Should Anything Other Than Growth EVER Matter for a SaaS Company (Like, Um, Profitability)?

August 19, 2016 Shareworks Marketing

What’s more important for a SaaS company: growth or profitability?  We have asked this question a lot as we have been moving to profitability.  As we researched the subject, we wanted to share some key insights.

Most of the smartest VC and banking minds have weighed in.  Their conclusion:  growth, growth, growth.

It’s as true for the barely-conceived startup as it is for Salesforce.  It’s consistent enough, it could be a meme: “It’s about the growth, stupid.”

But there is something suspicious about all this consensus:

  • It ignores some key differences between startups and public companies
  • It doesn’t recognize obvious exceptions to the rule
  • It all seems to come from the investor side of the table
  • It still doesn’t allow for an easy decision framework about how much to prioritize growth relative to profitability

We did our own analysis on 37 public Saas companies looking for answers to these questions.  

Our Research

We looked at the following correlations:

  • Enterprise Value versus Revenue
  • Enterprise Value versus EBITDA
  • Enterprise Value versus EBITDA (filtered with only positive EBITDA companies)
  • Enterprise Value versus 1-Year LTM Revenue Growth
  • EV/Revenue versus Revenue
  • EV/Revenue versus 1-Year LTM Revenue Growth
  • EV/Revenue versus EBITDA Margin
  • EV/Revenue versus Gross Margin
  • EV/Revenue versus Free Cash Flow
  • Enterprise Value / EBITDA versus EBITDA Margin
  • Enterprise Value versus Free Cash Flow

Our research confirmed much of the prevailing wisdom but also raised some key limitations.

What Drives SaaS Enterprise Values?  

Enterprise Value for our set of SaaS companies correlates very strongly with total revenue.  This is pretty obvious and no surprise.

Screen Shot 2016-08-19 at 3.11.59 PM

The more revenue you have, the more valuable you will be.   This is a point in favor of the “growth-only” mindset.  Wanna be valuable?  Grow big.

However, we need to highlight an important point here that doesn’t get mentioned nearly enough: comp selection.  

Our data above is based on a panel of selected comps.  The comps we choose have enormous implications.  In many ways, these SaaS companies are as similar to a Series A SaaS company as a mute dog is to a blind cat.  

Median statistics for this set include:

  • Enterprise value: $1.8B
  • LTM Revenue: $296M
  • LTM EBITDA: ($16M) — note it’s negative
  • EV/Revenue ratio of 6x (high of 12.2x and low of 1.2x)
  • Gross margin: 68.5%
  • 1-Year LTM Revenue Growth: 27.89%
  • Cash flow:  $47.68M — note it’s strongly positive

It’s important to keep this data in mind.  Not many Series A SaaS companies have $296M in revenue and are cash-flow positive.  On the flip side, most Series A SaaS companies are growing faster than 200% per year (over 10x our comp set).

People who believe profitability doesn’t matter often highlight that public SaaS companies are unprofitable yet very valuable.  Great point, but they are cash flow positive.  30 out of 37 of the companies in the set had positive unlevered free cash flows.

So let’s see what else this panel can teach us.

The correlation between Enterprise Value and Free Cash Flow (excluding cash flow negative companies) is actually stronger than revenue.

Screen Shot 2016-08-19 at 3.43.05 PM

In this case, we have eliminated negative cash flow companies.

So it is true that getting big by increasing revenues correlates highly with increased value.  But it is also true that increasing free cash flows also increases value.  You can increase your free cash flow by increasing revenue or by increasing operating profit. 

What Drives SaaS EV/Revenue Ratios?

We mentioned above that our sample set had a range of EV/Revenue ratios from 1.2x – 12.2x.  Many analysts spend their time trying to understand what drives changes in that ratio.

There are some good reasons for this.  Most analysts believe that these ratios are relatively stable in each industry.  Also, because they indicate value per dollar of revenue, you can easily multiply them against the revenue of a company at any stage to find its value.  

This is generally true for SaaS.  The answer over a decade is (drum roll)…5x.  So on average you can estimate the value of any SaaS company by multiplying its revenue by 5.  Pretty nice and simple right?  

