As SaaS founders are looking to scale and raise funding, it can be confusing and stressful to navigate in the uncertain market of the past few years. Valuations have dropped, and investors are more selective with their capital. So how can you tell if you’re on the right track?
In this session of SaaStr Workshop Wednesdays, the Managing Director & Head of Growth Equity at OMERS Growth Equity, Mark Shulgan, shares advice for focusing on the fundamentals and keeping profitability at the forefront.
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The Perfect Storm
Established in 1962, OMERS Equity has built an impressive software portfolio, including companies like Skillshare, Shopify, Hopper, and GitLab. Shulgan has been in the business for years, including his current role at OMERS. Reflecting on his experience, he comments, “Throughout my career, I’ve found it really important to focus on fundamentals and, ultimately, profitability,” going on to mention, “I define fundamentals as being the basic qualitative and quantitative characteristics of a company that ultimately contribute to its valuation.”
Shulgan believes that profitability will deliver long-term value. In the SaaS space, revenue growth was the king of metrics for many years, but that has changed.
To understand the significant shifts in the market, it’s helpful to think about how to calculate company value. Shulgan shares an equation that illustrates the current economic pulse:
Company Value $ = Free Cash Flow $ / (Discount Rate % – Growth Rate %)
Breaking down each element of the equation, we can see how the environment has impacted software valuations:
- Free Cash Flow: This is lower because of increased competition and higher costs due to inflation. Much of the increased competition can be attributed to adjacency, as Shulgan explains: “Free cash flows are down because of the increased competition that we’re experiencing with markets. Oftentimes, this is indirect competition for companies that are starting to sell into adjacency, so once you’ve built that very valuable and expensive-to-acquire installed base, it’s not uncommon to see a lot of software companies adding adjacent products to try and leverage that installed base.” For example, consider how Microsoft introduced Teams, which now competes with Slack and Zoom.
- Discount Rate: This has increased due to higher interest rates and volatility. Over the last year, interest rates increased by more than 200 basis points, and equity volatility increased by more than 10%.
- Growth Rate: Decreased due to lower growth from the competition and lower terminal growth from pulled-forward growth. “Growth rates have started to decelerate in part because we pulled forward a lot of growth during the pandemic, and there’s more competition and inflation,” Shulgan explains.
The cumulative effect has caused software valuations to drop around 40%, which is a justified correction within the market.
Growth Vs. Profitability, Revenue Trajectory, and Efficiency Metrics
Historically, EV/NTM sales were evenly driven by profitability and revenue growth. However, Shulgan says that it’s expected that the pendulum to swing back to the long-term historical trend as profitability becomes more critical to investors, especially in the current market conditions.
As companies scale, they will want to keep in mind that momentum will change over time. Pulling from a database of private and public companies, OMERS Equity analyzed organizations by size. They found that companies with lower revenue tended to scale more quickly than mature businesses. Levers SaaS leaders can use to grow include:
- Installed Base: Shulgan says, “Once you’ve acquired that customer set, you should really try to grow the product offering, try and grow your pricing as much as you can, and try to identify what your existing customers need and what sort of product adjacencies you can add because it’s going to significantly lower your cost of acquisition and drive more efficient growth.”
- Engineering Productivity: It’s crucial to balance adding new features with product maintenance. Also, approach M&A cautiously –– many companies underestimate how difficult it is to integrate acquisitions into your platform.
- Operational Efficiency: Companies have been expanding their employee base, which can mean they’re spending extra money and not operating efficiently.
Finally, as you scale, be mindful that unit economics and efficiency metrics do not meaningfully decline. If you start spending wildly, these metrics will degrade, so spend slowly and wisely.
- Revenue growth is no longer the primary metric that investors focus on –– keep profitability at the forefront.
- Free Cash Flow is down due to rising costs and increased competition due to companies selling into adjacency.
- Stay mindful of efficiency metrics as you scale, and be careful with spending.