Category Archives: Startups

The Two Dimensions of Startup Performance

When it comes to evaluating a startup’s performance, I think there are two key, orthogonal questions that need to be examined:

  1. Is the company delivering growth?
  2. Is management in control of your business?

Growth is the primary driver of value creation in a software startup.  I’m not going to quantify what is good vs. bad growth here – it’s a function of too many other variables (e.g., state of market, stage of startup).  For a seed stage company 100% growth (e.g., from $200K to $400K in ARR) is not particularly good, whereas 40% growth off $150M is quite strong.  So, the first question is — given the company’s size and situation — is it delivering good growth?

The second question is whether management is in control of the business.  I evaluate that in two ways:  how often does the company miss its quarterly operating plan targets and how often does the company miss its early-quarter (e.g., week 3) forecast for sales, expenses, and cash burn?

You can combine these two dimensions into a quadrant.

startup perf quadrant

Let’s take a look at companies in each of these quadrants, describe the situation they’re in, and offer some thoughts on what to do.

Moribund Startups
Companies that are moribund are literally on death’s door because they are not creating value through growth and, worse yet, not even in control of their business.  They make annual plans that are too aggressive and continually miss the targets set within them.  Worse yet, they also miss quarterly forecasts, forecasting sales of 100 units in week 3, 80 units in week 12, and delivering sales of only 50 units when the quarter is done.  This erodes the board’s faith in management’s execution and makes it impossible for the company to manage expenses and cash.  Remember Sequoia founder Don Valentine’s famous quote:

“All companies go out of business for the same reason.  They run out of money.” — Don Valentine, Sequoia Capital

While there may be many reasons why a moribund company is not growing, the first priority needs to getting back in control of the business:  setting realistic annual operating plans, achieving them, and having reliable early-quarter (e.g., week 3) forecasts for sales, expense, and cash burn.  I think in their desperation to grow too many moribund startups fail to realize that getting back in control should be done before trying to rejuvenate growth and thus die doing neither.

Put differently, if you’re going to end up delivering sub-par growth, at least forecast it realistically so you will still be in control of your business and thus in a far better position to either turnaround operations or pivot to a better strategic place.  Without control you have nothing, which is what your business will soon be worth if you don’t regain it.

Stuck Startups
Stuck companies face a different set of problems.  The good news is that they are in control of the business:  they make and hit their plans, they come in at or above their forecasts.  Thus, they can manage their business without the risk of suddenly running out of cash.  The bad news is that they’re not delivering sufficient growth and ergo not creating value for the shareholders (e.g., investors, founders, and employees).  Stuck companies need to figure out, quickly, why they’re not growing and how to re-ignite growth.

Possible reasons for stalled growth include:

  • Lack of product-market fit. The company has never established that it solves a problem in the market that people are willing to pay (an amount compatible with your business model) to solve. You may have built something that nobody wants at all, or something that people are not simply willing to pay for.  This situation might call for a “pivot” to an adjacent market.
  • Poor sales & marketing (S&M) execution. While plenty of startups have weak S&M organizations, a lot of deeper problems get blamed by startup boards on S&M.  Why?  Because most boards/investors want to believe that S&M is to blame for company performance problems because S&M issues are easier to fix than the alternatives:  just fire the VP of Sales and/or Marketing and try again.  After all, which would you rather be told by doctor?  That your low-grade fever and weakness is due to the flu or leukemia?  The risk is that through willful misdiagnosis you keep churning S&M executives without fixing (or even focusing on) a deeper underlying problem. [1]
  • Weak competitive positioning. Through some combination of your product and product marketing, customers routinely short-list you as a contender, but buy from someone else.  Think: “we seem to be everyone’s favorite second choice.”  This can be driven by anything from poor product marketing to genuine product shortcomings to purely corporate factors (e.g., such as believing you have a fine product, but that your company will not be a winner in the market).

