In this blog series we profile three core metrics for SaaS companies: revenue growth, churn and margin, from startup to $200 million dollar business. These metrics define a target profile that a SaaS company can use to compare their own performance.
Best In Class Margin - Using the Rule of 40
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company's overall financial performance. Combined with top line (revenue) growth it paints a picture of company health. Usually high growth companies have low or negative EBITDA (as they are driving to acquire customers) whereas mature companies (in the cash cow phase of a product lifecycle) are looking to maximize profitability as revenue growth slows down.
Brad Feld of TechStars, and Tomasz Tunguz of Redpoint Ventures developed a metric called the Rule of 40 (1) to help businesses measure the health of their combined revenue growth and margin. It states, very simply, that the combination of top line revenue growth plus EBITDA should equal 40%. For example, if you are growing at 50% annually, its OK to have a negative 10% EBITDA (the assumption being that you are spending to acquire customers and therefore losing money - a standard model for startups). Equally, if you are only growing at 5% annually, you had better be very profitable at 35%!
This model does not apply at very low revenue models; however, it can work for SaaS companies at $1m ARR and above. It was originally intended for larger scale companies of $50m ARR and above.
We can apply the Rule of 40 against our best in class Mendoza Line revenue growth model (see Part 1) to define an annual EBITDA model that would look attractive to investors. The chart below shows the result of this analysis, going from an EBITDA of -37% at $10m to 30% at $200m.
Interestingly, using this rule, a high growth company is still performing well with an EBITDA below 0% until reaching $50m (when the target growth rate is 40%). At $100m when a company is considering going public, they should to be showing an EBITDA of 15% and a growth rate of 25%.
The Rule of 40 is useful on both ends of the performance spectrum; where companies have low growth and low margin, they are obviously in trouble. However, the Rule of 40 also can highlight risks within a high performing company. It is my experience that lines of business that can generate double digit growth and a high EBITDA (for sake of argument, lets say its a mature business with 10% growth and 50% margin) are not being given the due care and attention they should. Seen as natural high performers, it is entirely possible that the margin is being achieved through starvation of investment. In this case, the product value will start to deteriorate and service levels will begin to drop. The natural end result is an increase in churn (see Part 2) as customers leave for competitors. Having a strong customer success function will be critical for this type of business, to remain close to emerging customer behaviors.
Therefore the Rule of 40 acts not only as a measure of good performance, but also as a "canary in the coal mine" for future customer exodus. Perhaps the high performing business is exactly as it seems, but at least some important questions need to be asked and answered.
The Rule of 40 establishes a quick method of looking at company health. In the next post we will bring all the metrics together to compare and contrast best in class SaaS performance for a startup with revenues of $10m, a company at the brink of going public at $100m, and a mature company at $200m.
(1) The Rule of 40 was developed by Brad Feld and Tomasz Tunguz. For this post, I used information from the article "The Rule of 40 for SaaS and Subscription Business" by Fabio Mazzeu, SaaSholic
Opmerkingen