On the lookout for the purple cow
Profitability vs. Growth?
To predict investors' actions, you need to understand their incentives.
Growth at all costs is a concept promoted by venture capital funds (“VC”s) and there is a reason for it.
Unlike a startup, a VC by design has a limited lifetime, a cap of 10-12 years including investment period of 3-5 years in addition to 5-7 years for divestment. After which, the VC fund will be liquidated.
More importantly, VCs monetize by way of exits i.e. sale of shares of the portfolio startups and not from receiving dividends. A future exit will have higher value when a startup is showing a hockey stick curve traction of revenues and users.
And therefore, VCs are only after the very exciting few startups with exponential growth, the ones which stand out on the hope that other investors will buy out on a much higher valuation in the shortest span of time i.e., the purple cows! Which also means that a VC will encourage any startup they speak with to grow exponentially.
MENA VCs are no different, the growth at all costs vocabulary however is foreign to us in the region, one example is the famous Cash Burn concept, try saying “Cash Burn” in Arabic and you will hear what I mean.
Startups today have more option.
Thanks to the MENA VC boom in 2020 which is financed mainly by national fund of funds such as Saudi Venture Capital Company “SVC”, ISSF Jordan, Waha Capital, Mubadala, ADQ etc who opted to promote entrepreneurship to fight unemployment as part of their strategy, we are no longer hostages to the very few VCs we had in the region initially, which is very healthy.
You know your strategy better!
Given however the nascent nature of VC industry in MENA, and unlike international markets, fund managers in MENA are mainly generalist, you will find a handful of managers who specialize in certain verticals, which means that founders need to be extremely conscious when hiring VCs as board members and receiving growth at all cost advice.
If you decide to stop growth today, will you be profitable?
In the current outlook with recession on the way and pull back of investors at later stage in particular, growth all cost doesn’t seem to make sense and focused spending is the way to go.
Ideally you want to keep your burn as low as possible while you are not raising, until you hit product market fit, then you can expedite your profitable growth by spending money to create momentum.
Rule of 40
For software as a service (“SaaS”) companies, the rule of 40 is popular metric.
It says that a SaaS company’s growth rate when added to its free cash flow rate should equal 40% or higher. It measures the tradeoff between profitability and growth.
The rule has become a favorite of SaaS industry experts and investors.
And while this metric is primarily used by investors it can actually be helpful to SaaS management themselves. You can get a solid idea of how much your growth spending is working to attract high-quality, long-retaining clients. This is what’s crucial to not only grow a product quickly, but to grow one sustainably and avoid either stagnation or decline.
Simply put, SaaS companies above 40% generates profits at a sustainable rate.
As for profitability, many analysts prefer Earnings before Interest, Tax, Deprecation and Amortization (“EBITDA”) as the go to indictor, some use net income or cashflow.
The rule of 40 calculation allows managements and investors to normalize such factor, examples of calculations as follows:
- 20% revenue growth + 20% EBITDA margin = 40%
- 0% revenue growth + 40% EBITDA margin = 40%
- 40% revenue growth + 0% EBITDA margin = 40%
Now do you want to make the calculation a bit complicated?
The weighted Rule of 40
Given investors’ recent preference for growth over profitability, especially for smaller companies, there has been an increasing shift toward a weighted Rule of 40. The Weighted Rule of 40 gives twice the weighting to growth than profitability. You definitely need to speak to your board on this given the coming downturn!
The commonly-accepted weighted rule of 40 gives twice the amount of weight to growth than profitability. This is particularly common in smaller SaaS companies that are still gaining their foot print and working to scale to a new level.
The formula to calculate is:
(1.33 x Revenue Growth) + (0.67 x EBITDA Margin) = Weighted Rule of 40
Finally, some actionable advice:
- Set realistic growth targets. The commonly held perception that SaaS companies need to have soaring rates of growth in recent years doesn’t apply today. Given the current market outlook, total addressable markets will not grow exponentially in the coming 24 months so adjust for reasonable growth rate in the near term.
- Prioritize net retention. Go after new customers but also focus on the existing ones by investing in post-sales to increase cross-sell and upsell.
- Create a Rule of 40 committee: create an operating committee to support the management team in building a path to the rule of 40. And remember, top performers insist on transparent data and metrics that allow them to gain a view of growth and margin drivers. This visibility will help you to execute against bold growth, efficiency, and productivity targets, and to make wise decisions on spending.
Written by: Hasan Al Shami