Clouded Judgement: What it Takes to Become a Public SaaS Company—Part 1

Redpoint Ventures
Jun 23 · 16 min read

By: Jamin Ball

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A few weeks ago I wrote an article summarizing Q1 earnings for public SaaS companies, highlighting what it takes to operate a successful public company from a metrics perspective. But for many startup entrepreneurs, a more helpful analysis would entail looking at what it took for each of these companies to become public in the first place. So in this article I’ll do just that, examining every SaaS IPO since the beginning of 2018, plus a few other influential IPOs before that period (36 in total), and analyzing how they all stacked up on a few key operating metrics at the time of their IPO. My hope is that every SaaS entrepreneur can use this data to set goals for themselves around what it takes to become a public SaaS company. There’s a lot to unpack here, so today, in part 1, I’ll go deep on benchmarking operating metrics. In part 2 I’ll analyze what a successful IPO process consists of — the 2-week investor roadshow leading up to the pricing of the IPO plus the first day of being publicly traded.

If you don’t have time to read the entirety of this article, here are the takeaways I hope everyone comes away with. To become a public company, every SaaS founder should aim for:

  • $200M ARR (minimum $100M)
  • 90% of revenue derived from subscriptions
  • 50%+ YoY ARR growth
  • $18M of net new ARR in the quarter you go public
  • 72% gross margins
  • 121% net dollar retention
  • 25 months gross margin adjusted CAC payback
  • (31%) LTM operating margin

Are the SaaS IPO Markets Open?

Before diving in, let’s level set on the periods of high volatility we’ll cover, and define the list of companies that went public to “re-open” the markets during these times. In the graphic below I’ve highlighted the windows I’ll discuss. I looked back 5 years to find all the points in time that might be considered a “SaaS crash”“: Toward the end of 2015, multiples dropped by 55%, and we saw a 6 month SaaS IPO hiatus before Twilio went public in June 2016. In the Fall of 2018, the threat of a trade war caused multiples to drop 31% and we again saw a 6 month hiatus before Zoom and PagerDuty went public in April 2019. Finally, earlier this year, Coronavirus fears sank multiples by 40%, and for the 3rd time we saw a 6- month SaaS IPO hiatus before ZoomInfo went public just a few weeks ago.

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To summarize, the set of companies I’ll be highlighting in each section below that went public when the markets were “closed” are Twilio, Zoom, PagerDuty and ZoomInfo. You’ll see in the data that these companies on average performed much better than the overall basket, which supports my claim that the IPO markets are always open for the best companies.

Metrics Benchmarking

Top Line: Revenue, ARR and Growth

LTM Revenue

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As you can see, most businesses fell into the $150M — $250M range, and very few had <$100M. When we look at the 4 businesses that went public during a “closed window” there are no obvious trends that stand out in relation to market preferences. ZoomInfo and Zoom both were quite large, Twilio was right in the middle, and PagerDuty was on the smaller end. To me this further demonstrates the binary nature of revenue. Founders should aim for ~$200M of LTM before going public.

Implied ARR

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Similar to revenue, most businesses had anywhere between $150M — $250M ARR, and none had <$100M.

% revenue derived from subscriptions

The most obvious company to look at to see how the markets value lower gross margin businesses is Twilio. They are currently growing ~70%, with best-in-class net retention and payback unit economics. However, they have 55% gross margins. Twilio’s margins are not lower because of professional services. They are lower because they “rent” telecommunication infrastructure and “pass through” a percentage of their revenue to telco providers. Because of its lower GM, Twillio trades at ~17x forward revenue while its high-growth SaaS peers are trading at ~25x. The ~30% discount the market assigns to Twilio relative to its high-growth peers is because the market has concluded that every dollar of Twilio revenue is worth less than a dollar of revenue from someone like Datadog.

Now, circling back to professional services revenue. Generally professional services revenue, as shown by Twilio, is a lower gross margin revenue stream. Typically professional services implies there’s a larger human component to deploying your software. This could include sending individuals on-site to your customers office to help them deploy or implement the software. This human labor component comes with a cost. There’s a general consensus that professional services revenue is “bad” because it’s lower margin. I actually disagree with this sentiment. Professional services revenue can be bad if companies have to leverage them to onboard new customers. This could imply your customers either aren’t ready for your solution, or don’t understand it enough. In either case, your product probably doesn’t have true product-market-fit, and you’re using human resources to force a solution down your customers throats. This inherently won’t scale. On the other hand, if your solution is attacking a heavily legacy-solution-dominated market where you’re either moving them to a cloud solution, or changing the way they think about solving a problem, you may need this human labor to make your customers successful initially. They need this hand-holding to successfully go through “change management” to get up and running. Without it, your customers may never truly realize how to use your product correctly, might not understand the power it offers, or roll it out to enough users to make it sticky. This in turn could lead to higher levels of churn that should have been avoidable. Looking at it this way, you pay a small price up front, and in the long run reap the benefits of true software margins and the professional services go away (only used for implementation). As companies get big enough they can often leverage system integrators (SIs) or channel partners to implement these services. The one piece of advice I’d give to founders: If you’re worried your professional services revenue is too high, track professional services revenue as a percentage of new bookings every quarter. What you’d like to see is this steadily going down over time. And if you’re still worried, look at Workday. When it went public nearly 40% of its revenue came from services. Today that number is just under 15%, and its gross margins are 70%. They’ve also expanded their market cap nearly 9x from $5B to $45B. Workday is a perfect case study on how to effectively leverage professional services revenue early on to build a successful and thriving business.

