As with much of investing, there are many grey areas around how a venture capitalist might analyse a SaaS business.
In order to help founders see how they might benchmark, compared to the rest of the market (from a venture capital point of view), we put together a guide for companies in this category. This blog isn’t written in ink and no metric is ever viewed in isolation (hence the many grey areas). Whilst there are exceptions to every rule — this blog is designed to give yourself a yard-stick to measure out how you compare.
This blog is arranged in the form of questions about funding that founders we speak to often ask.
What stage of funding am I at?
This is an important question as it affects which investors you should be talking to. If a venture capital fund only invests in Seed/Series A rounds — they won’t have a big enough cheque book to support a B stage company. Vice versa, a Series B investor won’t be comfortable with the risks inherent in seed stage investing. Here’s a table intended to be a guide for what level of funding your SaaS business may be at:
What are investors actually looking for?
Whilst there are many metrics that venture capitalists look for, some are more important than others. This is a list of the good signals and red flags we are looking for in SaaS ventures we meet:
How do I compare to my peers?
Let’s get down to the numbers — it’s often very hard to see from within a business how your metrics look compared to peers. Below is a chart of different metrics that would indicate the health of your venture according to that particular criterion. You may find that your metrics go across several categories, which is completely normal and can be industry-specific. More important is identifying which metrics matter most to your particular business, and staying laser-focused on them. As an example — if you’re selling to SMEs your churn will be higher (as your customers will more frequently go out of business) — as a result we would take your effective churn (total churn less customers going out of business) into consideration too.
What was that word?
There’s a bit of lingo that can be a barrier to companies seeking funding. Here are a few commonly used terms by VCs, what they mean and why they’re important:
T2D3 is an acronym for triple-triple-double-double-double, which is the ideal annual revenue growth rate for SaaS companies. Below is an example of 7 top SaaS companies and their growth trajectories over 5 years:
SaaS quick ratio:
Growing your revenue fast is great but the majority of people in the SaaS industry know that high churn and a lack of account expansion can kill even the fastest growing companies. If you grow fast, but don’t manage to keep your customers, it will be extremely complicated to scale. This is where the SaaS Quick Ratio comes in handy.
Customer life time value is the best estimate of the total net profit from a customer. It is effectively a mini-DCF calculation of the future cashflows coming from the average customer, less the cost of obtaining that customer.
ARPU = average revenue per user
n = inverse of churn
WACC = weighted average cost of capital
Costs = annual costs to support the user in a given period
CAC = cost of customer acquisition
The 40% rule:
40% = (Growth rate %) + (Profit %)
The 40% rule suggests that your growth rate plus your profit should add up to 40% (essentially this is a rule of thumb for how you should be allocating your capital). So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.
Efficiency = % Annualised Run Rate growth + % Burn
The Mendoza Line:
The Mendoza Line is based on just two assertions.
The first is that most venture investors prefer to invest in companies that have at least the chance to become standalone public companies (which is not to say most achieve this objective). Looking at the realistic low bar of what it takes to be a public company, this implies being at run rate revenue (ARR) of $100 million at the time of IPO, while still growing at 25 percent or greater in the following year.
The second is that most of the time, growth rates only decline, but do so in a way that is on average fairly predictable. For a best-in-class SaaS company, the growth rate for any given year is between 80 percent and 85 percent of the growth rate of that same company in the prior year. We refer to this as growth persistence (and this assumption holds true from about a $10 million run rate on).
Is that all?
As mentioned at the start — there’s a raft of grey areas that feed into consideration of the above metrics. Outside of these, other things VCs may consider include: what is competition like in your industry? What was your revenue last month? Is there much financial history to look at? How are you procuring customers? Is your IP protected? Do the founders have a strong track record/ industry expertise/ resilience? All of these factors also come into the equation.
Where can I find out more?
In order to compile this, we’ve used many resources which we highly recommend for further reading:
Lean Analytics by Alistair Croll & Benjamin Yoskovitz