'Efficient growth' is now a survival strategy for software startups

How times have changed. For almost a decade, software was the undisputed engine of growth. Driven by the rise of SaaS, software became the dominant theme across both public and private markets. Between 2011 and 2018, the global software industry’s market capitalisation increased at double the rate of the overall market, according to analysis by McKinsey. In 2021, accelerated even further by the pandemic, software valuations and growth went on to blow away all prior records.

But the pandemic masked headwinds that had been building for years. That long period of growth had come with a cost: software industry profitability had been deprioritised, falling by half over the decade. Then inflation, followed by rising interest rates, severely impacted corporate cash flows. Companies began to cut back heavily on software spend.

As a result, software valuations tumbled and growth efficiency (the measure of how quickly a company recovers its sales and marketing expenses through revenues) declined significantly between 2021 and 2023.

In public markets the reaction was visible for all to see. The high growth mentality was quickly replaced by a renewed focus on profitability. In a bid to preserve valuations, the hot metric became 'margins', specifically, free cash flow (FCF) margins.

But as McKinsey's analysis now reveals, prioritising margins at the expense of growth came at an unnecessary cost for many. An overcorrection that boosted margins wiped away an astonishing $500B in enterprise value.

In private markets, and most notably in venture, a similar but subtly different dynamic took hold during the 2021-23 period. 'Growth at all costs' was replaced by 'cash preservation'. As VCs reacted to wider market changes and investment rates slowed, startups feared that the next round of funding was suddenly in serious doubt. This cash restraint was broadly justified as today, 2 years later, many of these startups have indeed survived to tell the tale.

But for some this has come at a huge cost.

Chronic underinvestment has left them dangerously exposed in a venture funding market where investment criteria have continued to rise. Slashing spend at the expense of growth was, in some cases, an overcorrection - just as it was in public markets. This has left many startups uninvestable, just at a time when quality is being rewarded with record deal sizes and valuations.

For those startups still in the game, the mantra must now be 'efficient growth'. This lies somewhere between 'growth at all costs' and 'survival'. But how do startups determine where this point lies? The ability to deliver against tough investment criteria whilst at the same time protecting the cash runway has become one of the most critical founder skills.

A quick dive into public market fortunes provides some unexpected insights.

Short term gain, long term pain

While public companies in the top quartile for valuation multiples had previously achieved superior performance through higher revenue growth, in 2022 and 2023 they pivoted hard to focus on improving free cash flow (FCF) margins.

As McKinsey's analysis demonstrates, the impact of this change was dramatic: From 2018 to 2021, FCF margins for top-quartile and median companies were within a two-percentage-point range. In 2022 and 2023, however, companies with top-quartile valuation multiples achieved six to eight percentage points higher FCF margins, on average, than median companies.

The markets rewarded the players that focused on margins, which were a greater differentiator between top-quartile and median companies than growth was in 2023.

But there was a hidden cost.

In the past, market expectations for growth for a top-quartile software company (implied by valuation multiples and margins) lined up with companies’ actual growth rates, yet in 2023, actual growth exceeded growth expectations by 4 to 8 percentage points. As McKinsey says, this outcome suggests that the growth levels implied by software valuations (a function of growth outlook, margins, and cost of capital) fell short of the growth that was realized, suggesting that players could have focused less on margins and invested in additional growth throughout 2023.

The outcome was stark: "Our analysis suggests that these actions left significant value on the table. Even in a trying macroeconomic environment, software companies could have expanded their businesses more than they actually did. In fact, despite the challenges of rising interest rates and dropping growth efficiency, top-quartile software companies would have been better off keeping margins where they were in 2021, at 23 percent, instead of expanding them to 29 percent."

And then the killer line: "Had companies reinvested six percentage points of margin into growth, even at a lower growth efficiency, this could have yielded about a 9 percent uplift in enterprise value."

The takeaway is clear: When markets change, figuring out the correct growth formula to maximise value can be counter-intuitive, even for established businesses. But what about businesses that are just beginning to scale?

Rule of 40

Sacrificing profitability for rapid growth is a classic SaaS startup strategy. A key metric at growth stage (typically Series C) - when ARR is starting to be measured in $10M's - is the Rule of 40. This says that a healthy SaaS company has a combined growth rate and profit margin of 40% or more. Growth stage investors put huge store by this metric.

