The one metric software businesses should be tracking in 2020
Written by OMERS Ventures Partner, Laura Lenz
As someone who has been a professional venture investor for nearly two decades, some of the horror stories in the last year have naturally had me reflecting on how we got to where we are, as an industry. These recent experiences have encouraged a positive shift on the part of founders and investors to value an increased focus on profitability, but is a move away from the ‘growth at all costs’ mentality enough? I’d like to see it more as a starting point for re-evaluating the systematic measures we apply to business success.
Venture investors, by our nature, are risk takers. We look for outliers and when we believe we spot them, we take big bets. Some will fail — failure is a valuable part of the cycle, and an important part of the ecosystem that breeds true standout founders and their businesses. I don’t think the issue that got us here is businesses failing, or even underperforming. It’s much bigger than that. At some point, our industry started taking big bets based on something other than the core economics of a business.
We are probably all guilty at some point of being seduced by big numbers, the enthusiasm of a founder with an inspiring vision, or the throngs of other investors competing to get into a particular deal. But when did profitability stop being a part of the patterns we actively seek?
In 2000 and 2018, over 80% of the IPOs in North America were for unprofitable companies (source; Seeking Alpha). This number dropped dramatically after the market correction in 2003 (to 45%) and in 2010 (to 40%).
A recent article by Mary Ann Azevedo in TechCrunch dove into this issue of profitability particularly in SaaS businesses, and like many, suggested that we need to revise our pursuit of the mythical unicorn.
If we are going to compare the reality of what we do to an animal, I’d suggest we look elsewhere. A lion is the undisputed king of the jungle. It is calculated in its search for food. It considers how many calories would be expended in a chase to kill its prey, and whether success in the hunt would result in replenishing those calories. It’s not unlike one of the calculations investors should be doing every day, looking at the lifetime value of a customer (LTV) and the cost to acquire that customer (CAC).
A business only makes sense if the LTV is at least three times greater than the CAC. That means that for every fully-loaded sales and marketing dollar spent to acquire a new customer, at least $3 of lifetime gross profit is generated.
However, this CAC calculation only includes sales and marketing costs. When did we abandon the consideration of other expenses in the business such as research & development, operations and general admin? Did that happen in the first tech bubble of 1999? Or was it in 2007 before the global financial crisis hit? For founders who started their business in the last decade, it is feasible that they have only ever experienced a bull market, and in many cases been pushed by their investors to grow at all costs, with blatant disregard for profit (or shockingly, sometimes even gross profit).
A new (old) measure for viability
I would advocate that to see the true health and growth potential of a business, we must also look at a revenue per employee metric, especially in companies that have software as the core value driver.
This metric is well-suited to software-focused companies, which aim to use technology to scale the ability to generate revenue far beyond what would be possible in more traditional personnel-heavy businesses. Further, because salaries are often the largest component of a company’s costs, this metric also more effectively integrates the company’s efficiency in generating revenue.
In publicly traded technology companies, the average revenue per employee is $480,000 per year. This is half what healthcare and energy industries report (Source: Visual Capitalist). The public outliers of course are Apple, Netflix and Facebook that generate over $1.6M per employee.
Recognizing that earlier-stage companies haven’t yet reached the same scale of these public companies, their stats are (rightly) much lower. According to a recent KeyBanc Capital Markets SaaS Survey, $139,000 is the median ARR per employee for businesses over $5M in ARR. This drops precipitously to $71,000 for companies in the 25th percentile.
It would be interesting to do the calculation to see where your business ranks, and to examine the path to revenue per employee that has the potential to scale exponentially as your business grows. When I am working with startup founders, I ask:
- As a CEO, do you have a strong understanding of what each employee contributes to the business?
- (For companies beyond the Series A level) Do you systematically look at headcount and trim modestly to ensure your revenue per employee stays competitive and primed for growth? It’s something large enterprises do as a matter of course, but it’s not as common in early stage businesses.
- And more important, is this a metric that your board is tracking?
As investors, we have as much of a role to play in being accountable for the success of the business as the founders we back. If we don’t ask these tough questions, are we really doing our job?