Stuck companies need to figure out, with as much honesty as possible with themselves, their customers, and their prospects, why they are stuck and then take appropriate steps to fix the underlying causes.  In my opinion, the hard part isn’t the fixes – they’re pretty obvious once you admit the problems.  The hard part is getting to the unpleasant truth of why the company is stuck in the first place. [2]

Unbridled Startups
Like Phaeton driving his father’s chariot [3], the unbridled startup is growing fast, but out of control, and thus risks getting too close to the Sun and burning up or simply smashing into the ground.  Unbridled startups typically are delivering big growth numbers – but often those big numbers are below the even bigger numbers in their aggressive annual operating plan.  The execs dismiss the plan as irrelevant and tell the board to look at growth and market share.  The board looks at the cash burn, noting that the management team — despite delivering amazing growth — is often still under plan on sales and over plan on expenses, generating cash burn that’s much larger than planned.

If the growth stops, these companies burn up, because they are addicted to high cash burn and can suddenly find themselves in the position of not being able to raise money.  So to keep the perpetual motion machine going, they’ll do almost anything to keep growing.  That might include:

  • Raising money on an unattainable plan
  • Raising money on undesirable terms [4] that hurt earlier investors and potentially really hurt the common stock
  • Spending heavily on customer acquisition and potentially hiding that in other areas (e.g., big professional services losses)

Remember that once the Halo is lost, it’s virtually impossible to get back so companies and executives will do almost anything to keep it going.  In some cases, they end up crossing lines that get the business in potentially serious trouble.  [5]

Unbridled companies need to bring in “adult supervision,” but fear doing so because they worry that the professional managers they’ll bring in from larger companies may kill the growth, driven by the company’s aggressive, entrepreneurial founders.  Thus, the board ends up in something of a waiting game:  how long do we bet on the founding/early team to keep driving crazy growth – even if it’s unbridled – before we bring in more seasoned and professional managers?  The smart part about this is realizing the odds of replacing the early team without hurting growth are low, so sometimes waiting really is the best strategy.  In this case, the board is thinking, “OK let’s give this [crazy] CEO one more year” but poised to terminate him/her if growth slows.

The transition can be successfully pulled off – it’s just hard and risky.  I’d argue MongoDB did this well in 2014.  But I’d argue that Anaplan did it not-so-well in 2016, with a fairly painful transition after parting ways with a very growth-oriented CEO, leaving the top job open for nearly 9 months [6].

So, the real question for unbridled companies is when to bridle them and how to do so without killing the golden goose of growth.

Star Startups
There’s not much to say about star startups other than if you’re working at one, don’t quit.  They’re hard to find.  They’re great places to learn.  And it’s sometimes easy to forget you’re working at a star.  I remember when I joined Business Objects.  The company had just gone public the prior year [7], so I had the chance to really dig into their situation by reading the S-1.  “This place is perfect,” I thought, “20-something consecutive quarters of profitable growth, something like only $4M in VC raised, market share leadership, a fundamental patented technology, and a great team — I’m critical as heck and I can’t find a single thing wrong with this place.  This is going to be my first job at a perfect company.”

That’s when I learned that while Business Objects was indeed a star, it was far from a perfect company.  It’s where I learned that there are no perfect companies.  There are always problems.  The difference between great and average companies is not that great companies have fewer problems:  it’s that great companies get what matters right.  Which then begs the question:  what matters?

(Which is an excellent topic for any startup strategy offsite.)

# # #

Notes
[1] One trick I use is to assume that, by default, we’re average in all regards.  If we’re hiring the same profiles, using the same comp plans, setting the same quotas, doing the same onboarding, providing the same kit, then we really should be average:  it’s the most likely outcome.  Then, I look for evidence to find areas where we might be above or below.  This is quite different from a vigilante board deciding “we have a bad sales organization” because of a few misses (or a personal style mismatch) and wanting to immediately replace the VP of sales.  I try to slow the mob by pointing out all the ways in which we are normal and then ask for evidence of areas where we are not.  This helps reduce the chance of firing a perfectly good VP of sales when the underlying problem is product, pricing, or competition.

[2] And that’s why they make high-priced consultants – a shameless plug for my new Dave Kellogg Consulting business.

[3] See Ovid’s version, the one I was raised on.

[4] For example, multiple liquidation preferences.

[5] I seem to have a knack to end up competing with companies who do – e.g., Oracle back in the late 1980s did some pretty dubious stuff but survived its comeuppance with $200M in financing from Nippon Steel (which was a lot of money, back in the day), MicroStrategy in 2000 got itself into trouble with reports of inflated earnings and had to pay nearly $100M in settlements (along with other constraints), Fast Search and Transfer managed to get acquired by Microsoft for $1.2B in the middle of an accounting scandal (and were even referred to by some as the “Enron of Norway”) and after its $11B acquisition by HP, Autonomy was charged with allegations of fraud, some of which are still being litigated.

[6] Yes, you can argue it’s been a successful IPO since then, so the transition didn’t hurt things and perhaps eventually had to happen.  But I’m also pretty sure if you asked the insiders, they would have preferred that the transition went down differently and more smoothly.

[7] I was employee number 266 and the company was already public.  My, how times were different back then.

Are You Counting Payments as Renewals?

Enterprise SaaS has drifted to a model where many, if not most, companies do multi-year contracts on annual payment terms.  How did we get here?

  • Most enterprise SaaS products are high-consideration purchases. Buyers typically perform a thorough evaluation process before purchasing and are quite sure that the software will meet their needs when they deploy.  These are not try-and-buy or wing-it purchases.
  • Most SaaS vendors will jump at the opportunity to lock in a longer subscription term. For example, with an 85% gross retention rate you can offer a 5% discount for a two-year contract and end up mathematically ahead [1].  Moreover, with a default annual increase of 5 to 10% built into your standard contact, you can offer a “price lock” without any discount at all (i.e., the customer locks in the price for two years in exchange for a two-year commitment).

When you combine the vendor’s desire to lock in the longer term with the customer’s belief that the solution is going work, you find a fertile ground for doing two- or three-year contracts.  But these multi-year deals are almost always done on annual payment terms.

Most SaaS vendors don’t want to take the next step and ask for a multi-year prepayment.  The upside for the vendor would be to eliminate the need for collections in years 2 and 3, and eliminate the chance that the customer — even if unhappy — won’t make the out-year payments.  But most vendors refrain from this because:

  • It’s seen as an unusual practice that’s frowned upon by investors
  • Most investors believe you could better maximize ARR by simply raising more capital and sticking with annual payments
  • It can lead to lumpy renewals and cash flows that are both hard to manage and understand
  • It can lead to large long-term deferred revenues which can hinder certain M&A discussions.  (Think:  large balance of cashless revenue from suitor’s perspective.)
  • It complicates the calculation of SaaS metrics, sometimes confusing investors into believing that good metrics are bad ones. (I think I am literally the only person in Silicon Valley who is quick to point out that a 75% three-year retention rate is better than a 90% one-year one [2].)

Thus, we end up in a situation where the norm has become a two- or three-year contract with annual payments.  This begs a seemingly simple “if a tree falls in the forest and no one hears it, did it make any noise” kind of question:

Quick, what’s the difference between a one-year contract that’s renewing for the first time and a three-year contract that’s coming up for its first downstream annual payment?

I’ve often quipped that they’re both “renewals,” but in the former case they’re handled Customer Success and in the latter they’re handled by Legal. [3]

But let’s be clear, regardless of the process you use to manage them [4], they are not the same, and should not automatically be treated as such for the purposes of calculating SaaS metrics. One is the voluntary renewal of a subscription contract; the other is the payment of a contractual commitment.

If you don’t want to renew your subscription, there’s nothing I can do to force you.  If you don’t want to make a contractually committed payment I can sue you.

