Great ventures meet the Rule of 40, the best ventures master profitable fast-growth

The investment crunch since 2022 and subsequent AI-driven SaaSpocalypse, 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. However, these metrics are not just relevant for SaaS, but for many ventures with significant recurring revenue components.

1. Recurring Revenue Growth. The rate at which the company is growing its annual recurring revenue (ARR) is a key factor in its valuation. Rapid revenue growth, especially recurring one, is a positive sign. It indicates that the company has a large and growing customer base. Faster ARR growth correlates with higher valuation multiples.
   
2. Gross Margin. The difference between the revenue generated by the company and the cost of goods sold (COGS), is an important metric. A high gross margin indicates that the company is generating significant profits. If the COGS is relatively high, valuation multiples correlate to gross margin rather than ARR.
   
3. CAC/CLTV. We use the Customer Acquisition Cost to Customer Lifetime Value ratio to evaluate the cost-effectiveness of a company’s commercial efforts. A low CAC/CLTV ratio indicates that the company acquires customers at a relatively low cost compared to the revenue that those customers generate over their lifetime. This is positive, as it suggests that the company is using its sales and marketing resources efficiently and effectively.
   
4. Churn Rate is the rate at which customers cancel their subscriptions is an important metric in valuating a SaaS company. A high churn rate is a negative sign, indicating that the company may have difficulty retaining its customers. A negative net churn rate – a company’s ability to upsell to existing clients outpaces the annual loss of clients – is a very positive sign.
   
5. Market Size: The size of the market that the company operates in is an important factor in its valuation. A large and growing market is a positive sign, indicating that the company has significant growth potential.
   
6. Burn Multiple is a financial ratio that measures a company’s ability to generate revenue from its shareholder-derived assets, particularly equity and long term debt. It measures how much cash is consumed for each €1 of net new ARR/revenue generated. The ratio’s use is to quickly evaluate a company’s efficiency in generating revenue from its capital. A high ratio (>3) shows that the company grows too inefficiently from an investor perspective. A low ratio (<1) indicates typically that a company’s growth is capital efficient and is considered investment-worthy.

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.

Rule Of 40

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 unsustainable 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.

Adjustments to Ro40

However, a warning regarding Ro40 is in place. It can be played by activating too many software development hours on the balance as an “investment”. That leads to an unrealistic high 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.

Profitable growth

In the end, the Ro40 metric, however 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.