As growth investors at Bessemer, we hear the same benchmarking questions over and over from portfolio companies as they third and final mercury What should my gross margin be? How does my growth rate compare to peers in the market? Leaderslike youwant to model their businesses around these benchmarks to achieve their goals. There is a problem, though. Private market financial fcf/revenue are some of the most elusive financial data points in the world. They are also some of the most helpful.
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Understanding Free Cash Flow to Revenue
The purest test of a management team and its operational discipline is arguably how well it can maintain strong shareholder returns as the business matures. As businesses near the top of their initial S-curve, revenue growth tends to go here and free cash flow becomes more fcf/revenue. However, the companies we analyzed had a median last 12 months LTM free cash flow of just 10 percent of revenue. Spending needs to align with realistic growth forecasts, and growth fcf/revenue existing customers driven by customer retention, cross-sell, and upsell takes on greater significance. But McKinsey research finds that barely one-third of software companies achieve the Rule of
Free cash flow determines profitability. As investors, we want to ensure that as a business consumes money for product, go-to-market, and administrative needs, it is doing so prudently.
While it is favorable for businesses to generate cash, in the cloud economy, sometimes generating that cash sacrifices revenue growth that might otherwise be acquired with more aggressive spending.
When looking at burn for a cloud business, we want to consider it in the context of growth. As this hypothetical suggests, investors look at the cash consumption of a business relative to the revenue that it generates, which is why the efficiency score becomes a helpful metric. Younger companies tend to have higher growth rates and higher burn rates, and companies at maturity have lower growth rates and lower burn and sometimes cash flow positivity.
The Cash Conversion Score CCS is another metric that we often use to evaluate whether or not the capital that cloud companies raise and consume is generating a meaningful return. As the ratio of the ARR to total capital invested into a company minus cash, the Cash Conversion Score is effectively the return-on-investment of each dollar ever invested into a company.
For both founders and investors, the Cash Conversion Score is, therefore, a powerful proxy for returns. If a company has a CCS of 1. If we assume that the average cloud company gets a 10x revenue multiple more in-line with historical norms vs. Every dollar put into the company is getting a 10x return. Similarly, a company with a 0. ROI is not driven by Cash Conversion Score directly, but CCS indicates multi-year trends in a couple of incredibly important things, including product-market fit and a scalable sales and marketing organization.
It is therefore a core KPI we track in evaluating cloud businesses. The average Cash Conversion Score for cloud companies tends to increase as it matures, from an average of almost 0. Knowing the worth of a company matters to different constituents for different reasons: For founders, a higher round valuation might mean less dilution and ability to raise more capital and fund a new product or geography; for prospective employees, a lower valuation might mean more opportunity for upside and runway for career growth; and for current employees, a higher valuation might mean more value to their stock options.
But just as company metrics are obfuscated in the private markets, so too are private company valuations. In this lesson, we will dig into what private investors are willing to pay for cloud companies, looking at valuation multiples, round size, and dilution.
For cloud founders and executives looking to fundraise from VCs, understanding what multiple they will get is one of the biggest unknowns. In cloud, it is almost always a function of one thing: growth. As a consequence, the general rule is that higher growth rates command higher multiples. You might note that the valuation environment of the past decade was more conservative than that of , as we analyzed in the Cloud Benchmarks Report.
The average Cloud multiple in was 34x up from 9x in The valuations that different industries command can vary widely as well, oftentimes due to the size of TAM itself, but also because the specifics of selling into those markets correlate with different underlying growth rates. The industry that has commanded the highest multiples in the Bessemer portfolio over the past decade is fintech, with a 33x average, followed by security at 29x and data infrastructure at 27x; however, we have seen multiples as high as 50x and x in all three of these categories.
Today, though, we see a step-function change in the valuation environment for cloud companies, which we largely attribute to an increased quantum of capital in cloud, strong investor demand, and ongoing tailwinds that are driving growth rates to new heights.
Below, we look at only the Bessemer portfolio companies in cloud that transacted between and plot their growth rate relative to ARR. Round size is the other major lever that cloud companies can toggle when structuring a fundraise.
Knowing how much to raise at each stage of growth while balancing the tradeoff of dilution and runway is a tension that you will likely have to grapple with. For most companies, the ability to raise money is a key to success. Without financing, you could not hire the engineers, salespeople, and other talent you need to grow.
Given the negative cash flow dynamic that we covered in Lesson 2 , cloud companies are often reliant on the capital markets to maintain enough runway for operations. The irony, though, is that as companies prove their abilities to grow, raising money gets easier and easier.
Access to capital is easiest for those that do not need it. Investors are willing to give companies more money as their investments are de-risked, and companies are more willing to take it as it represents less dilution. Looking at the data validates this trend: As companies generate more revenue, their round sizes go up. Interestingly, even though the ARR buckets go up non-linearly, the round sizes go up linearly.
That means larger companies are not raising larger rounds proportional to the size of their ARR. As companies mature and their valuations grow, they understandably have to sell less of their businesses for the same quantum of capital—price per share goes up.
As a consequence, we see the dilution that founders take decreases with scale. How good is it? See rankings and related performance below. Zacks Rank Home - Zacks Rank resources in one place. Zacks Premium - The only way to fully access the Zacks Rank.
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Researching stocks has never been so easy or insightful as with the ZER Analyst and Snapshot reports. Boards are increasingly engaging leaders on this point. And the compensation committee of another large SaaS company has devised incentive plans for top executives tied to progress achieved against the Rule of The best will act in enlightened self-interest. By taking a hard look at what rate of growth the business can reasonably maintain and steering the organization to maintain it in the most efficient way possible, leaders can turn the Rule of 40 into a winning proposition for the organization and all its constituents.
Never miss an insight. We'll email you when new articles are published on this topic. Skip to main content. SaaS and the Rule of Keys to the critical value creation metric. By Paul Roche and Sid Tandon.
LinkedIn Twitter Facebook Email. We strive to provide individuals with disabilities equal access to our website. If you would like information about this content we will be happy to work with you. Net retention rate: An important measure of growth efficiency, this metric shows how effective the company is at driving growth in its existing customer base while keeping churn low the median for top-quartile SaaS companies is percent; bottom quartile is percent.
Last 12 months LTM median payback period 1 1. The LTM median payback period is calculated as sales and marketing spend over the prior quarter divided by the sum of net new ARR multiplied by gross margin.
FCF is cash flow from operations minus capital expenditures. The correlation between the LTM FCF percentage and value multiples applies to both moderate and fast-growing companies in this size range, with moderate-growth companies seeing the highest correlation.
Our analysis shows that the top quartile within the moderate-growth band has a median FCF of 31 percent; bottom quartile is 15 percent. The top quartile for fast-growers more than 30 percent revenue growth rate is 26 percent; bottom quartile is 10 percent. About the author s. Sid Tandon Partner, Bay Area. Explore a career with us Search Openings. Related Articles. Article Developer Velocity at work: Key lessons from industry digital leaders.
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