Let’s consider an example.  We have six customers, Alpha through Foxtrot.  The first three did one-year deals, the second three did three-years deals.  The simple question is:  what’s your gross dollar retention?  A merely acceptable 83% or a very healthy 95%?

payment renewal

If you calculate on an available-to-renew (ATR) basis, the rate is 83%.  There were 300 units up for renewal and you renewed 250 of them.  If you include the payments, the rate is 95%.  1,050 units were up for renewal or payment, and you invoiced 1,000.

This is a case that feels a little bit wrong both ways.  Including the payments uplifts the rate by mixing involuntary payments with voluntary renewals; to the extent you want to use the rate as a satisfaction indicator, it will be over-stated [5].  However, excluding the payments seems to fail to credit the company with the auto-renewing nature of multi-year deals.

One thing is clear:  payments certainly cannot be included in any ATR-based rate.  You cannot view making a contractually required payment as the same thing as voluntarily renewing a contract. 

Because of prepaid multi-year deals, I have always calculated retention rates two ways:  ATR-based and ARR-based.  The former is supposed to give you an idea of how often, given the chance, people want to renew their contacts.  The latter is supposed to show you, mathematically, what’s happening to your ARR pool [6].

I have an issue, which is highly subjective, when it comes to out-payments on non-prepaid, multi-year deals:

  • On one hand, I can argue they are contractual commitments that the vast majority of customers will honor and thus are effectively – save for a few rare cases – identical to prepaid multi-year deals. Think:  the money’s good as in the bank.
  • On the other hand, I can argue that a dissatisfied customer – particularly one who blames the vendor and/or the software for their failure – will not want to pay, even if the contract says they’re supposed to. Think:  it’s a toothless contract that the vendor will not likely not enforce against an angry customer.

Philosophically, I can argue that these out-year payments are either “good as in the bank” or I can argue that they’re “basically renewals that will ‘churn’ if the customer is not happy.”  The first argument says to treat them like prepaid multi-year deals and put them in ARR-based retention rates.  The second argument says they’re effectively voluntary renewals and should be counted as such.

In reality, you need to know what happens at your business.

I believe for the vast majority of businesses, customers honor the contracts and we should treat them like prepaid, multi-year deals in ARR-based rates — and you should always publish in parallel ATR-based rates, so people can see both.  However, if your company is an outlier and 10% of those payments are never collected, you’re going to need to look at them differently – perhaps like renewals because that’s how they’re behaving.  Or get better lawyers.  Or stop doing non-prepaid, multi-year deals because, for whatever reason, your customers are not honoring the commitment they made in exchange for you to give them a price lock.

# # #

Notes

[1] Over 2 years you get 190 units versus an expected 185.  (Not counting any expansion.)

[2] 0.75 > 0.9^3 = 0.73 – you need to compound annual rates to compare them to multi-year ones.

[3] Or, really, Accounts Receivable but that doesn’t sound as funny.

[4] I’d argue that when you define your customer success process that you should treat these two customers identically.  Whether it’s a payment or a renewal, in a good customer success process you should constantly monitor customer progress with the hope that the renewal (or the payment) is not some big decision, but merely incidental.  (“Yes, of course, we want to keep using the software – is it just a payment year or do we need to renew the contract?”)  This might increase your cost to renew a bit – because you’ll be paying CSMs or renewals reps to do collection work that could theoretically have been done by Accounts Receivable – but it’s still the right answer if you want to maximize ARR.

[5] While payment does not necessarily indicate satisfaction, it probably does indicate the absence of intense dissatisfaction.

[6] e.g., I’d use the the churn rate (1 minus the retention rate) as the discount rate in a present value calculation.

What It Takes to Make a Great SaaS Company

I’ve been making a few presentations lately, so I thought I’d share the slides to this deck which I presented earlier this week at the All Hands meeting of a high-growth SaaS company as part of their external speaker series.

