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The Rise of Profitability as a Key Driver of SaaS Valuations

Summary
  • Why profitability, the net income or cash flow of a business, is now taking on a more prominent role in the valuation process
  • What this focus on profitability means for SaaS founders

In the world of SaaS, growth rate (how quickly net revenue is growing year to year) has always been the driving force behind valuation. This metric is typically followed by retention, gross margin, market size, and sales efficiency, with profitability being a secondary consideration.

However, the landscape is changing, and profitability, the net income or cash flow of a business, is now taking on a more prominent role in the valuation process.

The Subjectivity of Profitability

The definition of profitability varies among investors. Some focus on actual cash flow, while others look at metrics such as GAAP revenue like EBITDA. Regardless of the specific definition, the idea that profitability only means you are profitable is false. Profitability is more commensurate with how you're achieving said growth, particularly in relation to sales efficiency and cash flow.

Typically the cost of capital is low enough that businesses and investors are willing to overinvest in non-revenue producing functions and headcount, such as R&D teams, even if the efficiency isn't great, because they are gaining market share, multiples are high, and they can essentially build their own moat with the high gross margins. VCs like this because businesses constantly need additional capital as their success continues to grow and the VC can continuously provide.

But as interest rates and cost of capital increase, the math on unprofitable growth narrows significantly and investors are becoming more reluctant to overspend in these categories. Investors want to see a path to profitability or a justification for why a company is unprofitable. Is it because they’re overspending and burning through capital or is sales efficiency so high that they’re still adding annual recurring revenue (ARR) efficiently and gaining majority market share?

Under these circumstances, sales efficiency and a closer proximity to breaking even are increasingly important. Investors still believe innovation and growth are paramount, but want to see them develop thoughtfully over time instead of burning through resources to get there as quickly as possible.

Why is Profitability Gaining Attention?

Interest rates and the cost of capital have increased substantially in recent years, making profitability a mitigating factor for investors.

As a founder needing to improve profitability, you can do one of three things:

  1. You can use your own cash flows to grow. If your company has an efficient business model that is cash flow positive, you can use your own profit to grow.
  2. You can raise equity. If your business is unprofitable, investors have historically given businesses like yours equity, debt, or a combination of both to help generate growth.
  3. You can raise debt. Maybe you’re profitable or have good sticky customers, but you could use a little extra cash flow to boost growth, so you use debt instead of a resource partner.

The second two rely on external capital for growth, and if it comes from external sources in a rising interest rate environment, the weighted average cost of capital (WACC) is going up and amplifying the cost to grow. Equity is tightening up because investors are less willing to give more equity when they're concerned about longevity, lack of efficiency, and the expense of debt in this interest rate environment.

The bootstrap founder doesn’t need debt or equity, which allows them to elevate their growth, efficiency, and profitability. And because of their efficiency, the return on investment is reliable, making them even more attractive to equity providers who need to deploy capital. Now the resources investors are putting to work on those already profitable businesses are accelerating growth, not just maintaining growth.

The Outlook for Founders

Founders who have raised capital

For SaaS founders who have raised capital, it is crucial to be conscious of efficiency, not just in terms of sales, but across the entire business. Funding could become more expensive or even dry up, so understanding why and how you’re burning capital is essential. Is it because the company is going after a large market and spending more to achieve high sales efficiency? Or is it because the company is overspending on non-revenue generating items in a bid for future revenue?

It's easier to get into unprofitable growth than reverse and get into profitable growth, but the current outlook for founders is that profitability and efficiency are critical for success. If you’re not being efficient, then you need to get a clear picture of why and start taking steps to reverse it.

Founders who are bootstrapped

On the other hand, bootstrapped founders who have focused on efficiency and profitable growth are in a strong position. They have grown their businesses effectively and are now reaping the rewards.

These founders have the opportunity to take market share, hire talented employees from struggling VC-backed businesses, and look at potential liquidity events or capital raises themselves to capitalize on the current market conditions.

Poised for Opportunity

Vista Point was founded on the knowledge that these founder-led, bootstrapped SaaS companies were going to be the future. SaaS founders own more of their business, and because of the proliferation and efficiency of technology and open source tools, they are able to be more profitable and more successful.

Add to this the state of the current economy and marketplace, and there has not been a more opportune time for SaaS founders. At Vista Point, we're seeing clients like Hostaway receive $175 million in strategic growth investment and others closing deals with amazing multiples because they're incredibly sales efficient, they're profitable, and supply and demand is favoring the seller.

Learn more about common milestones that lead founders to pursue a transaction or how to prepare your company to sell.

Modified on Jul 12, 2023