If your SaaS business needs startup funding and you’re looking to attract investors, you likely have a million questions burning in your mind. What are investors looking for? How do I maximize my business’s valuations? How can I make sure I stand the best chance of sky-high revenue multiples in a competitive market? 🤷♀️
In our search for the answers, we reached out to Sandy Kory (Managing Director at Horizon Partners, and General Partner at HorizonVC, a subscription metrics expert and top SaaS investor. His extensive background in the industry spans the last 15 years, and includes hands-on experience with both bootstrapped and venture-backed subscription companies in a variety of industries.
Enjoy this Q&A with him!
SIDHARTH: As an experienced SaaS investor, what attributes do you believe consistently lead to the most valuable companies? 💰
SANDY: Firstly, great founders are crucial - but “great” is very hard to identify a priori. Ideally, founders have built a record of going above and beyond expectations in their work leading up to founding.
Most critically, the great founders learn from their mistakes. While they consistently hit their targets (which isn’t easy, because great founders set ambitious goals!) when they miss, they use it as an opportunity to learn and improve.
Despite the importance of awesome founders, metrics such as revenue, users, and so forth are paramount to investors. In this market, SaaS companies with strong revenue growth quickly earn high valuations and intense competition.
In terms of metrics, I personally like the Rule of 40 (R40), as it accounts for capital efficiency.
To exemplify how useful this can be, let’s say there are two SaaS startups and each are at $6 million ARR. One is growing at a rate of 200%, meaning it has tripled year-over-year. That startup is burning $1M per month. The other startup is growing at a rate of 100% per year, and burns $100K per month.
Which of these businesses is doing better?
I think the average venture capitalist (VC) would go for the one with higher growth, the first business.
I disagree, since that business has an R40 score of 0. The second company has an R40 of 80, well above the accepted cutoff of 40. That means the second business is much more efficient with their spending.
SIDHARTH: How has this played out in the markets? Are there any businesses you’ve seen outperform VCs expectations? 🏆
SANDY: In my portfolio, I have two businesses - Sendbird and People Data Labs - that I think didn’t get the attention they deserved early on. I think People Data Labs, at the seed stage, was growing over 100% year-over-year and was close to breakeven. But it would have gotten more VC attention if it were growing 200% and hemorrhaging cash.
If I see an early stage startup with a Rule of 40 score of 110 or 120, I think it’s likely a very interesting company. I’d also note that this level of growth and efficiency likely means the founders are incredibly good at execution - which is the most important factor, I think, in building a unicorn or decacorn.
That said, high-burn startups can also go very far - I’m sure at one point, Uber was bleeding cash and had a bad R40 score, but was a great startup.
In general, when you’re talking about SaaS businesses with ARR in the range of $1-5M, $5-10M, or maybe even $10-20M, VCs want to see growth. A business with high growth as well as very high burn is going to be a bit more attractive than a company with high growth but very low burn, or breakeven.
SIDHARTH: If a business has a low Rule of 40 score, what are some potential mitigating factors that would make it more attractive to investors? 🤔
SANDY: If I were looking at a business in this situation, the thing I would be most intrigued by is high growth from word-of-mouth. That’s because usually, sales and marketing is your biggest cost variable. If most of your growth is through word-of-mouth, you probably have room to cut back on S&M spending, which would make your numbers look a lot better.
When assessing a business with a low R40, I’d also keep in mind that G&A and R&D costs also typically normalize as you get bigger. So maybe your costs are high right now because you’ve just hired 5 awesome new engineers, and they’re making great software that your customers clearly love. I think it’s fair to have a high burn because of that.
The problem occurs when you’re only growing by spending a lot on S&M, and not because customers truly love your product. In that case, I suspect the cost of hiring 5 new engineers probably won’t flip your product into one that your customers are happy with.
SIDHARTH: So you’re looking at gross margin, S&M spend, and R&D spend. You’re seeing if the R40 score is low because the business is really investing in its future. Is that right? ❓
SANDY: Yes, that’s right. There are other things that can impact your R40 - like when founders pay themselves market rate for their work. Usually, founders underpay themselves.
So maybe you have a founder that needs to pay themself a little bit more because they’re supporting a family. Or they just hired a few new, high-compensation executives. Those kinds of investments can take time to ramp up and contribute to growth.