This one’s kind of a romp — it starts with some background on Kellblog (in response to some specific up-front questions they had), takes a brief look back at the “good old days” of on-premises software, introduces my leaky bucket concept of a SaaS company, and then discusses why I need to know only two things to value your SaaS company:  the water level of your bucket and how fast it’s increasing.

It kind of runs backwards building into the conclusion that a great SaaS company needs four things.

  1. An efficient sales model.  SaaS companies effectively buy customers, so you need to figure out how to do it efficiently.
  2. A customer-centric culture.  Once you’ve acquired a customer your whole culture should be focused on keeping them.  (It’s usually far cheaper than finding a new one to back-fill.)
  3. A product that gets the job done.  I like Clayton Christensen’s notion that customers “hire products to do jobs for them.”  Do yours?  How can you do it better?
  4. A vision that leaves the competition one step behind.  Done correctly, the competition is chasing your current reality while you’re out marketing the next level of vision.

Here are the slides:

The Three Marketing Books All Founder/CEOs Should Read

Few founder/CEOs come from a marketing background; most come from product, many from engineering, and some from sales, service, or consulting.  But few — ironically even in martech companies — grew up in the marketing department and consider marketing home.

When you combine this lack of experience with the the tendency that some marketing leaders and agencies have to deliberately obfuscate marketing, it’s no wonder that most founder/CEOs are somewhat uncomfortable with it.

But what’s a founder/CEO to do about this critical blind spot?  Do you let your CMO and his/her hench-agencies box you out of the marketing department?  No, you can’t.  “Marketing,” as David Packard once famously said, “is too important to be left to the marketing department.”

I recommend solving this problem in two ways:

  • One part hiring:  only hire marketing leaders who are transparent and educational, not those who try to hide behind a dark curtain of agencies, wizardry, and obfuscation.  Remember the Einstein quote:  “if you truly understand something you can explain it to a six-year old.”
  • One part self-education.  Don’t fear marketing, learn about it.  A little bit of fundamental knowledge will take you a long way and build your confidence in marketing conversations.

The problem is where to begin?  Marketing is a broad discipline and there are tens of thousands of books — most of them crap — written about it.  In this post, I’m going to list the three books that every founder/CEO should read about marketing.

I have a bias for classics here because I think founder/CEO types want foundational knowledge on which to build.  Here they are:

  • Positioning by Al Ries and Jack Trout.  Marketers frequently use the word “positioning” and after reading this classic, you’ll know exactly what they mean [1]. While it was originally published in 1981, it still reads well today.  This is all about the battle for the mind, which is the book’s subtitle.
  • Ogilvy on Advertising by David Ogilvy.  Ogilvy was the founder of marketing powerhouse agency Ogilvy and Mather and was the king of Madison Avenue back in the era of Mad Men.  Published in 1963, this book definitely shows signs of age, but the core content is timeless.  It covers everything from research to copy-writing and is probably, all in, my single favorite book on marketing. [2]
  • Crossing the Chasm by Geoffrey Moore.  The textbook classic Silicon Valley book on strategy.  Many people refer to the chasm without evidently having even read the book, so please don’t be one of them.  Published in 1991, it’s the newest of the books on my list, and happily Moore has revised it to keep the examples fresh along the way.

If I had to pick only one book, rather than suggesting original classics I’d revert to a summary, Kotler on Marketing, an overview written by Philip Kotler [3], author of one of the most popular marketing college textbooks, Marketing Management. [4]

If reading any of the above three books leaves you hungry for more (and if I were permitted to recommend just a few follow-up books), I’d offer:

