One of the most frequent questions we are asked by founders and entrepreneurs is whether their focus should be on growing revenues or achieving profitability, especially when it comes to the impact on Enterprise Value. It is a complicated question that presents meaningful tradeoffs unique to each company and one that companies should always feel a healthy amount of tension over. There is a difference between choosing profitability over growth and not having the ability to grow efficiently. To build Enterprise Value over time, a company has to be able to execute on an efficient growth model. Efficient growth is what drives Enterprise Value.
At Founders Advisors’ annual Silicon Y’all SaaS and Internet Summit, this question is asked to the Private Equity panel each year, and each year 100% of these extremely sophisticated investors indicate that they are more excited to invest in a company growing 50% and breaking even than one growing 10% with 20% EBITDA margins. However, they universally acknowledge that for operators and owners in the trenches, it isn’t that simple of a decision.
The Case for Profitability
The simplistic purpose of every company is to produce returns for its owners. Beyond that ultimate goal, turning a profit is required to sustain a company and its employees. While serial entrepreneurs may have a war-chest from an earlier exit to fund early losses, bootstrapped companies do not have this luxury and often have to focus on getting to a breakeven level quickly before cash available for operations dries up. Recognizing this, there is no harm in managing to breakeven, especially if maximizing profitability would require taking in capital at an unappealing valuation or bringing on debt with restrictive terms (personal guarantees, risky covenants, high rates, etc.).
The Case for Growth
A true single-instance, multi-tenant SaaS platform has the capacity for unlimited scalability. Once the product and tech are well-developed and hardened, the success of a SaaS company shifts from overcoming product and execution risks (does it work and is the team strong?) to demand and capital risk (is it needed/used and how can we grow even faster?). Because of this, if SaaS companies can show strong bootstrapped growth with manageable churn, investors love to pour capital into a platform that has grown but is constrained by its own capital availability. Private equity investors are great to help think through strategic decisions and guide based on their experience, but they are looking for investments where much of the heavy lifting has already been done. With low churn and high ARR, PEGs can eventually dial back the sales and marketing spend for customer acquisition and significant profitability often results for the company for years to come.
What is the Right Balance between Profitability and Growth?
While they all acknowledge that it is somewhat rudimentary, PEGs examine SaaS companies based on the “Rule of 40” – that is, Growth Rate + EBITDA Margin should be greater than 40. The strongest companies are often scoring greater than 80. Each industry has its own rule threshold. Therefore, as owners weigh their current options to fund growth or focus on achieving a profitability hurdle, they can determine how to effectively budget growth-driving expenses like sales and marketing, development, conference sponsorship/participation, etc. against the anticipated impact to their bottom line.
Ultimately, having a proven growth model is the key for investors and drives valuation upward. Sophisticated investors recognize that some companies may have had to choose profitability over spending for continued growth, but their capital can assist by efficiently increasing sales and marketing expenses in channels that historically have yielded fruit. If it is not clear to an investor that a company has a model for growth, the investment will be less attractive and valuations suppressed. In understanding the growth model, they’ll key in on unit economics – if you can point to past trends around successful sales and marketing campaigns, they’ll be excited to pour fuel on that fire.