The internet is a vast tome of information full of lore, speculation and myths. You can find gems of wisdom and truth, but sifting through the noise can be exhausting. This is especially true for entrepreneurs – conventional “wisdom” and urban legends abound.
Over the years, we at Shareworks by Morgan Stanley have encountered a number of common beliefs, or “myths” if you will, about running a successful SaaS company.
In the spirit of the Mythbusters TV show we’d like to address six of these myths by looking at the facts to determine their validity. We’ll assign each myth to one of three categories: confirmed, plausible, or busted. The myths we’ll focus on center around the most common beliefs about profitability for Saas companies. Along the way, we will also see what choices affect success and failure rates for SaaS companies.
Here are the top 6 Saas profitability “myths” we will evaluate:
- Prioritizing growth over profitability will increase your value
- You and your investors probably feel the same way about the importance of profitability
- Achieving Saas profitability is basically impossible without investment
- Bootstrapped Saas businesses are always better for common shareholders
- Minimizing burn optimizes your chance of survival and success
- It’s simple to get profitable: just “take your foot off the accelerator”
#1 Prioritizing growth over profitability will increase your value
We recently published an article that goes into detail on this question. After a lot of research, we found the “SANE” formula:
The valuation multiple in the formula above refers to a company’s Enterprise Value / Revenue ratio (EV/Revenue).
The authors did the best job we have seen yet of statistically validating what drives increases in EV/Revenue ratios.
If they are right, then increasing your growth rate by 1 percentage point would increase your value by about twice as much as increasing your EBITDA profit margin by 1 percentage point.
There are still a lot of other reasons why you might choose to prioritize profitability. But, in general, prioritizing growth will increase value twice as much as improving profitability.
This myth is confirmed.
#2 You and your investors probably feel the same way about profitability
Now that we have all of this data about the importance of growth, it seems like VCs and entrepreneurs should be on the same page. Growth is more important than profitability right?
Not so fast.
Most experienced entrepreneurs understand that the economic incentives of investors differ from entrepreneurs in important ways. Just take liquidation preferences as an example.
VCs and entrepreneurs don’t always see eye-to-eye.
VCs are famous for prioritizing growth above everything else. For example, Paul Graham proposes some simple math: startups=growth.
Paul argues less than ~1% weekly growth is a sign that a company isn’t a startup. This seems way too limiting of a definition to me.
Regardless, most investors share Paul’s convictions. If you need any additional proof, just read Jeff Bussgang’s great article Growth vs. Profitability.
A classic example of the importance of growth to VCs is the T2D3 approach.
The idea of T2D3 is that successful venture-backed SaaS companies should first get to product-market fit by getting to about ~$2M in annual revenue. Then they should triple revenue for two years and double revenue for three years after that. After 5 years, they will end up around $100M in revenue and ready for a big exit.
Investors typically calibrate growth and profitability expectations based on your size. Brad Feld has written a great post about “the rule of 40%.”
The rule of 40 means that a SaaS company’s 1-year revenue growth rate (%) plus its 1-year profit margin (%) should sum to 40%. Growth and profitability can offset each other. If you have low growth, you should be profitable. If you have high growth, it’s OK to be unprofitable.
But most investors only apply the rule of 40 to larger companies (e.g., companies with more than $10M in revenue).
What are investor expectations based on your stage? Here are some thoughts based on research.
Table 1: Investor Growth and Profitability Expectations by Stage
|Pre-Seed||Seed||Series A||Series B||Series C and beyond|
The growth rates in this table are actually quite a bit lower than those in the T2D3 approach. In our experience, you can find VCs whose growth expectations aren’t quite as high as the T2D3 approach would require. But they are still high.
So VCs generally want growth. Do they ever want profitability?
Sometimes if the markets are really bad or if your company has grown to Series C or larger stage. But mostly no.
Do entrepreneurs ever want profitability? You can probably answer that question yourself. In our experience, the answer is that it can often make sense for entrepreneurs more than it does for investors.