  • As a follow-up to Positioning, I’d recommend The 22 Immutable Laws of Marketing also by Al Ries and Jack Trout and also written in the same accessible style.  This book would place second in the “if I only had one book to recommend” category and while less comprehensive than Kotler it is certainly far more accessible.
  • As a follow-up to Ogilvy on Advertising, and for those who want to get closer to marketing execution (e.g., reviewing content), I’d recommend The Copywriter’s Handbook by Robert Bly.  Most founder/CEOs are clear and logical writers who can get somewhat bamboozled by their marketing teams into approving gibberish copy.  This book will give you a firmer footing in having conversations about web copy, press releases, and marketing campaigns.
  • As a follow-up to Crossing the Chasm, I’d recommend Good Strategy, Bad Strategy, an excellent primer on strategy with case studies of great successes and failures and Blue Ocean Strategy, a great book on how to create uncontested market space and not simply compete in endless slug-fests against numerous competitors — which is particularly relevant in the current era of over-populated and over-funded startups. [5]

As founder/CEO you run the whole company.  But, for good reason, you might sometimes be hesitant to dive into marketing.  Moreover, some marketeers like it that way and may try to box you out of the marketing department.  Read these three books and you’ll have the tools you need to confidently engage in, and add value to, important marketing conversations at your company.

# # #

Notes

[1]  The Wikipedia entry on positioning isn’t a bad start for those in a hurry.

[2] Right from the second sentence, Ogilvy gets to the point:  “When I write an advertisement, I don’t want you to tell me that you find it ‘creative.’   I want you to find it so interesting that you buy the product.”  Love that guy.

[3] Of 4 P’s fame.  Kotler’s 4 P’s defined the marketing mix:  product, place, price, and promotion.

[4] Kotler on Marketing is deliberately not a summarized version of his classic, 700-page textbook, but alas it’s still written by someone who has produced numerous textbooks and nevertheless has a textbook feel.  It’s comprehensive but dry — especially by comparison to the others on this list.

[5] I can’t conclude any post on marketing thoughts and thinkers without a reference to one of the great marketing essays of all time, Marketing Myopia, by Theodore Levitt.  It’s old (published in 1963) and somewhat academic, but very well written and contains many pithy nuggets expressed as only Levitt could.

Hiring Profiles: Step 0 of a Successful Onboarding Program

Happily, in the past several years startups are increasingly recognizing the value of strong sales enablement and sales productivity teams.  So it’s no surprise that I hear a lot about high-growth companies building onboarding programs to enable successfully scaling their sales organizations and sustain their growth.  What’s disappointing, however, is how little I hear about the hiring profiles of the people that we want to put into these programs.

Everyone loves to talk about onboarding, but everybody hates to talk about hiring profiles.  It doesn’t make sense.  It’s like talking about a machine — how it works and what it produces — without ever talking about what you feed into it.  Obviously, when you step back and think about it, the success of any onboarding program is going to be a function of both the program and people you feed into it.  So we are we so eager to talk about the former and so unwilling to talk about the latter?

Talking about the program is fairly easy.  It’s a constructive exercise in building something that many folks have built before — so it’s about content structuring, best practice sharing, and the like.  Talking about hiring profiles — i.e., the kind of people we want to feed into it — is harder because:

  • It’s constraining.  “Well, an ideal new hire might look like X, but we’re not always going to find that.  If that one profile was all I could hire, I could never build the sales team fast enough.”
  • It’s a matter of opinion.  “Success around here comes in many shapes and sizes.  There is not just one profile.”
  • It’s unscientific.  “I can just tell who has the sales gene and who doesn’t.  That’s the hardest thing to hire for.  And I just know when they have it.”
  • It’s controversial.  “Turns out none of my six first-line sales managers really agree on what it takes — e.g., we have an endless debate on whether domain-knowledge actually hurts or helps.”
  • It’s early days.  “Frankly, we just don’t know what the key success criteria are, and we’re working off a pretty small sample.”
  • You have conflicting data.  “Most of the ex-Oracle veterans we’ve hired have been fish out of water, but two of them did really well.”
  • There are invariably outliers.  “Look at Joe, we’d never hire him today — he looks nothing like the proposed profile — but he’s one of our top people.”

That’s why most sales managers would probably prefer discussing revenue recognition rules to hiring profiles.  “I’ll just hire great sales athletes and the rest will take care of itself.”  But will it?