So you can have reasonable stories where startups have low R40 scores. Sometimes, they’re investing a lot and it hasn’t shown up yet. There’s a lot of nuance there.
SIDHARTH: When are companies with re-occurring revenue given the most credit? 💳
SANDY: Transactional revenue is probably the area where investors will be most attracted to revenue that’s not recurring, but is re-occuring.
Why? Because that revenue tends to be very predictable. Case in point, investors love Shopify. Most of its revenue comes as a % of sales.
SIDHARTH: When are companies with re-occuring revenue priced least fairly? 👎
SANDY: When retention behavior is not obvious, investors can miss the underlying value in a business with re-occurring revenue.
For instance, some products have intermittent usage profiles. Users will stop using the product for some time, but critically, they don’t move to another product. These customers are “returners” and not “switchers”. When you lose users because they’re switching to a competing solution, that’s when you have a big problem.
SIDHARTH: If you’ve lost a customer, why does the reason for that loss matter to investors? 🤨
SANDY: Investors are looking for market leaders on a particular product. If you think about a company like Zoom, there may be patterns of declining usage during the summer for example, when a segment of their customer base - colleges and universities - are on break. Those customers will return when classes start up again.
On the other hand, if customers are leaving for a competing software, that suggests that your product might not be the market leader that investors want it to be.
You can account for users who leave and come back by talking about their LTV:CAC. Think about Shopify - they have very high churn, where customers sometimes move to platforms like Magento, but then they come back. That means Shopify spends very little on S&M, and their overall LTV:CAC ratio is high.
It all comes down to whether or not your product is good, and if it’s good, whether or not you can prove that with data.
SIDHARTH: If you have high churn, how do you know whether or not those customers are going to come back? 📉
SANDY: If you have salespeople, they can tell you when you’re losing deals to someone else. It’s important to be intellectually honest, because it’s easy to fool yourself by brushing off responsibility for losing customers.
In addition to information you get from your salespeople, you can use exit surveys to ask your customers direct questions about their decision to leave.
You should also investigate if the churn results from intermittent use. If you’re creating a great product, then you understand the needs of your customer very well. If you have that going for you, you should be able to develop strong theories about usage patterns.
In some situations, you need to investigate whether or not high churn is due to your customers going out of business. I imagine that QuickBooks has probably always had relatively high churn compared to enterprise software companies, but that’s because they work with so many small businesses that tend not to last. They have a mature product and they know their customers, so I doubt they’re beating themselves up over high churn.
It’s worth mentioning that if you have customers with intermittent demand, then I don’t think your business will get the same revenue multiple as a business with richer cohort retention. However, if you’re growing fast and have a great R40 score, then you’re probably pretty interesting to investors.
If you meet those two criteria - fast growth and high R40 - then you’re probably strong at building products. In that case, you can keep expanding your product to gain those sticky customers. If you have product muscle, a good investor will see that.
SIDHARTH: Everyone loves subscription companies, but not everyone loves every subscription company. What are the biggest reasons that companies get dinged? What do they need to avoid? 🛑
SANDY: Churn is probably the biggest issue. I think there are two major scenarios where churn can bite you.
One is when a business targets SMB customers. They grow super fast to say, $3-5M in ARR, and they have a churn rate of 5-6% per month. It’s possible to have high growth in those early stages even with churn that high.
The problem happens once that business starts getting close to $5-6M in ARR. That’s when it becomes very difficult to keep replenishing customers. You’d need to dramatically expand the top of the funnel to make it sustainable, which gets nonlinearly more challenging as you scale.
Unfortunately, it can be hard for a founder to see a problem. Imagine you just shot from $1M to $2M in ARR. That apparent early success could easily make you unwilling to explore the possibility that you have a churn problem.
Or you think you can easily fix the problem, and maybe you can, but it’s easy to trick yourself with that line of thinking. Barring major product innovations, it can be very difficult to get your churn down once you’ve reached about $2-3M in ARR. Once you get there, the more you grow, the more you will start to flatline.
At that point, a SaaS business with high churn and flat growth is not going to get a strong revenue multiple.
SIDHARTH: How badly could high churn and flatlining growth impact a business’s revenue multiple? 😬
SANDY: It’s very hard to find buyers for SaaS businesses with 5-6% monthly churn or greater, especially when the churn is viewed as a structural problem.
