My first business that I started was Batteries.com. The business was exactly what it sounds like—your single source for portable power for every conceivable gadget. I started the business at the age of 22 and quickly learned a lot about the basics of running a business, including:
- how to manage inventory
- how to make sure the business was financially capitalized
- how to maintain a positive profit margin
In a business driven by selling physical products, EBITDA and profit are the metrics that matter. Fast forward to my second business, Technuity, and I was surprised to learn that many of the hallmarks of running a good company were not the same for a software company. All of a sudden, I was no longer concerned with the bottom line, but rather almost all of my focus shifted to the top line —specifically, how fast we were growing it.
Rather than a multiple on EBITDA or profit, software companies are typically valued for multiples of their revenue. Specifically, multiples of their Annual Recurring Revenue or ARR. So a company that can bring in $1,000,000 in ARR typically can expect to be worth somewhere between 5-8x that amount (so in this case a $5M to $8M valuation). This methodology has large implications for how the business is run. In order to maximize the value of the business, it is in your best interest to aggressively pursue revenue.
Let’s look at an example of a business that has $1M in ARR and is generating $100,000 in profit. Let’s assume a 5x multiple so this business would be worth $5M. Now, if you use the residual $100,000 of profit and hire 2 more sales representatives that are able to generate an additional $500,000 in revenue, your total revenue would be $1.5 M which results in a valuation of $7.5 M. If you were an investor in this fictional business, would you rather have your ownership be worth $5M with $100,000 in profit each year or have your investment be worth $7.5M with zero profit?
This is a no brainer for almost every software investor — they would take the additional $2.5M in value! This is why you see software companies not generating a profit — they are too busy utilizing every dollar to drive top-line revenue to maximize shareholder value. Since growth requires capital, software companies are often raising money to fuel their growth. Maximizing ARR allows software companies to raise money at the highest valuation possible — an element critical to maintaining growth.
Venture economics rely on growth over profits. In fact, a popular benchmark for SaaS businesses is: Growth Rate + Profit Margins > 40%
Applying this model, if your growth rate is above 40%, it’s acceptable for your company to not be profitable. The larger your growth rate is, the less profitable you have to be. There are many examples of businesses that operate in this manner today—Salesforce is not profitable to this day and more recently, Pluralsight filed for an IPO with $167M in revenue and losses of $96.5M.
All of these learnings fundamentally shift the focus of a good software CEO — rather than worrying about margins, you should be worrying about building an awesome product and hiring enough salespeople to help you maximize your ARR potential. Because right now, that’s how you win the game.