- Profitability can often minimize downside risk even if achieving it decreases upside
- It minimizes survival risk
- It gives a lot of control back to the entrepreneurs–especially if they still have a controlling stake on the cap table
If you choose to take VC money, you should recognize what typical VC expectations are. VCs and entrepreneurs don’t agree all of the time about the importance of profitability. But they agree much of the time.
This myth is plausible.
#3 Achieving Saas profitability is basically impossible without investment
Scaling a SaaS business is notoriously slow and hard. After a lot of research, we found 3 articles that highlight SaaS growth challenges best:
- Do You Scale? It’s Harder in SaaS. The founder of Echosign says scaling the servers and tech of SaaS companies is 10x easier than scaling a consumer internet business. But scaling the people side of the organization is much harder in SaaS.
- Jason Lemkin’s From Initial Traction to Initial Scale. Jason basically says its “magic and impossible” to scale a SaaS business to $1M. And that’s not the bad news. He says growing from $1M to $10M is even harder.
- The Unprofitable SaaS Business Model Trap. Jason Cohen argues that many SaaS companies’ business models are fundamentally flawed. They never achieve profitability. Or, if they do, they achieve miniscule profits over 4 years.
Most of these articles lead to the same conclusion. SaaS is really, really hard. Building a SaaS business of over $10M in revenue is almost impossible. Getting a SaaS business profitable is like lightning striking twice.
So you might think bootstrapping a SaaS business is unheard of.
One VC recently completed a limited study comparing the results of boostrapped SaaS companies versus venture-funded SaaS companies. He found that 12 out of 37 (roughly 1/3rd) of the companies in his dataset were bootstrapped.
In conclusion, creating SaaS companies is hard but there are plenty of profitable and bootstrapped SaaS companies out there.
This myth is busted.
#4 Bootstrapped SaaS businesses are always better for common shareholders
On the one hand, it can seem obvious that you should always take a big venture round. Research shows that venture-backed companies scale faster than non-venture-backed companies.
On the other hand, many experienced entrepreneurs would prefer to bootstrap their business.
Shikhar Ghosh at the Harvard Business School surveyed 2,000+ venture-backed startups from 2004-2010. He found that 75%+ fail to return capital and 30-40% liquidate for nothing.
A few years ago, researchers found that between 90-97% of Y Combinator-backed companies failed to produce a big exit. Most industry experts consider Y Combinator one of the best startup incubators ever.
So VC funding certainly doesn’t guarantee success. The truth is even worse. Upwards of 80% of venture-funded companies will fail.
Network effects, first-mover advantages, and economies of scale are important realities. But it’s in the best interest of every venture capitalist to make sure you worry about these things. After talking to many VCs, you would think every market is a winner-take-all market. In reality, it’s hard to find even one true winner-take-all market.
If you could achieve the exact same result without venture funding, it would be foolish to take the dilution that comes with venture funding.
So which one is better? The specific pros and cons for each company are too varied to discuss comprehensively.
Are there any statistics?
Yes. Ghosh’s research found that non-venture-backed companies fail more often than venture-backed companies in the first four years of existence, typically because they don’t have the capital to keep going if the business model doesn’t work. Venture-backed companies tend to fail following their fourth years—after investors stop injecting more capital.
So venture-backed companies have an initial survival advantage over non-venture-backed companies. But they fail more often than non-venture-backed companies do after 4 years.
What about success levels? Here we can use general information from VC firms.
We re-created a hypothetical venture capital portfolio in the spreadsheet above. Based on this information we can see that the median exit for most common shareholders (employees or founders with stock) is very small – only about $630K.
Remember, this means everybody who has common equity would need to split up the $630K.
Since employees own 100% of bootstrapped startups, they would only need to create $630K of total company value to enjoy the exact same exit as a typical venture-backed startup.
This means that if survival rates are equal and you can sell your non-venture backed startup for anything more than $630K on average, you are probably better off without venture capital.
