There are lots of blogs and anecdotes on (a) how to build a successful SaaS company and (b) what a successful SaaS company looks like. Yesterday’s post by Neeraj Agrawal from Battery Ventures titled The SaaS Adventure is another great one as he describes his (and presumably Battery’s) T2D3 approach.
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I was at a board meeting recently and heard something I’ve not heard before from a late stage investor. He described what his firm called the 40% rule for a healthy software company, including business SaaS companies. These are for SaaS companies at scale – assume at least $50 million in revenue – but my Illusion of Product/Market Fit for SaaS Companies correlates nicely with it once you hit about $1m of MRR.
The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.
Now, growth rate is easy in a SaaS-based business. Just do year-over-year growth rate of monthly MRR. You can do total revenue, but make sure you do MRR also to make sure you don’t have weird things going on in your GAAP accounting, especially if you have one time services revenue in the mix. It’s always worth backtesting this with YoY growth of gross margin just to make sure your COGS are scaling appropriately with your revenue growth, regardless of whether you are on AWS, another cloud provider, or running bare metal in data centers.
Profit is harder to define. Are we talking about EBITDA, Operating Income, Net Income, Free Cash Flow, Cash Flow or something else. I prefer to use EBITDA here as the baseline and then back test with the other percentages. If you are running on AWS or the cloud, this should be pretty simple and consistent. However, if you are running your own infrastructure, your EBITDA, Operating Income and Free Cash Flow will diverge from your Net Income and Cash Flow because of equipment purchases, debt to finance them, or lease expense. So you have to be precise here with which number you are using and “it’ll depend” based on how your SaaS infrastructure works.
While the punch line is that you can lose money if you are growing faster, the minimum point of happiness is 40% annual growth rate. Now, some people will focus on MRR growth rate, others ARR growth rate, and yet others on weird permutations of year of year growth rate by month. Others will focus on the same strange permutations for GAAP revenue to justify growth rate. Regardless, you need a baseline, and I’ve always found simply doing year-over-year MRR growth rate to be the easiest / cleanest, but I always make sure I know what is going on underneath this number by using the other calculations.
I often hear – from sub-scale SaaS companies, “we can get profitable right away if we slow down our growth rate.” And – that’s often a true statement, but you will end up being sub-scale for a much longer time when you end up with a 20% growth rate and a 20% profit. So – if you are going to raise VC money, get focused on the T2D3 approach to get to scale, then start focusing on the 40% rule.
With yesterday’s announcement that early-stage VC Greycroft has raised a $200 million growth fund, this type of fund has officially become a trend. But before we dig into the dynamics of it, let’s pay homage to the originator of this concept, Union Square Ventures.
In January 2011, USV raised what I believe was the first “opportunity fund.” Prior to this, plenty of VC firms invested across the early stage to late stage spectrum from the same fund (e.g. Battery, General Catalyst, Sequoia, Greylock, Bessemer). Others had separate early stage funds and late stage funds, often with separate teams and economics (e.g. Redpoint, DFJ, North Bridge) typically aimed at different opportunities. But the USV Opportunity Fund was the first time, at least in the post 2001-Internet bubble cycle (or last decade, if you want to put it that way) where an early stage firm created a separate fund to invest in late stage rounds of their existing early-stage portfolio companies. In USV’s case, Fred Wilson explains the strategy extremely clearly in the post The Opportunity Fund.
Greycroft is the latest firm to raise this type of fund. In the last week I’ve talked to two other early stage VC firms who are raising similar opportunity funds. In one case they referred to it as a growth fund. In the other case they referred to it as an opportunity fund.
In the fall of 2013, we raised a similar type of fund called Foundry Group Select. It was a $225 million fund, just like our other three $225 million funds raised in 2007, 2010, and 2013. But we called it “Select” instead of “Growth” or “Opportunity” for a specific reason – we only use it to invest in existing portfolio companies of ours.
USV has done a magnificent job of investing in later stage rounds of their existing portfolio companies as well as later stage rounds of companies that fit tightly within their investment thesis. We decided to drop the second half of that strategy as we didn’t want to spend time being late stage investors. It’s not natural for us as an entry point and we didn’t want to add anyone to our team since keeping our team size exactly the same is a deeply held belief of ours.
The decision to raise this fund came out of a combination of desire and frustration. We have a well-defined fund strategy, based on a constant size of each of our funds. Our goal is to make about 30 investments in each fund (2007 has 28, 2010 had 31) that range between $5m and $15m over the life of the company. Part of this strategy is that we are syndication agnostic – we are happy to go it alone through two or three rounds of a company if we have conviction about what they are doing. We are equally happy to syndicate with one or two other VC firms. Either way, while we focus on being capital efficient (we’d rather not overfund the companies we are involved in early), we are interested in buying as much ownership as we can at the early stages.
As a result, when a company begins to accelerate dramatically, we weren’t in a position to contribute meaningfully to the later stage rounds since we’d likely already have something in the $10m to $15m range invested. That’s the desire part of the equation – we knew we could make money off a later stage investment, but when we were talking about investing an incremental $1m or $2m it didn’t really matter much.
The frustration part was more vexing to us. In a number of our successful companies, we saw a long line of financial investors lining up to follow. None of them would engage as a lead, but all want to participate when a round came together. If a company was raising $30m, we’d have $50m+ of “followers” waiting to take whatever was left. We didn’t find that particularly helpful.
So we raised Foundry Group Select. We explicitly limited it to only companies we were already investors in and on the boards of. As a result, it is literally zero incremental work for us since we are already deeply involved in the companies we are investing in. This led us to an interesting decision – since we recycle 100% of our management fee, why would we charge a management fee on this fund if we are doing no incremental work? The conclusion was easy – we don’t charge a management fee. We only make money when the investments make money, resulting in very tight alignment with our LPs.
To date, we’ve invested from Foundry Group Select in Fitbit, Sympoz, Return Path, Gnip (acquired by Twitter), and Orbotix. It’s been a powerful addition to our strategy without creating any extra overhead on us.
I’ll end where I started – by paying homage to our friends at Union Square Ventures. They’ve led the way on many elements of early-stage investing post-Internet bubble, dating back to 2004 when Fred and Brad raised the first USV fund. As the “opportunity fund” becomes a trend, they’ve once again created something that, in hindsight, looks brilliant.