In the chart below you can see the percentage of subscription revenue each company generated when compared to total revenue over the last 12 months.

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Clearly you can see the market in turbulent times was more receptive to pure subscription models. This is not surprising given the predictability of subscription revenue.

Net New ARR

New logo ARR + expansion ARR — churned ARR — contracted ARR in a quarter.

Or, simply taking the ending ARR from one period and subtracting the ending ARR from 1 quarter prior. I place a lot of emphasis on this metric when evaluating private companies raising funding rounds. I don’t care about the absolute value of it, but rather the trajectory. I love to see the net new ARR added every quarter going up. It shows growth is accelerating, and the go-to-market team is successfully scaling. When looking at “what it takes to go public” we’ll just look at the absolute value to give founders a target. You can see the data below:

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Net new ARR is a derivative of growth (or is growth a derivative of net new ARR? My calculus days are too far behind me…). As a founder I’d target ~$15M of net new ARR / quarter as the benchmark to make it public. With the exception of PagerDuty, we see the other 3 businesses to go public in a “closed window” were all in the top quartile. This is the first sign of the importance of growth.

YoY ARR growth

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Again with the exception of PagerDuty, all of the businesses to go public in a “closed window” were in the top quartile. As a founder I’d target 40–60% YoY growth to make it to the public markets. There is clearly a separate category of businesses growing 75%+, which I’d consider best-in-class.

Another interesting way to look at the data is to order the business by growth (like the above graphic), but instead shade each bar based on how the stock reacted 1 year after the IPO. In the below graphic I’ve shaded the bars red if the company’s stock price increased by 100% or more 1 year after IPO. As you can see, there’s a big grouping of red toward the left of the graph suggesting high-growth businesses were more correlated with increased stock returns. Veeva was the only company well inside the top quartile of growth whose stock did not double 1 year after IPO.

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Unit Economics — Net Revenue Retention / Payback / Rule of 40

Net Revenue Retention

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All businesses to go public during a “closed window” had top quartile net revenue retention. Yes, I realize ZoomInfo is below the 139% threshold, but for a business with a big component of revenue from SMBs, I consider 109% quite good.

Gross Margin Adjusted CAC Payback

(Previous quarter S&M) / (Net New ARR x Gross Margin) x 12

In the below chart I’m showing the average payback of the 4 quarters leading up to IPO (this removes the effect of an abnormally good or bad most recent quarter’s payback). This metric is a good way to evaluate how sustainable a company’s growth is. For private companies I like to see payback around 20 months or less, and anything <12 months is best in class. When payback creeps up too high, it suggests your burn rate is too high, and ultimately when you have to decrease burn, growth will follow suit. The companies that can sustain high growth rates are the most successful in the long run.

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Here I think you can really see the emphasis the market places on “efficient” businesses when we’ve been in a so-called “closed window.” As evidenced by the data, ZoomInfo, Twilio and Zoom all had best in class payback periods, and Pagerduty was just outside the top quartile. In many ways a short payback period is a good proxy for how long it will take a business to become profitable. A low payback implies profitability will come sooner rather than later (and you can sustain high growth rates), and public investors clearly value this.

Rule of 40

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Again, with the exception of PagerDuty, each businesses to go public in a “closed window” typically fell to the left of this chart well inside the top quartile.

ACVs

To calculate the implied ACVs for each company I take the most recent quarter’s subscription revenue before IPO, multiply it by 4 (to get implied ARR), then divide by the number of customers disclosed in the prospectus.

Margins / Expense Ratios

Gross Margins

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Not surprisingly, the markets had a preference for higher gross margins during “closed IPO windows.” While Twilio had lower gross margins, it had exceptional payback and net retention,which made their model quite attractive despite the low gross margins.

LTM GAAP Operating Margin

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LTM Sales and Marketing (S&M) Expense % Rev

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LTM Research and Development (R&D) Expense % Rev

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LTM General and Administrative (G&A) % Rev

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Wrapping Up

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Next week I’ll publish part 2 that dives into the actual process of an IPO itself. Among other things, I’ll discuss how much money companies raise through IPOs, at what dilution, and go deep on the controversial topic of an “IPO pop” and how bankers price IPOs.

Thanks for reading!

Redpoint Ventures

Since 1999, Redpoint Ventures has partnered with visionary…

Redpoint Ventures

Written by

Redpoint partners with visionary founders to create new markets or redefine existing ones at the seed, early and growth stages.

Redpoint Ventures

Since 1999, Redpoint Ventures has partnered with visionary founders to create new markets and redefine existing ones.

Redpoint Ventures

Written by

Redpoint partners with visionary founders to create new markets or redefine existing ones at the seed, early and growth stages.

Redpoint Ventures

Since 1999, Redpoint Ventures has partnered with visionary founders to create new markets and redefine existing ones.

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