Driven by demand for cloud-based services, the global SaaS industry has grown 7x over the last decade to $200bn+. A growth rate that, if continued as many predict, will see it more than triple by 2028.
Despite this, valuation multiples have been falling since their recent peak mid-way through 2021, although they have recovered somewhat over the last nine months. The inflationary pressures, rising uncertainty, and volatile tendencies of the tech and SaaS sectors have all contributed towards the fall.
While multiples vary slightly in broad terms by vertical, average SaaS EBITDA multiples currently range from 10x-15x, down from highs of up to 20x. Premiums are now being given to firms demonstrating leading profit margins, with investors and acquirers placing greater importance towards profitability and the ‘Rule of 40’, moving away from the growth at all costs methodology.
The Rule of 40 metric states that revenue growth percentage added to profitability percentage should be at or above 40 percent, allowing performance to be easily compared across businesses in one clean number.
A recent McKinsey & Company report has also shed light on this shift in emphasis to profitability and that, despite its reputation for high growth and lofty valuations, relatively few SaaS companies are able to sustain growth rates above 30-40% in the long term. Analysis of more than 200 software companies of various sizes between 2011 and 2021 found that businesses exceeded Rule of 40 performance only 16% of the time.
Investors consistently reward those companies that are at or above the Rule of 40. Naturally in the early years, given the nature of SaaS businesses, they are least profitable as heavy investment in scaling is required. As growth begins to slow, either naturally through capturing market share or economic conditions, a focus towards profitability can be beneficial if looking for expansion capital or an exit in the near term.
This can be achieved through focusing on securing future growth and continually pivoting resources to core revenue drivers, adjusting as needed based on the business’ life cycle, to stay at or above the Rule of 40. The following provides an outline of best practices to help achieve this:
1. Set Realistic Growth Targets:
2. Prioritise Net Retention:
3. Optimise Go-to-Market Spend:
4. Build New Business – Fast:
Embracing these steps can enable SaaS companies to set achievable growth targets, prioritise customer retention, optimise sales and marketing, and swiftly create new business opportunities for long-term growth and value creation. Overall, leading to positioning for higher valuations.