a healthy pace.
To keep sight of ARR growth and net revenue retention, companies need to stay agile and iteratively adapt to solving their changing customer needs and competition. Staying nimble and prudent at all times — from when you look out the window and see markets rewarding your competitors with inflated valuations to times of downturn — can earn companies dividends.
Growth levers
After every milestone a company achieves, there are levers to pull to help grow more effectively and profitability. These levers, if done effectively, would enable companies to refocus their strategies toward increasing margins. These levers can be organic, including building a robust go-to-market motion that not only lands a customer but also cost-effectively drives expansion revenue and consistent renewal. Refining a data-driven land-adopt-expand-renew motion over time can help experiment with where there needs to be more investment.
As mentioned, evolving pricing models with multiple tiers can help increase acquisition and retention without marginal costs.
Further, as a company scales, being able to reinvest money back into the business either tactically (in sales) or strategically (in R&D) can help improve competitive positioning without equity dilution or cash burn.
Other levers are inorganic, including leveraging a strong balance sheet for accretive add-on acquisitions that can drive synergies and top-line growth. A potential partnership can also bring in more cost-effective distribution channels to acquire a new cohort of customers.
This is why being profitable is critical because not only can a company reinvest assets into the business for compounding growth, but it can also roll-up other companies smaller in size for additional product expansion.
Scenario planning
Investors constantly use scenario planning to either base their investment thesis or determine upside/base/downside cases for the future of a portfolio company. Planning out potential scenarios when refining an operating framework is critical; even during downturns, the company should have some plan to help them survive rather than being taken aback. Having a solution to what the runway would look like 12–18 months from now or potential levers to pull if you will be tight on cash are reasons why frequent scenario planning can go a long way. It forces you to look at the whole picture and make prudent decisions for long-term benefits.
Looking ahead
As competitors are more careful and are waiting for greener pastures, now is the time to double down and enable cost-effective revenue-generating initiatives for early-stage companies. In the current market, where funding levels have decreased, companies must be aggressive and strategic simultaneously. Short-term benefits shouldn’t come at the cost of long-term success. After all, many world-class and category-defining software companies are born out of recessions.
Sources:
Clouded Judgement: https://cloudedjudgement.substack.com/p/clouded-judgement-11422-a06
Insider Intelligence: https://www.insiderintelligence.com/insights/fintech-valuations-funding/#:~:text=Record%2Dhigh%20inflation%2C%20the%20war,have%20to%20revisit%20their%20priorities
Scale Venture Partners: https://www.scalevp.com/
Disclaimer: All information presented within this site is for informational purposes only. Because this information presented is based on my personal opinion, it should not be considered investment advice.