Catalyst and Scale Venture Partners have shown that SaaS EV/revenue multiples are quite stable.  Here is the chart from the latest Catalyst article:

Screen Shot 2016-08-19 at 12.06.30 PM

A few important points.  First, “quite stable” doesn’t mean totally stable.  There was a major dip around the 2008 great recession.  And there are a lot of peaks and valleys over the years.  5x is great long-term rule of thumb.  But values can change by 0.75x-1.00x pretty regularly.  And during a recession, they can decrease by 60% or more.

Second, this is median panel data again.  And, as we pointed out earlier, individual SaaS company multiples can range from 1.2x to 12.2x.  That’s an order of magnitude.  

This is probably why valuation analysts often try to explain the difference in EV/Revenue ratios.  

If they could just find what explains the difference between EV/Revenue ratios, then they could use the new improved ratio to predict the value of any SaaS company.  

Let’s try it with our data set. 

Then the question is: What correlates well with EV/Revenue?  Well, rather than cutting and pasting in a lot of charts, we’ll give you the highlights.

We looked at the following potential correlations:

  • EV/Revenue versus Revenue
  • EV/Revenue versus 1-Year LTM Revenue Growth
  • EV/Revenue versus EBITDA Margin
  • EV/Revenue versus Gross Margin
  • EV/Revenue versus Free Cash Flow

It turns out that there isn’t much correlation among any of these graphs except for one.  Can you guess it?

You can download all of the graphs and charts here, even the ones we don’t feature in this article.

Screen Shot 2016-08-19 at 3.45.55 PM

It’s growth.   We are showing LTM (last twelve months)  growth against EV/Revenue here.  Many analysts have pointed that NTM (next twelve months) shows an even higher correlation.

Here’s what an NTM graph would look like taken from the Catalyst article.

Screen Shot 2016-08-19 at 3.47.10 PM

Pretty awesome right?  The correlation here is quite high indeed.  This would contribute to the theory that growth explains most of the differences in EV/Revenue ratio for SaaS companies.

Important Caveats

OK, so at this point in our story we have largely confirmed conventional wisdom.  Growth is the biggest factor in SaaS valuations.  But there are some really important caveats that don’t get mentioned often.

  • Our analysis ignores some key differences between startups and public companies
  • It doesn’t highlight some obvious exceptions to the growth-only approach
  • Too few entrepreneurs have agreed with what the VCs/bankers are saying
  • We still don’t have an easy decision framework about how much to prioritize growth relative to profitability

Key Differences Between Startups and Public Companies

For public companies, accounting profitability metrics don’t correlate at all or correlate negatively with valuation.  

But (and this is a big one), total value does correlate with free cash flow.

It is true that growth explains a lot of the difference in EV/Revenue ratios for our panel of companies BUT remember most of these companies are cash flow positive. Most startups are not cash flow positive.  

You could argue that startups would be even more sensitive to growth than to profitability.  That certainly seems likely.  Most of the buyers of startup stock are VCs.  VCs prioritize growth probably even more than public market investors.

But there’s another important narrative here.  Public companies do value free cash flow.  So being cash-flow positive could also increase startup valuations.

To understand this, we really need something more thorough than a bunch of scatter plots.  There are a bunch of problems with scatter plots.  The worst is that they only show the relationship between two variables.  In the real world, several factors could affect a company’s valuation.

How could we solve this?  Enter the regression analysis.  [Economists everywhere clap your hands.]  A regression analysis is a much more scientific way to confirm the relationships between variables.

If we had a statistically significant regression analysis of SaaS valuation, that would be as close to perfect as possible.

Catalyst Investors have done just that.  They did a regression analysis to find the predictors of EV/Revenue ratios for public SaaS companies.  It’s a thing of beauty.

They came up with a really complex one and a simple one.  The simple one could get some real traction.  This should give us the best way to understand SaaS valuations.  They call it the SANE formula.  Here it is:

Screen Shot 2016-08-19 at 2.27.59 PM

This just intuitively feels right.  Profitability should play into a company’s value unless the markets are really short-sighted.

