Balance: The secret component of profitable growth
Industry Sector Enterprise Value to Revenue (EV/R)
A dramatic shift in market dynamics
Software companies balance against the Rule of 40
One industry, four generations
Expenses (% of LTM Rev)
Efficiency Score **
*Last 12 months
** Operational Efficiency Score definition: FY22 Forecasted revenue growth compared to Total Operating Expenses. Scale: (0.00x - 1.00x)
Classic software businesses
Classic software businesses have typically grown out of the on-premises world. They tend to have complex delivery models and perpetual revenue streams, where licenses are generally renewed every 3-5 years. As their customers increasingly move towards SaaS, leading classic software businesses need to realize that transforming to SaaS is no longer an IF question. Their growth is slowing and is significantly lower than their Gen 1-3 SaaS peers.
These businesses must look at how the SaaS landscape has changed and adopt growth strategies, business, and Op models from Gen 2 and 3 businesses (e.g. Product Led growth, Consumption pricing, Platform Engineering, etc.) to advance with the macroeconomic market. These leaders need to make significant investments to fully transform themselves into SaaS businesses.
How can they achieve higher growth rates while still making the necessary investments to fully transform into a SaaS model?
Gen 1 SaaS
This generation’s major innovation was to take enterprise software out of the on-premise world and provide it instead as a rentable service. These SaaS companies typically have a top-down selling model with lengthy sales cycles and complex deployments. And because they were largely built on their own private clouds, these businesses have been unable to take full advantage of the improved unit economics and operating leverage that the hyperscalers offer to accelerate the speed of innovation.
As mature and scaled businesses, Gen 1 SaaS companies score well on the “Rule of 40”, with balanced growth and profitability. These companies must seek growth beyond their core markets while fighting intense competition from the "born in the cloud “next-generation vendors that are winning customers through immersive UX and innovative pricing strategies.
How can they maintain their balance of growth and profitability while competing with the next generations of SaaS players?
Gen 2 SaaS
Gen 2 SaaS companies have deliberately spent heavily on R&D while spending less on sales and marketing, have automated much of the traditional marketing, sales, and commercial operations capabilities to keep customer acquisition costs (CAC) low, and were successful in converting products and IT from a cost center to a profit center. Their fast – almost viral – growth has come from direct adoption of their products and services by line of business or end users. This behavior was amplified by the pandemic creating large demand.
As these companies try and scale up to the next level, they must craft go-to-market plans to sell into larger and more complex organizations and industries. They must also embrace the public cloud in a bigger way if they haven't already.
How do they profitably achieve escape velocity to scale and drive growth without losing their product-led DNA? How can they navigate through demand destruction challenges to navigate the post-pandemic era?
Gen 3 SaaS
Born digitally native, Gen 3 SaaS vendors have successfully embraced the public cloud to gain operating leverage and drive differentiated value for their customers. They have adopted innovative business models such as consumption-based pricing and network-driven go-to-market strategies like cloud marketplaces or developer-led expansion. With strong product adoption, these companies enjoy best-in-class net dollar retention rates (Avg > 120%) within the industry.
However, Gen 3s rank highest in operating spend (Op Expenses = 140% of revenue). Unlike their counterparts, most Gen 3 SaaS are < $1B in ARR and haven't encountered the next-level scaling challenges that Gen 1 and 2 vendors have gone through. With high growth and now margin expectations tied to their valuations and stock prices, these companies have to find their way into efficient growth.
Will their new business models hold up during a recession, when customers may cut down on consumption to save costs? How can they maintain their hyper-growth trajectory while still improving margins and cash flow? How will they participate in the evolving ecosystem of enterprise SaaS?