The investment crunch since 2022, changed not only the valuations of SaaS ventures, but also the weight of performance metrics.
Traditionally, when scanning SaaS (Software-as-a-Service) ventures, investors typically look at the following key metrics to determine its potential value.
Overall, these metrics can help SaaS ventures evaluate their performance and identify areas for improvement. By tracking these metrics over time, companies gain valuable insights and make data-driven decisions to drive growth and profitability.
However, now that burning a hole in the ground is not fashionable anymore for startups or scaleups, the Rule of 40 (Ro40) has become the most popular single metric that correlates best with SaaS valuations. The Ro40 states that the sum of a company’s revenue growth rate and EBITDA (earnings before interest, taxes, depreciation, and amortization) margin should be at least 40%.
SaaS investors use the Ro40 metric as a simple, effective way to evaluate a company’s ability to balance growth and profitability. The Ro40 takes into account both revenue growth and profitability, two key factors in valuating a SaaS company.
Investors are typically looking for SaaS ventures that are able to grow quickly while also generating profits. Or at least show a clear path to profitability. A company that has a high growth rate but bad profitability is not sustainable in the long run. While a company with high profitability but low growth may not be able to compete effectively in a rapidly evolving market.
Companies that meet or exceed the Ro40 threshold are attractive investment opportunities. But, those that fall below the threshold may face challenges in attracting investment and need to improve their financial performance.
Overall, the Ro40 metrics is useful for evaluating the financial health and growth potential of SaaS companies. It has become an increasingly important factor in investment decisions. At Icecat Capital, it is the first metric we look at when scanning a tech investment opportunity.
However, a warning regarding Ro40 is in place. It can be played if a venture starts to activate software development hours on the balance as an “investment”. That leads to a higher EBITDA, and temporarily a higher EBT as long as amortization didn’t fully kick in. In case of such practices, it is better to adjust for this activation, or – if applied over longer periods – take the EBT percentage in stead of the EBITDA percentage in the R040 formula.
Another situation is when COGS is considerable – let’s say larger than 5%: better to look at the Gross Margin than at ARR as a basis for calculations and valuations.
Also be aware of approaches to pump up ARR by presenting hours-based services as part of subscriptions. Hours-based services don’t have the “multiplier” that is present in software- or content-or other IPR-based subscriptions. IPR-based services are produced once, and are sold many times. Hence the “multiplier”. Therefore, it is best to differentiate hours- and other non-IPR-based revenues from IPR-based revenues, and apply a lower multiplier to non-IPR revenue components.
In the end, the Ro40 metric, however it is calculated, is subjugated by a profitable fast-growth approach. The best ventures both master capital efficiency and rapid sales growth, and use all the innovation power they can muster to this end.
Read further: Invest, CAC, churn, CLTV, IcecatCapital, Ruleof40, SaaS, techvaluation
Founder and CEO of Icecat NV. Investor. Ph.D.
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