I read an interesting slide deck by OpenView Partners which made the statement that only 0.1% of SaaS companies have a chance of reaching $100m in Annualised recurring revenue (ARR) by year 5 of operations. The sample size given was 5,000 SaaS companies in America. That is not to say if you don’t get to $100m in 5 years you will never get there, as there were a handful of companies that achieved this target in greater than 5 years. However what this tells me is the base rate for success in this space is very low even on a 10 year horizon.
Not only that the companies that achieved this $100m ARR target burnt a ton of cash to get there, in some cases in excess of $1 billion.
As an investor I am trying to constantly evaluate investments I own and ones that potentially I would like to own. There are number of metrics you can use and each one can be cherry picked to produce the outcome that you want.
It would be foolish of me to think that the stuff we can measure is all that matters. Really the stuff that we can measure is the byproduct of something going on inside a business. By the time any signs of distress are showing up in the numbers then the business has probably hit the top of its growth curve or it is struggling to Cross the Chasm (h/t Matt Joass).
However there are some VC tools that I like to have in my kitbox that helps me identify an emerging business and compare them to what great companies looked like at the early to mid stages of their development. Two of these are outlined below.
Rule of 40
Brad Feld wrote a post outlining his simple Rule of 40 which adds revenue growth rates and the Net income %. The idea that the combination of the 2 gives a good idea of the trade off between growth and profitability. Ideally best of breed have managed to maintain a 40% target. For example if you are growing Annualised revenue at 100% and your Net Income is -50% then your score is 50%. If you are growing revenue at 30% then you should be hitting profitability at 10%, if not, then maybe you are spending too much to acquire new clients or your fixed costs are too high.
The following chart prepared by Tomasz Tunguz from Redpoint in a blog post The Data Behind the Rule of 40% shows a median ratio of Revenue growth (as measured by ARR) plus the Profit ratio (as measured by NPAT/Revenue) over the years since formation. Note after year 8 the median company falls below the 40% line. Early doors the best companies are growing and acquiring clients as quickly as the market will allow.
As Brad points out the thinking with Saas companies is they can be profitable immediately if they slow down their growth rate i.e. stop acquiring clients. However this Rule of 40 gives a neat benchmark to assess where profitability should be kicking in as growth eventually slows. And it does slow as shown in the chart below from OpenView Partners. The median ARR growth rate is around 30% when revenue exceeds $20m.
Neeraj Agrawal from Battery Ventures explained his rule of thumb (T2D3) as a Saas your target is to triple your annualised recurring revenue for the first 2 years and then double the ARR in the next 3 years giving the acronym T2D3. This is the holy grail target of $100m in Annualised committed revenue in 5 years. At this level you are typically in the “Unicorn” status of a $1 billion market cap and you are ready to IPO if not already.
The chart below shows 7 companies that hit this target and achieved multi billion market capitalisations.
So with these 2 VC metrics in mind how do some of Australia/NZ’s SaaS business models compare? I will compare a company that has achieved on both of these metrics and has 10 years of trading history in Xero to two companies that are relatively young in their life, Big Un Limited and Get Swift.
Not much more needs to be said about the trajectory of Xero. Xero nailed T2D3 and they have continually doubled revenue for a couple of years out after year 5.
The Rule of 40 tracks fairly well with the median data shown. XRO is slightly under the median seen around Year 9-10 with the ratio tracking around 20% for XRO versus around the median of 25-30%.
XRO shows how product/market fit and growth all works to create a fantastic SaaS business.
Big Un Limited (BIG)
Very early days for this company. As the 2 charts show below it is well ahead on its target for T2D3 and is keeping ahead of the Rule of 40.
Big Un seems to me to be tracking well on most metrics including growth, clear path to profitability and cashflow conversion. The unknown for me is the churn rate of its clients as it is early days for the company, as well as the ultimate market size.
This is a young company that seems to me to be heavily promoted. In my experience I have found the best companies to be humble with its investors and ruthless with its competition.
GSW recently reached a market cap of close to $500m on a fully diluted basis. I guess you could call them half a Unicorn? Is a Unicorn without a horn just a horse? Anyway where is GSW compared to a pre-IPO VC life cycle?
This is a tricky one as GSW was Distributed Logistics before 2015 so let’s call FY2015 as Year 0. As the chart below shows GSW increased revenue by 30% in FY2017. Revenue is still below $1m. With their recent announcements in regards to client wins then shareholders are hoping, or more to the point, pricing in some serious T2D3 action in the next few years.
GSW had a FY2017 loss of -$1.9m giving a profit ratio of -400%. With revenue growth of 30% then GSW is not looking too good on the Rule of 40 metric.
With a lot of competition in this space from OnFleet, Bringg, Sendle/Shipstation and Australia Post/Shipster then the Annualised revenue metric will be one to watch closely as to how GSW can monetise the big announcements they have recently made.
Still early days for GSW so it pays to keep an open mind but BIG seems to be pulling ahead of GSW at this stage of the early life cycle.