In fact, the nonsensicality of the fairly typical approach to building a startup sales force becomes most clear when viewed through the onboarding lens.

Imagine you’re the VP of sales enablement:

“Wait a minute. I suppose it’s OK if you want to let every sales manager hire to their own criteria because we’re small and don’t really know for sure what the formula is.  But how am I supposed to build a training program that has a mix of people with completely different backgrounds:

  • Some have <5 years, some have 5-10 years, and some have 15+ years of enterprise sales experience?
  • Some know the domain cold and have sold in the category for years whereas others have never sold in our category before?
  • Some have experience selling platforms (which we do) but some have only sold applications?
  • Some are transactional closers, some are relationship builders, and some are challenger-type solution sellers?”

I understand that your company may have different sales roles (e.g., inside sales, enterprise sales) [1] and that you will have different hiring profiles per role.  But you if you want to scale your sales force — and a big part of scaling is onboarding — then you’re going to need to recruit cohorts that are sufficiently homogeneous that you can actually build an effective training program.   I’d argue there are many other great reasons to define and enforce hiring profiles [2], but the clearest and simplest one is:  if you’re going to hire a completely heterogeneous group of sales folks, how in the heck are you going to train them?

# # #

Notes

[1] Though I’d argue that many startups over-diversify these roles too early.  Concretely put, if you have less than 25 quota-carrying reps, you should have no more than two roles.

[2] Which can include conscious, deliberate experiments outside them.

 

 

Slides from My SaaStr Annual 2019 Presentation (5 Questions CEOs Struggle With)

Thanks to everyone who attended my session today at the amazing — and huge — SaaStr Annual 2019 conference in San Jose.  In this post, I’ll share the slides from my presentation, Five Questions SaaS CEOs Wrestle With (and some thoughts on how to answer them).

The folks at SaaStr recorded the session, so at some point a video of it will be available (but that probably won’t be for a while).  When it is up, I will also post it to Kellblog.

In some sense definitionally, there were two types of people in the audience:

  • CEOs, who hopefully received some fresh perspective on these age-old, never-quite-put-to-bed questions.
  • Those who work for them, who hopefully received some insights into the mind of the CEO that will help make you more valuable team members and help you advance your career.

As mentioned, please send me feedback if you have examples where something in the presentation resonated with you, you applied it in some way, and it made a positive impact on your working life.  I’d love to hear it.

Here are the slides from the presentation.

Rule of 40 Glideslope Planning

Enterprise SaaS companies need a lot of money to grow. The median company spends $1.32 to acquire $1.00 in annual recurring revenue (ARR) [1].  They need to make that investment for 14 years before getting to an IPO.  It all adds up to a median of $300M in capital raised prior to an IPO.

With such vast amounts of money in play, some say “it’s a growth at all costs” game.  But others hold to the Rule of 40 which attempts to balance growth and profitability with a simple rule:  grow as fast as you want as long as your revenue growth rate + your free cashflow margin >= 40%.

The Rule of 40 gets a lot of attention, but I think that companies are not asking the right question about it.  The right question is not “when should my growing startup be Rule of 40 compliant?” [2]

For more than half of all public SaaS companies, the answer to that question, by the way, is “not yet.”  Per multiple studies I’ve read the median Rule of 40 score for public SaaS companies is ~31%, meaning that more than half of public SaaS companies are not Rule of 40 compliant [3].

So, unless you’re an absolutely amazing company like Elastic (which had a Rule of 40 score of 87% at its IPO), you probably shouldn’t be unrealistically planning to become Rule of 40 compliant three years before your IPO [4].  If you do, especially if you’re well funded and don’t need additional expense constraints, you might well compromise growth with a premature focus on the Rule of 40, which could shoot off your corporate foot in terms of your eventual valuation.

If “when should we be Rule of 40 compliant” is the wrong question, then what’s the right one?

What should my company’s Rule of 40 glideslope be?

