By Joe Krancki
John Maynard Keynes wasn’t thinking about venture capitalists when he spoke in 1936 about the “animal spirits” that guide markets, but few actors in our modern economy are driven more by these forces at such a fundamental level. Not long ago, for VCs it was all about growth. Growth above all else. However, having seen huge sums get shredded by growth-obsessed companies that trip up, wiser VCs have been changing their tune over the last couple years. Since Bill Gurley penned On the Road to Recap, the growth vs. profitability debate has grown louder. In the world of SaaS, profitability is now an important component of valuation.
Despite calling ourselves Frog Capital, we don’t let animal spirits rule our thinking. In our experience as an ambitious scale-up investor, we’ve learned you need to focus on both growth and profitability at the same time in order to build a high-value SaaS business. Seemingly opposite, yet complementary and interconnected, profitability and growth are indeed the Yin & Yang of SaaS value creation.
As a CEO, balancing profitability and growth need not be a miserable exercise. The best scale-up teams we see tackle this challenge head-on with robust planning, strong execution and a long-term strategy for creating a resilient business. For good reason, these perspectives form the three central pillars of Frog’s Scale-up methodology and how we work with our portfolio companies, like Dealflo and Vulog, our most recent SaaS investments.
How can you address growth and profitability together?
Many SaaS investors and entrepreneurs are familiar with the Rule of 40%, which contends that a healthy scale-up’s revenue growth plus EBITDA margin should be at least 40%. From a financial perspective, this KPI helps separate the wheat from the chaff. At Frog, we use it to benchmark companies too. But, it’s not enough to understand the potential of a business or to develop a plan for maximising value. A deeper level of analysis is required.
At Frog, when we zoom in on a SaaS business, we focus on the financial impact of Customer Operations and Revenue Operations. These two operational areas align directly with profitability and growth, the Yin & Yang of SaaS. Understanding these capabilities and how they reinforce each other is essential. Management teams who continuously measure, test and improve their Customer Operations and Revenue Operations are well on their way to creating a valuable company.
The Yin: Profitability via Customer Operations
What is it?
Customer Operations encompasses all the activities required to create and deliver the product and any related services to customers. It’s job is to sustain and nurture customers, making them successful and hooking them on the product. It’s a supportive background force, the Yin of SaaS.
Why is it important?
In SaaS, the customer is both King and Kingmaker. Year-end ARR is the starting point for next year, so it’s worth investing to protect every bit of it. Lose clients along the way, and you’ll have a hole to climb out of that eats time and money. If you delight customers with great service and new value-enhancing features, you’ll have an NPS to boast about and an opportunity to expand accounts. You can obtain the coveted “negative churn”.
What should you measure?
The financial goal of Customer Operations is to generate as much free cash flow as possible for every unit of ARR flowing through the business. The key financial metric is recurring margin, and the main levers are costs related to delivering the product and all support services. Focus on improving each element of COGS, R&D and G&A as a percentage of revenue to increase margins, generate more free cash flow, and build shareholder value.
The Yang: Growth via Revenue Operations
What is it?
Revenue Operations is the growth engine of the business. It’s job is to identify prospects and convert them to customers as efficiently as possible. It is also tasked with account expansion through up-selling and cross-selling. Revenue Operations encompasses Sales, Marketing and the aspects of Customer Success that have revenue accountability. It is an active driving force, the Yang of SaaS.
Why is it important?
If you’re not growing, you’re standing still. If you’re standing still, you’re dead. Consider a study of 3,000 software companies by McKinsey. Not only did high growth software companies produce five times the shareholder returns of medium growth companies, but alarmingly those that grew at 20% or less annually had a 92% chance of ceasing to exist within a few years. While Revenue Operations does the obvious job of building scale, it also helps to ensure long-term sustainability.
What should you measure?
The goal of Revenue Operations is efficient growth, to generate as much net new ARR as possible for each unit of sales and marketing. Net new ARR is calculated as ARR from new customers plus up-sell/cross-sell ARR from retained customers minus ARR from lost customers. The key financial metric here is the SaaS Magic Number. Other important financial metrics include CLV, CAC, and Payback. Driving these metrics in the right direction will accelerate the growth of the business and shareholder value.
Creating a highly-valued SaaS company is no easy feat, and it requires a focus on both growth and profitability. Sometimes investors and entrepreneurs forget this, particularly at the top or bottom of a cycle when animal spirits tend to be strongest. When they forget, the price they pay can be catastrophic. From the moment a company becomes a scale-up, it needs to continually focus on improving processes, applying technology and automation, and developing high-performing teams that will deliver not just growth, but efficient growth. Management and board members tasked with maximising value creation simply can’t ignore profitability for the sake of growth. They must harmonise the Yin & Yang of SaaS.