These days, healthy SaaS businesses can be valued at 10-20 times revenue or more. Having high churn and low growth will reduce that number by several orders of magnitude. If you’re an ambitious SaaS founder, that’s quite disheartening.
SIDHARTH: You mentioned that there’s another situation in which churn can be highly problematic. 🧐
SANDY: Here’s an example to illustrate:
Imagine you’re at $10M in ARR, and seeing rapid growth. Your retention story is pretty good. Maybe you have 85% GRR, which isn’t spectacular for enterprise SaaS, but it can be good enough. Perhaps you also have 100% NRR.
Suddenly, you start to see little cracks in the floor - maybe your infrastructure isn’t as scalable as you thought, and you lose a few customers here and there. Then, you get to $15-20M, and that’s when you realize those cracks in the floor reach all the way to the foundation.
Then, maybe you abruptly find yourself with 72% GRR and 88% NRR. In that case, the magnitude of the churn isn’t as high, but it’s affecting other metrics that will have investors jumping overboard. When you have rapid growth, and retention starts going down, it’s like a fast moving train.
On the flip side, if your retention improves as you scale, that’s a development that investors will fawn over.
SIDHARTH: So high churn scares off investors. What else do businesses need to avoid? 🚫
SANDY: If churn is the biggest problem, the second is rising customer acquisition costs.
The most difficult scenario is when a subscription business grows rapidly to $3-5M in recurring revenue despite high churn. In this case, founders and early investors might think the model is much more scalable than it is. But they’ll often see their CAC often going up at the same time their LTV is trending down.
My advice for these businesses is to boost retention by carefully monitoring cohorts and prioritizing product improvement. If the product consistently improves, word-of-mouth will rise as you grow. That can end up solving just about every problem.
Having great product vision and execution is, in my opinion, the best way out of a churn problem.
SIDHARTH: What are the biggest differences you see in public versus private market valuations in SaaS? 📈
SANDY: The private market has the highest growth companies and, not coincidentally, the highest valuations.
On the flip side, there are plenty of public SaaS companies with modest growth rates, along with healthy valuations that don’t apply to private companies with the same growth rates. The market values scale, so a $200M ARR business with 40% growth is typically going to get a higher multiple than a $10M ARR business with the same growth.
SIDHARTH: Is there a SaaS metric that you think is often overlooked? 👀
SANDY: There are questions that I think are important, but they can sometimes be difficult to answer with simple metrics.
One is a measure of value creation for customers. Creating value is the best leading indicator for monetizing your users. I know Canva tracks things like the number of designs made, which is a huge number and it’s growing.
In Canva’s case, they’re not growing by charging more per unit of value created. They’re intensely focused on creating more value, and then revenue follows. Different products have different ways of measuring this, so there’s no one standard, but as an investor I love when businesses can show that they’ve been thinking about it.
The other one is also hard to measure, but I like when businesses can show that they’ve been getting inbound customers with word-of-mouth.
Net Promoter Score (NPS) is somewhat of a standard, but it doesn’t always translate to inbound customers. So while high NPS is great, I’d also like to see additional sources of data outside of NPS - again, showing high word-of-mouth.
SIDHARTH: If we had to coin a “Sandy Kory Golden Rule” for building a SaaS company, what would it be? ⭐️
SANDY: I’ll borrow a page from the book of SaaStr and Jason Lemkin, who, in my opinion, is a great source of SaaS wisdom. He says that leads are the hardest thing about getting from $1M to $10M in revenue. I agree, and I have seen this play out dozens of times.
The best “hack” is to have inbound leads. This is difficult, so a good way to do it is to have high word-of-mouth. We’ve been coming back to that point, but it’s important to reiterate! Word-of-mouth is challenging, because it’s always relative.
I appreciate companies that are bottoms-up or product-led, as those are typically most scalable once they’ve achieved a degree of product-market fit. When leads are inbound because a product is great, it makes everything easier.
With inbound leads, marketing is less difficult because all channels will have better ROI. Sales are easier because closing inbound is much more straightforward than outbound. Finally, product engineering is easier as hiring tends to be smoother when there’s a product users love - it naturally leads to many additional areas for product development, which should prove attractive to the best talent.
As I mentioned before, focusing on value creation is key. Make sure you have a way of measuring value creation.
SIDHARTH: I’m sure our readers will want to hear more - where can they find you? 🔎
Follow me on Twitter!
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