Thinking incrementally about SaaS

An overview of the key output of the growth software machine

I have been away for a couple of weeks, but I’m a dad now! Wish me luck on the dad bod.

Anyways, I’ve been experimenting with different directions to take this substack. I think I’m going to stick to where I can add the most value: blending SaaS investor and management experience so that my readers can better understand a multi-hundred billion dollar profit pool.

The next few weekly posts are probably going to touch on the following topics:

1. How I think about keeping score for SaaS businesses

2. How a SaaS management team should approach planning, forecasting and allocating capital

3. Metrics investors should be focused on and questions they should be asking

I’ll sprinkle in some company-specific commentary as well when I see something interesting. This week I shared some thoughts on Alteryx. If you have questions on the analytics space, feel free to DM.

Buck @BucknSF

Have done some work on $AYX recently. First time in a few years. TLDR: AYX is not part of the modern data stack so tread carefully What has changed: 1. When I last did work cloud data warehousing was still very early and not on the roadmap for most G2k

On to the post. For folks who have been around SaaS and growth investing/operating for a bit, most of this shit will be obvious. But for a much larger group of people it won’t be.

Focus on the incremental to keep score

Successful growth company investing and management requires a strong opinion about what the future will look like. Big outcomes tend to be driven by some sort of platform or technology shift which opens the door to a new way of doing things. Good management teams have clarity about the opportunity presented then prosecute it. Good investors fund those teams.

The future is obviously unpredictable. So we start with a big picture view of the future and update it as new information comes in. But what information matters most?

For SaaS I always start with incremental revenue. Why? Well, to start it is most predictive of what a company is worth.

Note: For what is worth, the R-square of EV/sales vs growth is about .5. Total revenue to enterprise value R-square is .55

Incremental revenue is very predictive of business value. This makes sense, as it is another way of thinking about growth. But, more importantly from an investor’s perspective, nearly all SaaS businesses are built to generate incremental revenue. Annualized contract value (ACV) and annual recurring revenue (ARR) added are industry terms that effectively mean the same thing and most management teams are goaled on these metrics.

If the incremental revenue machine starts to break down, run away

One mental model of a SaaS business is that it is a big incremental revenue generating machine. Engineers, product managers, account executives, and marketers are hired. Products are built and sold and incremental revenue comes out the other side and is added to the existing base of recurring revenue. Good SaaS machines are investment constrained - if more dollars are poured in, more dollars come out the other side. The best SaaS businesses are geared to return the same or more dollar for dollar as they scale.

Obviously it is much more complex than this. Market size and competition are limiters on how big the machine can get. And certain management teams struggle to build their machine beyond a certain size. Building machines is hard!

But, as an investor, if the machine starts to break down you should be very wary. A good example of this is Box. Box went public in 2015 doing about $200M in annual revenue. Box just finished CY20 doing $771M in annual revenue. Despite a near 4x in revenue, the stock is effectively flat from the day 1 closing price of $23.21.

So, what happened? A lot, but most importantly incremental revenue stopped growing.

Signs the machine is breaking

Ok, so I’ve outlined the easy part of SaaS investing: finding a metric that is predictive of share price. But, how do you predict the predictive metric? That is obviously much harder, but below are some things I look for.

Structural

• Is the competitive landscape stable? Do new entrants have a potential product, distribution or business model advantage?

• Are systems integrators investing in practices focused on implementing the product?

• Are large customers continuing to grow spend?

• Is customer growth meaningfully changing?

• Is there a looming platform shift (e.g., the shift to cloud) that the company has not yet undertaken?

Investment

• How fast is AE headcount growing? Total headcount?

• Is the stated M&A strategy changing?

• Has the company had success rolling out new products?

• Is the company becoming less efficient at acquiring incremental revenue?

Behavioral/other

• Are sales leaders or executives leaving the company?

• Is the beat/raise cadence changing?

• Are metrics being withdrawn?

I’ll spend more time on some of these in the future. Thanks for reading!