The commonly held perception is that SaaS companies have seen soaring rates of growth in recent years. And they spend based on today’s numbers, adjusting their growth and free cash flow objectives according to where they are in their life cycle to stay at or above the Rule of 40 (see sidebar, “Focus on the metrics that matter”). Leading players keep the organization squarely focused on securing future growth, continually pivoting resources to core revenue drivers. Through our work with dozens of SaaS companies and performance analysis of 100 others, we’ve discerned a set of practices that are highly correlated with Rule of 40 success. But our analysis finds almost no correlation between these measures and value multiples. Other conventional measures that many industry leaders and watchers use include ARR per customer, ARR per employee, operational expenditures per employee, growth persistence, and the “magic number” (a measure of sales efficiency). The top quartile for fast-growers (more than 30 percent revenue growth rate) is 26 percent bottom quartile is 10 percent. Our analysis shows that the top quartile within the moderate-growth band has a median FCF of 31 percent bottom quartile is 15 percent. The correlation between the LTM FCF percentage and value multiples applies to both moderate and fast-growing companies in this size range, with moderate-growth companies seeing the highest correlation. From a Rule of 40 standpoint, this is the metric that industry watchers use to determine the FCF percentage, especially for large companies with revenues greater than $600 million. as a percent of revenue for the past 12 months. LTM free cash flow (FCF) percentage for mid-to-large SaaS companies: This indicator measures FCF 2 FCF is cash flow from operations minus capital expenditures.Last 12 months (LTM) median payback period 1 The LTM median payback period is calculated as sales and marketing spend over the prior quarter divided by the sum of net new ARR multiplied by gross margin.: This indicator reveals how successful a company is at generating returns on its sales and marketing investment and scaling them as the business grows (the median for top-quartile SaaS companies is 16 months bottom quartile is 47 months).Net retention rate: An important measure of growth efficiency, this metric shows how effective the company is at driving growth in its existing customer base while keeping churn low (the median for top-quartile SaaS companies is 130 percent bottom quartile is 104 percent).Annual recurring revenue (ARR) growth: This measure reflects a company’s ability to drive topline growth, crucial for Rule of 40 performance since revenue lags behind ARR for SaaS companies (the median for top-quartile SaaS companies is 45 percent bottom quartile is 14 percent).These are the measures that companies should track. Of the roughly 20 operational metrics we assessed for SaaS companies, four have a high correlation with enterprise value to revenue multiples (exhibit). Analysis of more than 200 software companies of various sizes between 20 found that businesses exceeded Rule of 40 performance only 16 percent of the time. But McKinsey research finds that barely one-third of software companies achieve the Rule of 40. The rule has become a favorite of SaaS industry watchers, including boards and management teams, because it neatly distills a company’s operating performance into one number. The popular metric says that a SaaS company’s growth rate when added to its free cash flow rate should equal 40 percent or higher. How well leaders do in balancing these demands is where the “Rule of 40” comes into play. Knowing which levers to pull and which targets to aim for is especially important in SaaS because of the lag between bookings and revenues, the upfront expense of acquiring customers, and the constant rate of R&D spend required to keep features and products current. Spending needs to align with realistic growth forecasts, and growth from existing customers driven by customer retention, cross-sell, and upsell takes on greater significance. However, the 100 companies we analyzed had a median last 12 months (LTM) free cash flow of just 10 percent of revenue. In fact, of 100 public SaaS companies in the United States with revenues above $100 million that we analyzed in May 2021, the median revenue growth rate was just 22 percent.Īs businesses near the top of their initial S-curve, revenue growth tends to slow and free cash flow becomes more important. Despite the sector’s image as a bastion of hypergrowth, only a small share of SaaS companies sustains growth rates above 30 to 40 percent. That’s especially true for software as a service (SaaS). The purest test of a management team and its operational discipline is arguably how well it can maintain strong shareholder returns as the business matures.
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