The drive to profitable growth

I think everyone in the start-up space realizes the days of massive spend for "growth at all costs" while disregarding profitability are over (at least for now). The market and VC investors in particular are putting a premium on companies who can still grow at a fast rate, but also take into account profitability.

How does one measure this?

The metric that we use the most at Profitual would be the “rule of 40”. The rule states that your growth rate and profit margin when combined, should be at least 40% or higher for a SaaS technology start-up.

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Growth Rate = (Current Year Value – Prior Year Value) ÷Prior Year Value X 100% + EBITDA Margin (%) = EBITDA ÷ Revenue

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So, if a company has an ARR of $5M in 2023, and had $4M in ARR in 2022 their growth rate would be: ($5M-$4M)/($4M) X 100%= 25%

If the same company had an EBITDA of $500K and their revenue was $5M their EBITDA Margin would be: ($500K/$5M)=10%

Add them together and you get 35% which is below the 40% threshold and may be an indication that the company isn't hitting their growth and profitability goals.

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What does this mean for start-ups?

I've observed constant and consistent messages circling 3 core themes:

·      Pre-seed to Series A capital is going to be harder to raise;

·      You should expect it to take longer to raise your next round;  

·      You need to hit higher growth metrics (like overall sales while still maintaining rule of 40) to raise your next round. This is a much higher bar than what was expected of companies just over a year ago.

So, spend less money (than before) but hit the same high growth metrics (as before) and be profitable at the same time (this ones new). One can’t help but think: How is this going to be possible? I’ve had this feeling myself. If VC’s wanted additional runway but wrote larger check’s that would make sense. If the cost of employees (the main driver of start-up expenses) has reduced drastically that would also work. But neither of these things are happening in reality.

What’s the solution?

One thing I wonder about is the obsession that Investors (mentors, accelerators, everyone…) has with “ARR”. I’ve generally found that everyone wants ARR, but when we look at the financial models being created in the Profitual platform you can see how hard it is to build up a substantial amount of it - especially at the early stages. Usually, a start-up begins with selling their lowest priced tier and are then waiting for development to create enough additional value that they can release a more valuable and expensive tier. It’s only once the more expensive tiers are developed that we see any model really start generating substantial ARR.

So how does a start-up bridge the gap so that they don’t run out of money while also striving to generate high growth? I believe that there is a middle-ground where a start-up should look at revenue generating activities that will enhance their product roadmap while also reducing burn. The ever forbidden “consulting revenue”.

Now I don’t think start-ups should go out and start cleaning cars to generate any kind of revenue. But, if you are still working with your Ideal Customer, providing value that mirrors future capabilities of your product, you’re making some money, and you can see the pathway on how this work will enhance your overall product - why not go for it?

Caution: Most VC’s hate this!

At the SaaS North Conference this year, it was mentioned how Shopify only generates 25% of its revenue from subscription (ARR) with the remaining 75% coming from payments/marketplace (non-ARR generating) revenue streams. With a market cap that hovers around $100B I wonder if anyone is really disappointed that more of their revenue isn’t ARR? My guess is not. So if it works for Shopify, why can’t it work for your start-up?

While I don’t think many VC’s will change their thinking on ARR anytime soon, I also see the struggle for founders trying to navigate these new realities. I’m happy that we have moved towards a market that actually rewards profitable businesses over growth at all cost land grabs. I do however think reevaluating on how we all strive to achieve this profitable growth is a good idea for everyone.

Want to talk more about metrics and how they relate to your fundraising goals? Book a time with me here!