This is the fourth article in a series on novel ideas for SaaS metrics, which started with The unprofitable SaaS business model trap, COC: a new metric for cancellations, and The mistake of 1/c in LTV.
Its tough for a growing SaaS business to ascertain whether or not it’s truly profitable. Here’s a way to do it.
First model: EBITDASM
When Rackspace was scaling quickly, they had an interesting metric they called EBITDASM to answer the question: “Are we truly ‘spending to grow,’ or are we just fundamentally unprofitable?”
Here’s the logic:
We (Rackspace) have extremely efficient mechanisms for acquiring customers. When you add up all our costs in Sales and Marketing (SaaS metric: CAC), the result is very small compared to the total revenue we’ll earn from than customer over the next few years (SaaS metric: LTV).
Of course that means we’ll be intentionally unprofitable for now, because the cost to acquire a customer is spent today, but the revenue takes years to trickle in. That should be OK since we’ll be profitable in the long run. But we also know many companies think this way but are not profitable in the long run.
How will we know whether we really have a profitable business underneath this “spend to grow” behavior?
Well, since we know that all our S&M (Sales and Marketing) costs is indeed money well-spent, let’s exempt that cost from our monthly profit calculation, and see whether we’re profitable! If yes, we’ll make that money back. If not, we’re not yet “truly” profitable.
They call the resulting metric EBITDASM (since it’s Earnings not only Before Interest, Taxes, Depreciation, and Amortization — a common way to measure profit — but also before Sales and Marketing).
I like this model, and we’ve used it to-date at WP Engine.
The problem with EBITDASM
Suppose a company has a high CAC compared with LTV, i.e. unlike Rackspace they’re not financially efficient at acquiring customers versus how much gross revenue those customers represent. Then an assumption above breaks down: it’s not smart for the company to spend as much as possible to acquire new customers.
What ratio of LTV:CAC is “good enough” that the logic about is sound? Some say 3. Some say 5 is truly healthy. Some day 1 is fine if it’s improving. The real answer will lie somewhere between lowering CAC, increasing customer retention, decreasing variable costs, increasing average revenue, overhead costs, and other metrics related to the definitions of CAC and LTV.
How to resolve this, objectively?
Faithful readers might at this moment have the flash of realization that I had when considering that litany of metrics — they’re the almost same litany that come together neatly in the definition of COC (Cost of Cancellation). It turns out that COC is the key to this metric of “underlying profitability.”
Framing the Solution: Steady-State profitability: SSEBITDA
Reframing the question leads us to the simple conclusion.
Let’s think of this metric as steady-state profitability, which I’ll abbreviate SSEBITDA. Meaning: “If we were neither growing nor shrinking — thus in a ‘steady-state’ — what would our profit margin be?”
Having read the previous article on COC, the formula is simple:
SSEBITDA = EBITDASM – COC = EBITDA + SM – COC
Justification: To find steady-state profit, take actual profit, but exclude Sales and Marketing costs (because in steady-state we’re not trying to grow, so we’re not spending to grow), but then include COC (because by definition that’s the replacement cost of cancellations, which we need to incur to prevent revenue from shrinking).
This neatly and objectively answers the questions around “are we truly ‘spending to grow’ or are we using growth as an excuse to in fact just be unprofitable?” Because if we’re profitable in steady-state — even if actual spend takes us into the red — we know that the fundamental financials are profitable.
Corollary: Profitable Growth Rate
Another interesting metric falls directly out of SSEBITDA — “Profitable Growth Rate,” i.e. the rate of revenue growth the company can self-fund while still being profitable.
Where p is the cost of a dollar of revenue (defined in the COC article):
Profitable Growth Rate = SSEBITDA / p
Justification: If we put 100% of the funds from steady-state profitability into growth, we spend p dollars to earn each dollar of new recurring revenue.
Any growth larger than that will require being unprofitable, by a known amount. This is handy, because now we can justify “spend to grow” with precision.
For example, if SSEBITDA is 12% and p is 4, the company can grow at 3%/mo using its own money. Supposing the company is willing and able to spend more to grow at 8%/mo, it will be unprofitable by 20% (5% growth over profitability, multiplied by spending 4 dollars to earn ever 1 dollar of revenue). A company in exactly this situation I think you can say with confidence is indeed “spending to grow” in a responsible manner, and will result a profitable business once the dust settles.
More thoughts on SSEBITDA
A negative SSEBITDA still isn’t necessarily a bad thing. It depends on the context and goals of the company.
For example, an earlier-stage high-tech SaaS company will be spending much more in R&D as a percentage of revenue than a later-stage company. Or a mid-stage company (like WP Engine) might have higher G&A spend (office space, finance, legal, HR) as a percentage of revenue, until it grows into those services. Those are expenses that eat into EBITDA and thus SSEBITDA, but that doesn’t mean the company won’t be profitable with larger scale.
Here’s a few thoughts around how I interpret the metric:
- Understand the pieces. If you’re negative because GPM is low or COC is high, that’s an unprofitable model, and you need to address the root causes. If you have intentionally high R&D costs because you’re investing in product, and a bump in G&A because you just moved into a new office space, you know those will right themselves over time. You might even calculate an “expected SSEBITDA after scale” where e.g R&D plus G&A costs total 30% of revenue and see how you’re doing.
- Watch it directionally. At WP Engine we watch it move month over month from negative to positive and then continue to grow. While you see a positive trend, not just in the overall metric but in the pieces underneath, and when you have a roadmap for years to come about how you’re going to continue improving those metrics, that’s healthy regardless of the absolute value of the metric today.
- Once positive, growing as a percentage of revenue could be less important. Consider that if SSEBITDA is steady 10% of revenue, and the company is growing, then in absolute dollars SSEBITDA is growing. Of course it’s always great to see improvement in this metric as a percentage, but certainly it’s logical for a company to turn some percentage points back into investment in the business for de-risking and further growth rather than maniacally increasing this metric.
What do you think?
Let’s continue thinking out loud in the comments.