1. SaaS Financial Benchmarking… One Size Doesn’t Fit All, and Focusing on Gross Profit
As part of this blog series’ discussion on the importance of focusing on Burn Productivity, a recap on incumbent analyses of financial ratios and metrics follows.
A common conversation we at e.ventures have with our 100+ global portfolio companies is around benchmarking — of operating KPIs, financial ratios, valuation etc.
This post focuses on financial ratios — growth, margins and opex bases:
- Benchmark the median and top-quartile for each ratio,
- Identify some of the outliers for these ratios,
- Why compare cost bases relative to Gross Profit can make more sense than comparing them to Revenue
Feel free to drop me a note if you have any questions or thoughts.
With the recently completed 1Q 2020 earnings season (including April quarter-ends), we have compiled the quarterly data to present the below ratios.
- Of the 61 SaaS companies, the median LTM (last 12 months) ARR growth rate is 31%, (ARR is defined as the last quarter GAAP revenue, annualized i.e. multiply by 4)
- The top quartile (i.e. the 15th fastest growing company) is growing at 41%.
The chart below shows the constituents of the top quartile of ARR Growth YoY — ranging from 41% (Zscaler) through to 169% (Zoom).
Impressively, 13 of these 16 companies are above $400M in ARR — showing that scale isn’t necessarily a barrier to growth where large addressable markets exist.
Margin and Cost Ratios
SaaS businesses have a well-defined business model, generally with high recurring Gross Profit margins and a cost base that is largely comprised of headcount.
S&M and R&D expenses are broadly seen as growth investments, i.e. spur the growth of the business. Therefore while these two components have some aspects of fixed investment nature, they are largely variable particularly during a company’s growth stage and so are controlled in the context of cash availability and margin targets. G&A expenses are derivative of S&M and R&D spend, but are more fixed in nature.
This analysis defines the ‘top quartile’ of cost ratios as being the lowest cost relative to Revenue. Median / Top Quartile ratios (% of Revenue) respectively per below:
- Gross Margin — 74 / 78%
- Sales and Marketing — 45 / 34%
- Research and Development — 23 / 18%
- General and Admin — 17 / 14%
- EBITDA —  / 3%
- Free Cash Flow — 11 / 30% (defined as Operating Cashflow net of Capital Expenditures)
Why Using Gross Profit as a Base Is Better Than Revenue
While it easy to compare cost bases to Revenue, not every dollar of Revenue is created equally — Gross Profits, rather than Revenue, is an arguably more accurate assessment of value being generated on investments of S&M / R&D etc.
This is because the variable COGs / cost-to-serve of SaaS businesses vary significantly — i.e. self-serve, on-premise software businesses have lower hosting expenses and therefore higher gross margins closer to 90%, whereas other businesses that rely on other infrastructure components (payments, communications) drive lower margins closer to 50–60%. Professional-service heavy enterprise SaaS businesses have also traditionally had lower gross margins.
The proliferation and success of lower Gross Profit margin businesses — Shopify, Twilio, Fastly, Five9 to name a few that have margins below 60% — make comparing and planning Opex investments more difficult when using Revenue as a base.
Comparing Opex to Gross Profits is an alternative measure that makes this benchmarking easier.
Median / Top Quartile ratios (% of Gross Profit) respectively per below:
- Sales and Marketing — 62 / 51%
- Research and Development — 32 / 26%
- General and Admin — 23 / 19%
- EBITDA —  / 4%
Comparing the Highest / Lowest Cost Bases
The below table lists companies’ S&M relative to Gross Profit — the highest 5 at 1Q 2020 vs. the lowest 5. Acknowledging confirmation and survivor bias, of the lowest 5, it is interesting to note that:
- The Trade Desk, Veeva and AppFolio are vertical-specific solutions — speaking to the relative cost-effective ability to address a well defined customer set to sell system-of-record product suites.
- Atlassian is incredibly unique in driving a product-led (which we discuss here) growth strategy that drives strong network effects and self-serve onboarding, which drives significantly lower CAC.
Notably, growth isn’t clearly correlated with S&M spend — the lowest-5 spenders are growing in-line, if not faster, than the companies that spend the highest on S&M. There are many factors influencing growth, not least the company’s addressable market and timing, moat/competition, product differentiation, go-to market execution, to name a few.
Looking at R&D, there is again a large dispersion between numbers. The top-5 spenders are infrastructure or API-heavy product suites that require significantly higher R&D lift, relative to application layer tools that don’t need as much investment. It should also be noted that the companies in the lowest-5 spenders are generally growing slower than the median (with the exception of Zoom, whose R&D is largely based in China).
Financial Ratios As SaaS Companies Grow
Other topics in the series:
- SaaS Financial Benchmarking… One Size Doesn’t Fit All, and Focusing on Gross Profit — benchmarking growth, margins and opex items
- What Financial Ratios Should You Go Public With?… And What Should They Look Like Longer Term? — P&L ratios at various stages of their growth curve, from pre-IPO through to large scale, and why there is no ‘one size fits all’
- Magic Number and Rule of 40… Helpful, For Now — Showing that these metrics haven’t always been correlated to higher valuations
4. ‘Burn Productivity’… A Consistently Better Signaler of SaaS Valuation — Defining Burn Productivity and its stronger correlation with valuation owing to its capturing of product-led growth
5. How Does Burn Productivity Drive Profitability and SaaS Valuation?… — A Practical Example — Valuation and its stronger relationship to Burn Productivity via a first-principles look at the drivers of valuation