SaaS growth

This is an excellent blog post on SaaS company growth by Tren Griffin.

https://25iq.com/2018/05/19/business-lessons-about-growth-fr…

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His discussion with Patrick Osshaunnesy on Invest Like The Best Podcast last week was outstanding.

http://investorfieldguide.com/tren/

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Two especially great quotes/nuggets from this article:

…The grand slam financial success of a new business like Google will seem obvious to some people as they recall the path of the business to success. The unfortunate reality is that financial return from investing is generated from understanding the hidden value before it is discovered, not afterward. No points are awarded in investing or business for storytelling after the fact.

and

…Every business has an upper limit on growth and it is just a question of when that limit appears and not whether it appears. The point where growth plateaus for any business is determined by the size of the (total) addressable market (TAM).

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Not clear that the first applies: in my pf are several long-term investments in extremely well-known companies - there are no secrets at all about them - where the annualized returns demonstrate that plenty of ‘points are awarded… for storytelling after the fact’!

Indeed my preference is to completely ignore the anticipatory and explosive growth stage and patiently wait for the company to provide the ratios which really matter.

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Rules of thumb like the “Rule of 40” have been developed to give business some guidance. Fred Wilson describes the rule with some examples:

“If you are growing 100% year over year, you can lose money at a rate of 60% of your revenues

If you are growing 40% year over year, you should be breaking even

If you are growing 20% year over year, you should have 20% operating margins

If you are not growing, you should have 40% operating margins

If your business is declining 10% year over year, you should have 50% operating margins”

Does anyone use Rule 40 in evaluating their stock picks? This was a rather long article. Rule 40 could be a tool to help looking for growth.

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Thanks Jim05 for reminding us about the so-called Rule 40, according to the OP reference:

Rules of thumb like the “Rule of 40” have been developed to give business some guidance. Fred Wilson describes the rule with some examples:

“If you are growing 100% year over year, you can lose money at a rate of 60% of your revenues

If you are growing 40% year over year, you should be breaking even

If you are growing 20% year over year, you should have 20% operating margins

If you are not growing, you should have 40% operating margins

If your business is declining 10% year over year, you should have 50% operating margins”
(snip)
The Rule of 40 is not the only factors to be considered since you must also consider free cash flow, whether the business is generating network effects and the ability of a business to raise funds at an attractive rate and other factors I have written about on this blog. Kristina Shen of Bessemer Venture Partners believes:
“…Growth will always be the most important metric in terms of numbers that help indicate your valuation. We believe that looking at an Annual Recurring Revenue to Growth (ARRG) multiple will be one of the great valuation frameworks that you can leverage as you go forward. What are some of the other valuation frameworks we can look at? Growth is always going to be the one we look at the most, but some of the others we look at, as well, your cap payback and your sales efficiency. Your churn, looking at what percentage of your customers are retaining on an annual basis. Your cash flow efficiency, which we define as your net new ARR divided by your net churn.”

Now applying the 40% rule specifically to SaaS companies, our Fool brother duma/dumaflotchie at the NPI board (come on, can’t we all get along) made an excellent relevant post with the following references:
http://discussion.fool.com/rule-of-40what-really-does-it-predict…

• The Rule of 40% For a Healthy SaaS Company
https://www.feld.com/archives/2015/02/rule-40-healthy-saas-c…
The 40% rule is that your growth rate + your profit should add up to 40%. 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.

Now, growth rate is easy in a SaaS-based business. Just do year-over-year growth rate of monthly MRR. You can do total revenue, but make sure you do MRR also to make sure you don’t have weird things going on in your GAAP accounting, especially if you have one time services revenue in the mix. It’s always worth backtesting this with YoY growth of gross margin just to make sure your COGS are scaling appropriately with your revenue growth, regardless of whether you are on AWS, another cloud provider, or running bare metal in data centers.

Profit is harder to define. Are we talking about EBITDA, Operating Income, Net Income, Free Cash Flow, Cash Flow or something else. I prefer to use EBITDA here as the baseline and then back test with the other percentages. If you are running on AWS or the cloud, this should be pretty simple and consistent. However, if you are running your own infrastructure, your EBITDA, Operating Income and Free Cash Flow will diverge from your Net Income and Cash Flow because of equipment purchases, debt to finance them, or lease expense. So you have to be precise here with which number you are using and “it’ll depend” based on how your SaaS infrastructure works.
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• Silicon Valley rule of thumb points right way
http://blogs.reuters.com/breakingviews/2015/08/31/silicon-va…
There’s an Interesting graph “The 40% rule - revenue growth and operating margin for U.S. listed SaaS companies.”
The 40 percent threshold does not necessarily portend investment success.

Duma relates:

It is a VERY simple calculation of revenue growth rate + operating margin = greater than 40%.

Take SHOP for example…revenue growth 68% + negative 16% = 52%…above the 40% benchmark.

…. this rule seems more applicable to only the earliest venture capital type investment rather than later stage successful companies and are not comparable between different industries but instead perhaps more useful comparing companies within the same sector.

Thanks, duma for readdressing the Rule 40, a subject discussed in the past at the NPI board.

Regards,
Ray

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Very few companies would beat TTD on rule of 40.

For pure size plus growth, not sure who could touch NVDA outside of perhaps GOOGL/FB.

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I use the Rule of 40 as a metric I follow, for all companies not just SaaS. I use revenue growth + free cash flow as a percent of revenue, over the last year (I don’t use just one quarter).

Of the companies I own, the top 5 are:

FB, ANET, TEAM, NVDA, and PANW (all greater than 68).

I think the change in the rule of 40 number is more important than the actual number once above 40. Companies increasing revenue growth or FCF margin will have an improving number, which I think leads to improved stock price.

Jimbo

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