WeWork, a so-called tech company, just pulled its IPO, and a couple of recent high-flying IPOs – Peleton, Uber, Lyft – are trading below their opening prices. Given market jitters about the economy, very high valuations of some private tech companies, and the massive $s invested by VCs and PE firms in the sector, it’s a bit scary. But a number of thoughtful voices are helping separate the winners from the losers in this cloudy world and shifting the focus on the metrics underlying tech valuations.
Software is Eating the World Doesn’t Mean You Can Call Everything Software
First off, many of the so-called tech companies that are troubled are not pure software companies. Many great analysts have dissected these companies problems, but basically, these companies aren’t selling software. Peleton is a consumer bike and fitness vendor. WeWork leases office space.
Just because Revenue Growth was the number one driving factor in many Cloud company valuations for the past 10 years, doesn’t mean that all vaguely companies with fast growth, some software component, and even high customer retention, should be valued like a pure Cloud software company.
Profit KPIs, unit economics and cashflow all matter, and providing balance to growth. The Rule of 40 still reigns, but Revenue Growth isn't the only metric that counts.
Gross Profit
Various pundits are talking and sharing their thoughts on what metrics are important. Brad Feld recently published a post called: Why Gross Profit is More Important Than Revenue. He says that at Foundry Group, they’ve been looking at Gross Profit in their valuation analysis for a while for due diligence and for managing their portfolio companies. Brad’s a super thoughtful investor and writer, worth reading if you haven’t seen his blog. His argument is that if private companies are comparing their growth rates to comps of mature, cashflow positive public companies, then they are missing the point by only focusing on revenue growth (I think I got the argument right).The definition of Gross Profit is the dollar value of:
- Revenue $s minus Cost of Revenue $s equals Gross Profit $s
- Divide Gross Profit by Revenue X 100 and get the Gross Margin%
I’d add a caveat here that early stage SaaS companies, from a pure accounting perspective, should have very high Gross Margins, because the primary components of SaaS Cost of Revenue are Hosting, Customer Success, and Professional Services (which many pure SaaS companies don’t have). Early stage customers, by definition, don’t have a lot of customers, so they shouldn’t be spending huge dollars on items that go into Cost of Revenue. And most of their R&D is usually focused on new development (putting the expense into OpEx), as compared to fixing the old development.And given that the priority for most early-stage companies isn’t accounting and the complexities of defining Cost of Revenue inputs, my sense from working with hundreds of companies over the years is that Gross Margin for most early-stage SaaS companies is more of a vaguely accurate number unless you really dig into the inputs. Once a SaaS company is at scale, then gross profit should be managed, should be high and should improve as compared to ever going backwards.
I think one of the key reasons that Gross Profit is an important metric for investors is that it helps define whether or not a “tech” company is a true Cloud software company, or there’s a hardware, or marketplace, or advertising model, or some other component that chips away at Gross Margin. If you are a SaaS company, you know you are a SaaS company and don’t get confused by the noise.
This sounds obvious, but sometimes the metrics that are important to investors can mask the important metrics for operating executives working to build a truly valuable company that can withstand the ups and downs of the valuation market as we go into 2020.
How Are Valuation Metrics Shifting?
Revenue growth rate is still important and will continue to be important as an indicator of increasing value. Given the potential market size for Cloud software, both in terms of replacement of perpetual license revenue and growth in new markets and users, growth is a good indicator of the market opportunity and Go-to-Market execution.
Gross Profit is also important both to indicate whether a company is a pure SaaS company and that it is getting economies of scale on its sales, ie., that the cost of each sale is getting less gradually as the number of sales increases.
Free Cash Flow is now being used by many SaaS companies to in their Rule of 40 equation. Free cash flow is basically the cash left at the end of the day from operations minus any spending on assets. Free cash flow is dollars that can be spent on additional growth so free cash flow plus revenue growth is the best indication of the value being built in a company.
2020 promises to be an incredibly interesting year, in all sorts of ways. When building a SaaS company and its value, the most successful companies benchmark their key metrics and the drivers of those metrics all along the way.