However, there are some huge caveats. VC money will increase short-term chances of survival and it will help you grow faster. If you are one of the top 2 or 3 exits for your investors, you will likely become fabulously wealthy. Much wealthier than the average non-venture backed company.
But it seems reasonable to say that many non-VC-backed companies will create better outcomes for common shareholders. In the end, we consider this myth plausible.
#5 Minimizing burn optimizes your chances of survival and success
Based on much of the information above, it might seem obvious that you should keep burn down. This increases the chances that common shareholders will have more control.
It also will likely blunt the “growth at any cost” mindset that often comes with VC money.
However, according to recent research at Wharton business school, the truth is somewhat different.
This graph shows the representation between predicted failure rates of startups and spending per employee. The graph makes a nice U-shape.
This means that there is a Goldilocks effect to startup spending. You don’t want to overspend but you also don’t want to underspend.
The Goldilocks effect, or Goldilocks principle refers to situations where the best (or most frequently selected) choice between options arrayed along a spectrum is one of the middle choices. It comes from the children’s story about Goldilocks and the 3 bears. Goldilocks chooses the “middle” porridge that is neither too hot nor too cold.
Some entrepreneurs believe minimizing burn will definitely increase the chances of success. Statistics indicate otherwise.
So we are going to say that this myth is busted.
#6 It’s simple to get profitable, just “take your foot off the accelerator”
Capshare (now Shareworks Startup Edition) is moving to profitability right now. A lot is said about how easy it is to get to profitability.
Many companies think it is just as simple as “taking your foot of the accelerator.”
In theory, if you have enough revenue and you are spending enough on growth, this should be true. Simple math illustrates:
Cost of Goods Sold: $3.5M
General and Administrative: $2M
Sales and Marketing: $6M
Operating Profit: $(2.5M)
If you could trim $2.5M from your Sales and Marketing budget, you should get to profitability.
In practice, this generally means:
- Laying people off
- Changing your culture
- Eliminating perks
- Going without many things you have grown accustomed to
- Changing your company’s main goals, visions, and missions
- Changing your company’s fundamental system
Most companies would prefer to be successful without having to do the things above.
So the other option is to grow your way out of unprofitability. Though they probably don’t think about it consciously, most SaaS executives come to appreciate the power of Triangle Numbers.
Triangle numbers are numbers that represent the sum of adding one new number each period to a cumulative tally of recurring numbers from all previous periods.
Graphically, Triangle Numbers look like this image from a Wikipedia article on the subject.
It turns out this branch of math has special relevance for recurring-revenue businesses.
Increasing MRR by $5K / month for 3 months doesn’t mean you will decrease your cumulative costs by $15K. It actually means you will decrease your costs by $30K!
Though your Monthly Recurring Burn (MRB) has decreased by $15K, the total amount you have saved yourself in burn is $30K.
That’s double what you might think.
|Month 1||Month 2||Month 3||Subtotal|
|MRR Increase from Month 1||$5K||$5K||$5K||$15K|
|MRR Increase from Month 2||$5K||$5K||$10K|
|MRR Increase from Month 3||$5K||$5K|
You are adding revenue that recurs each month. So the revenue you add in Month 1 re-occurs in Month 2 and Month 3. The revenue you add in Month 2 reoccurs in Month 3. When you put it into a table (see above), it looks like a triangle.
MRR increases create this powerful triangular effect.
You can find the burn decrease from regular MRR increases with this equation:
Total Burn Decrease = MRR Increase * (n * (n+1)) / 2
Where n is the number of months of burn decrease you want to model.
There is a downside to Triangle Numbers as well. Regular increases to monthly recurring burn (MRB) also have a compounding effect on burn increase.
Adding $5K per month for 3 months to your burn doesn’t increase your total spend by $15K. It increases it by $30K using the same logic as above.
So if you needed one more reason to add burn carefully, here it is.
In conclusion, if you are willing to make some major company-wide changes or you can grow fast enough without a lot of expense, it seems reasonable that “taking your foot off the gas” could lead to profitability.
This myth is plausible.