That is, over the next several years what is your eventual Rule of 40 score target and how do you want to evolve to it?  The big advantage of this question is that the answer isn’t “a year” and it doesn’t assume Rule of 40 compliance.  But it does get you to start thinking about and tracking your Rule of 40 score.

I built a little model to help do some what-if analysis around this question.  You can download it here.

r40-1

In our example, we’ve got a 5 year-old, $30M ARR SaaS company planning the next five years of its evolution, hopefully with an IPO in year 8 or 9.  The driver cells (orange) define how fast you want to grow and what you want your Rule of 40 glideslope to be.  Everything else is calculated.  At the bottom we have an overall efficiency analysis:  in each year how much more are we spending than the previous year, how much more revenue do we expect to get, and what’s the ratio between the two (i.e., which works like kind of an incremental revenue CAC).  As we improve the Rule of 40 score you can see that we need to improve efficiency by spending less for each incremental dollar of revenue.  You can use this as a sanity check on your results as we’ll see in a minute.

Let me demonstrate why I predict that 9 out 10 ten CFOs will love this modeling approach.  Let’s look at every CFO’s nightmare scenario.  Think:  “we can’t really control revenues but we can control expenses so my wake up in the middle of the night sweating outcome is that we build expenses per the plan and miss the revenues.”

r40-2

In the above (CFO nightmare) scenario, we hold expenses constant with the original plan and come in considerably lighter on revenue.  The drives us miles off our desired Rule of 40 glideslope (see red cells).  We end up needing to fund $42.4M more in operating losses than the original plan, all to generate a company that’s $30.5M smaller in revenue and generating much larger losses.  It’s no wonder why CFOs worry about this.  They should.

What would the CFO really like?  A Rule-of-40-driven autopilot.

As in, let’s agree to a Rule of 40 glideslope and then if revenues come up short, we have all pre-agreed to adjust expenses to fall in line with the new, reduced revenues and the desired Rule of 40 score.

r40-3

That’s what the third block shows above.  We hold to the reduced revenues of the middle scenario but reduce expenses to hold to the planned Rule of 40 glideslope.  Here’s the bad news:  in this scenario (and probably most real-life ones resembling it) you can’t actually do it — the required revenue-gathering efficiency more than doubles (see red cells).  You were spending $1.38 to get an incremental $1 of revenue and, to hold to the glideslope, you need to instantly jump to spending only $0.49.  That’s not going to happen.  While it’s probably impossible to hold to the original {-10%, 0%, 5%} glideslope, if you at least try (and, e.g., don’t build expenses fully to plan when other indicators don’t support it), then you will certainly do a lot better than the {-10%, -32%, -42%} glideslope in the second scenario.

In this post, we’ve talked about the Rule of 40 and why startups should think about it as a glideslope rather than a short- or mid-term destination.  We’ve provided you with a downloadable model where you can play with your Rule of 40 glideslope.  And we’ve shown why CFOs will inherently be drawn to the Rule of 40 as a long-term planning constraint, because in many ways it will help your company act like a self-righting ship.

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Notes

[1] The 75th percentile spends $1.92.  And 25% spend more than that.  Per KeyBanc.

[2] Rule of 40 compliant means a company has an rule of 40 score >= 40%.  See next note.

[3] Rule of 40 score is generally defined as revenue growth rate + free cashflow (FCF) margin.  Sometimes operating margin or EBITDA margin is used instead because FCF margin can be somewhat harder to find.

[4] I’m trying to find data a good data set of Rule of 40 scores at IPO time but thus far haven’t found one.  Anecdotally, I can say that lots of successful high-growth SaaS IPOs (e.g., MongoDB, Anaplan, and Blackline) were not Rule of 40 compliant at IPO time — nor were they well after, e.g., as of Oct 2018 per JMP’s quarterly software review.  It seems that if growth is sufficiently there, that the profitability constraint can be somewhat deferred in the mind of the market.