Will there be a recession? Will private SaaS valuations be affected by the drops in the stock market? Will fundraising be tougher for all tech companies, or just certain types of companies? These are questions that we have been hearing from SaaS CFOs across the spectrum.
When companies finalized their 2022 budget plans in late 2021, the stock market was coming off all-time highs, Covid appeared to be receding and Russia had not yet invaded Ukraine. Since last November, the Nasdaq Composite Stock Index has lost 29%. Some SaaS companies that had been planning to file S-1s in Q1’22 are holding the registration. Boards are now requesting contingency budget plans if there’s a recession.
Navigating the Great Recession
We have been asked quite a bit lately how companies navigated the Great Recession of 2007-2009 and what companies can do today to protect against a downturn. If you look at public companies in 2008, for example, Salesforce and Netsuite, these SaaS leaders maintained their growth despite the Great Recession. In fact, their numbers show remarkable discipline in staying the course, despite the market. They maintained spending on Sales and Marketing, and investing in R&D. As a result, they increased the value of their companies as shown by their Enterprise Value and Market Cap multiples through this period.
Source: OPEXEngine 2022
Salesforce slowed growth, from about 51% in the calendar year 2007 to about 21% in the calendar year 2009, but they also became the first SaaS company to cross the billion $ threshold and improved EBITDA as well, while continuing to spend almost 50% of revenue on Sales and Marketing.
Source: OPEXEngine 2022
From conversations with the CFOs of these companies and some of the leading private SaaS companies of that era, like Hubspot, and others, the major way that these companies managed through the recession while continuing to build value and not slow their growth was to double down on their Growth and Efficiency KPIs. While presenting consistently improving financial metrics externally, they dug in internally to improve their operating focus.
The Magic Number and CAC ratio
A key operating metric to drive growth efficiently is the Magic Number, which looks at the efficiency of overall sales and marketing spend in producing new revenue. The Magic Number of sales and marketing efficiency is an easy-to-calculate rule of thumb to show whether your sales and marketing spending is producing sustainable recurring revenues. A ratio between 0 and 0.5 usually means a company does not have a sustainable growth model and needs better growth and marketing efficiency.
A ratio between 0.5 and 1 is better but can be improved. A ratio of 1 or greater indicates strong sales and marketing efficiency and a capital-efficient growth model. A ratio over 1.5 may mean there is room for growth opportunities thru increased investment in Sales and Marketing. This ratio is calculated by the change in subscription revenue between Q3 and Q4, multiplied by 4, and divided by the sales and marketing spend for Q3.
During the last recession, SaaS companies dug into their Magic Number and then also looked at another key SaaS growth ratio, the CAC ratio. The CAC ratio or CAC/LTV shows the relationship between the cost to acquire an average new customer (or segment of customers) against the profitability of the customer over the expected lifetime of the customer. To improve the average company CAC ratio, they compared benchmarks against peers and market leaders with the same business model to identify where they needed to improve. This gave teams targets to aim for, and incentives to the executive team to achieve those goals.
To improve the CAC ratio, SaaS companies segmented customers into buckets, ran the CAC ratio for each segment, and then identified profitable versus not-so-profitable segments. By moving away from unprofitable customer segments and expanding profitable segments, the overall company Magic Number and CAC ratio improved.
Thriving During a Recession
These companies also invested early and continually in reporting and analysis of their metrics. They put systems and processes in place to track these critical operating metrics and compared them to benchmarks on a continual basis, instead of doing the analysis as a one-off project. As the former CMO of Hubspot, Mike Volpe, said, it wasn’t easy to segment their customers and analyze profitable versus unprofitable segments the first time, but it yielded tremendous insights into improving their Sales and Marketing spend ROI.
Warren Buffet says “only when the tide goes out do you discover who’s swimming naked.” SaaS companies that double down on their Growth and Expense Efficiency KPIs, like the Magic Number and CAC Ratio will thrive even if there’s a recession. And investors that take a deeper look in diligence and continue investing in SaaS will be rewarded. In our next blog, we’ll report on other key operating ratios that help identify areas of strength and areas of weakness to help companies have the internal efficiency to navigate changing environments. The SaaS market will continue to grow. We are going thru one of those periods where the hype is exposed and strong operations will overcome the external market ups and downs.