McKinsey's analysis demonstrates how revenue multiples (EV/NTM revenue) typically rise, peak, then fall as Free Cash Flow margins gradually increase. For a Rule of 40 company the most efficient growth zone for FCF margin is in the 13-18% range. The mid-point is around 15%, which would imply a 25% Growth rate to hit the magic 40% figure. Hence, we have a robust formula for software companies looking to maximise forward value creation.

As McKinsey points out, the optimum ratio between Growth and FCF margin is different for all software companies - even within the Rule of 40 category - as it depends on the business environment and companies’ individual circumstances. In finding the optimal growth formula, a key factor is Growth Efficiency.

Growth Efficiency is a metric used to measure how quickly a company is converting its sales and marketing (S&M) spend into revenue growth.

Growth Efficiency = Net New ARR (over a period)/ Sales & Marketing spend over the period

The higher the Growth Efficiency the higher the Growth rate, which in turn 'permits' a lower FCF margin (higher spend) to enable the same degree of long-term value creation.

[A fascinating insight from McKinsey's study of 116 publicly listed software companies was that between 2021 and 2023, median growth efficiency declined by more than 50%. Among the software companies with at least $500 million in revenues, more than 90% fell below a growth efficiency of '1' in 2023. This means that each incremental dollar of growth investment yielded less than a dollar of new recurring revenue. Wow.]

Setting aside all the mathematics, the big takeaway is that optimising for valuation requires continued investment in growth and not just aggressive optimisation of margins. This all sounds logical when you think about it. But too often such simple logic has been ignored as market headwinds have increased and panic has set in.

And to underline the point, this miscalculation is set to continue. McKinsey's study of equity analysts' forecasts suggests that most software companies are expected to continue on this path, increasing margins and underinvesting in growth in 2024 and 2025. "This overly cautious behavior will likely result in software businesses leaving a considerable amount of revenue and value creation on the table." Wow, again.

Burn Multiple

But what about startups nearer the beginning of the scaling journey? How should they strike a formula for efficient growth?

At early stage, efficiency of growth is typically measured via a different metric, the Burn Multiple. The metric is used to assess how much capital a company is burning (spending) to generate each dollar of new revenue. It reflects the sustainability of the company's growth in relation to its cash burn.

Burn Multiple = Net Burn / Net New ARR 

The lower the Burn Multiple the more financially efficient the startup is. Conversely, a higher Burn Multiple might suggest that the company is spending too much relative to its revenue growth, which could be unsustainable in the long term.

Just as growth stage investors use the Rule of 40 metric to assess software companies, early-stage investors use the Burn Multiple metric. This typically kicks in at Series A. As the startup then progresses the Burn Multiple should be reducing.

But again, if there is anxiety over driving Net New ARR (and/or securing new funding) the temptation is to drive down the Net Burn. But just as the Rule of 40 demonstrates, you can't save your way out of a crisis if want to build long-term value.

And to be blunt, value-creation is the only thing that new investors really care about. They will give you no credit for just surviving. As far as they are concerned, by hibernating and hoping for a market recovery (that will likely never come in a timeframe of relevance) you are just delaying the inevitable.

In this more constrained funding environment, there is no softening of investment criteria. In fact capital efficiency expectations have increased over the past 2 years. To get funded at Series A in 2023 startups needed Burn Multiples of <2-3x. Now, in 2024, such multiples are no longer that eye-catching: top decile startups are coming to market at <1.

Value creation strategy

Founders must realise that whatever strategy they employ to deliver their own ambitions, investors only care about the strategy for value creation.

To optimise for value (and hence make the business more attractive to investors) founders must better understand the relationship between 'growth' and 'spend' for their particular sector, business model, and stage.

We can see that for growth stage and established software businesses, investors use key metrics such as the Rule of 40 and Burn Multiple as a proxy for value creation.

Of course, building value doesn't just mean efficiently driving new ARR. This fact is well-known by startups across other industries and verticals beyond SaaS.

Revenue is also a lagging indicator. Early-stage investors in HardTech and DeepTech for example will focus more on leading indicators of value creation; the team, the market opportunity, the technology, the changing regulatory landscape, to name just a few.

The lesson is that well before any funding campaign appears on the horizon, founders must have a solid grasp of the future value drivers and be relentless in prioritising these. This is particularly difficult in a changing funding environment, so taking the time to plan ahead is crucial.

As we can see from the McKinsey research, even established companies can heavily miscalculate. Many are currently stuck in the old orthodoxy of minimising costs. A more nuanced approach, with a firm eye on efficient growth, is required. This applies as much to startups as it does to public companies.

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