This formula also shows that revenue growth is valued more than twice as much as profitability among public companies.  This is a big deal.  

You could probably argue that the VCs got a lot of it right for private companies. For early-stage companies, growth may be an even more important factor, right?  But at a minimum it seems reasonable to predict it is roughly 2x as important.  

As we will discuss below, it also seems equally wrong to completely throw out the importance of profitability for companies of any stage, even if they happen to be startups.  

Case in point: there are some high-valuation, bootstrapped SaaS companies like Qualtrics and PluralSight in our backyard here in Utah.  Companies like this often attribute their success to a focus on profitability.

Obvious Exceptions to the Growth Rule 

It turns out EBITDA’s correlation to value changes the most of any of the potential predictors depending on market conditions.  Here is a graph showing how it is has changed over time.  This is from the Catalyst article again.

Screen Shot 2016-08-19 at 2.30.35 PM

As you can see EBITDA and gross margins have changed the most.  Also, did you notice when they become positively correlated with value.  Anything special about those years?

Yep, it was during the recession.  So profitability becomes really important during counter-cyclical periods.  Since most companies can’t really predict recessions, profitability is a form of insurance against stormy weather.

Remember profitability for a public SaaS company almost always implies that it is also strongly cash-flow positive.

So one exception to the growth rule occurs during negative economic periods. During these times profitability may be more important to your valuation than growth.

Another exception is related.  If you are going to run out of cash, profitability could be much more important than growth.

If you are startup and you don’t think you will be able to raise money on good terms, getting profitable (or cash-flow positive) might be 10x more important than growth.

This is a simple rule:  If prioritizing growth over profitability will lead to bankruptcy, you are better off prioritizing profitability.  A low-growth, profitable SaaS company will always be worth more than a dead one.

The Entrepreneur’s Perspective

You might be thinking, “This is all nice and good but VCs don’t care about profitability.”

That is both true and untrue.  Most VCs don’t want you to die.  But some VCs want you to grow so fast, they don’t mind if you die trying.  

Most VCs are good and, in most cases, their incentives align nicely with yours.  But on the margins some big misalignments in incentives can affect their decisions.  

One big misalignment is one called “VC moral hazard.”


Moral hazard is a lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.

VC’s have a lack of incentive to guard against your company’s failure in some ways.  They too would definitely be better off if you succeed.  But if you fail, the VC does not feel the downside as much as you do.

And, to compound the issue, VCs only do really well if you succeed at a really big level.  So they need you to grow really big to create what they call “a venture return.”

As much as they often try to deny it, VCs have a big form of insurance against your company’s failure.  It’s called 1) management fees and 2) a diversified portfolio.

Most entrepreneurs aren’t getting paid millions of dollars whether their company fails or not.  That’s the equivalent of VC management fees.

Second, most entrepreneurs don’t have a well diversified portfolio.  VCs portfolios are heavily concentrated in many startups.  But they aren’t 100% concentrated in 1 startup like most entrepreneurs.

So while it makes tons of sense that VCs prioritize growth, it may make much less sense for you.  As the public company data around profitability shows, pushing for growth over profitability increases risk.  That risk costs you more dearly than it does VCs.

Now, it could be that if you accept VC money, you are de facto accepting their goals.  So be aware of those trade-offs.

A Growth / Profitability Decision Framework

Most of the articles about the growth/profitability trade-off don’t give enough credit to the argument for profitability.  They also aren’t as statistically accurate.

But the Catalyst approach takes all of this into account in a statistically valid way.  

The SANE formula also can be a decision framework for the relative importance of growth and profitability.

Screen Shot 2016-08-19 at 2.27.59 PM

The exact answer will depend on too many individual company circumstances.  But they have given us a great rule-of-thumb.  

On average, for public SaaS companies, growth is twice as important as profitability.  E.g., you would need to increase your EBITDA margin by 2 percentage points to offset a 1 percentage point decrease in growth rate.

So you would need good reason to prioritize profitability over growth if your goal is to increase your valuation.

If you are interested in reading more, check out our article on the Top 6 SaaS Profitability Myths.

Want to see all of the supporting materials and data?  You can download all of the Excel analysis we performed for this article here.


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