Why SaaS companies can withstand the funding downcycle better

Why SaaS companies can withstand the funding downcycle better

by | Aug 16, 2023 | Functional Notes, Market Trends

Contrary to popular narratives that software is not impacted during downcycles, it does. To a large extent, it already has. Sales cycles have lengthened by 20-25% and public cloud vendors have seen their growth reduce. Over the last 5 quarters, YoY growth for US public SaaS companies has come down sequentially from 36% → 30% → 29% → 27% → 21%. 21% YoY growth in recurring annualized revenue is not bad, but certainly, not the same as it used to be.

At the same time, late-stage funding has dried up, declining as much as 80% YoY for late-stage SaaS. In 2021 and early 2022, rounds have happened at 50-100x ARR, whereas public markets are currently at 6-8x ARR. It’ll be a while before startups that raised capital at high valuations grow into these valuations or public market multiples increase. For example, a leading public SaaS company in the US raised a round at $5B+ valuation when they were at $70M-$80M ARR. Assuming a continuously good annual growth of 60% YoY and a return to valuations at 10x ARR, the company will take more than 4 years to grow into its previous valuation. A natural conclusion, therefore, is that companies will have to come back to market with significant down-rounds as cash rarely lasts for 4+ years. In SaaS, however, we are not seeing that so far. My prediction is that barring exceptions, that time is some distance away. Let’s understand why.

The most important metric, in my opinion, for a SaaS company is the burn ratio, i.e. the net cash a company needs to burn to increase its net ARR by $1. A burn ratio of 0.5 means that the company can add $1M of net new ARR with a spend of $0.5M. Not too far back, the conventional wisdom was that a good SaaS company should be able to reach $100M ARR with a net burn of $100M, though of course, the burn is not linear through the journey. During the last 3-4 years, this metric has gone haywire. Even great SaaS companies have had burn ratios upward of 2x. EBITDA margins have gone from 0% at the start of 2021 to -13% at its peak, or rather trough.

Burn in a SaaS company is driven primarily by three factors – growth rate, sales efficiency, and R&D spend. Let’s examine these in reverse order. R&D expense as a percentage of ARR is very high in the early years and tends to stabilize at 20-25%. During downcycles, companies have the option of delaying some features or products in their roadmap and thus contain the R&D spend.

Sales efficiency is the sales and marketing spend for every incremental dollar of sales (i.e. ARR). For SMB-centric companies, this is usually low, but high for enterprise-centric products. At the same time, enterprise customers tend to increase revenues every year and incremental revenue from existing accounts costs less compared to net new accounts. During downcycles, to control burn companies tend to focus more on existing customers and increasing revenues from them.

Most important factor is growth, but more importantly future growth. Typical sales person for SaaS takes at least one year to fully ramp up to “produce at full capacity”. Hence, to produce a new ARR of $20M in the following year, with an average AE quota of $1M, and an average achievement of 70%, you’ll need 28-30 productive AEs as you enter the year. Required sales capacity for future growth, therefore, requires an investment at least 12 months ahead of time. During downcycles, SaaS companies have the luxury to continue to show growth in the current year with the capacity expansions they did earlier and reduce focus on growth for the following year. Similar cuts can be made for demand generation. This can have the biggest impact on burn.

Moral of the story, most SaaS companies can reduce short-term burn without compromising growth, by reducing sales and marketing investments for the future, as well as by reducing R&D budgets. Founders today would (and should) rather wait and grow into the lofty valuations that they previously raised at rather than go through the pain of flat or down rounds.

There is no free lunch though. All of this comes at the cost of future growth. But you can fight tomorrow’s battles only if you survive today.


Originally published in The Financial Express: