Hey, I'm Dan! I'm the CEO of Plus and a venture partner at Madrona. I write the DL, a newsletter about tech in the Pacific Northwest

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Why VCs love SaaS businesses

A couple weeks ago, I shared a chart with the stock performance of recent tech IPOs along with this tweet:

there are two dominant startup models in tech today. (1) You can make money selling software. (2) You can lose money selling anything else.

Lots of people wrote back, and one person pointed out that a better metric to look at (than stock price) would be revenue vs. capital raised. He also pointed me to this fantastic TechCrunch article with the data, so here is a closer look at the efficiency of different businesses models, thanks to Boris!

This chart shows that most public SaaS companies need less than $1 of capital to acquire $1 of ARR. For example, Smartsheet (hidden behind PagerDuty) burned $55M of cash prior to IPO and grew to ~$130M of ARR, so it only cost ~$0.40 for Smartsheet to acquire $1 of ARR.

On the chart, companies “below the line” like Domo have had a harder time finding efficient growth, while Zoom (far left, middle of the way up) was actually able to grow to $423M of ARR with negative cash burn (i.e., they had more cash at time of IPO than they raised). Pretty incredible!

So SaaS companies build their businesses quite efficiently… Now here’s what it looks like when you add other recent (non-software) IPOs to the plot (note: instead of ARR, I used last twelve month revenue).

With the exception of WeWork, all of these companies are actually quite close to or above the line. However, a few things to note:

  • ARR ≠ revenue. SaaS companies have higher “quality” revenue that grows every year. $1,000 of ARR will grow to $1,200 of ARR next year, but $1,000 of mattress probably means $0 of mattress next year
  • Margins. Uber, Lyft, Casper, Peloton, and Sonos have 40-50% gross margins (vs. 80%+ SaaS gross margins), so they need 2x as much revenue to earn the same number of gross margin dollars
  • Growth and scale. Many of the non-SaaS companies can grow much larger than SaaS companies more quickly, and they are targeting significantly larger markets (e.g., transportation vs. data visualization)

So what does this all mean? VCs are looking to earn the best return for their money. If they invest in SaaS startups, there is the opportunity to invest $100M in a company and reach $100M+ of high margin ARR.

To earn the same returns with a non-SaaS company, investors need to (1) see significantly faster growth with the same $100M investment and/or (2) invest at valuation multiples that take into account lower margins and revenue quality.

This hasn’t really been happening over the last few years, so these companies get negative surprises when they go public, but hopefully we will see more rational valuations for non-SaaS startups over the coming years.

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