SaaS rollup vanity metrics: Part 2

In the age of information, it can be difficult to differentiate data that matters from data that doesn’t. SaaS rollups often encounter metrics which may indicate growth on the surface but don’t prove to add value in the long term – we call these “vanity metrics.”

This two-part series, written by Don Wharton in collaboration with Pavel Prokofiev, will discuss:

• Some of the most common vanity metrics,

• How SaaS rollups can utilize key metrics to identify attractive opportunities, and

• Best practices for using metrics to generate long-term value.

Link to Part 2.

The importance of identifying the right metrics

The primary aim of SaaS rollups are to maximize shareholder returns by prioritizing the generation of excess cash flow and appropriately reinvesting it in either additional acquisitions (compounding), reinvesting into the businesses (organic growth), or returning capital to investors (cash return).

While many investors tend to equate SaaS rollups with SaaS companies, we contend that SaaS rollups represent a distinct asset class. Although metrics such as the rule of 40 and gross churn may hold significance for individual SaaS companies, such metrics often overlook crucial considerations of the acquisition cost of each asset and how excess cash flow is deployed. To distinguish vanity metrics from useful metrics, SaaS rollups must focus on the metrics that prove value creation for the investor.

The most common vanity metrics

Total Addressable Market

Total addressable market (“TAM”) is a favorite among startup companies, particularly for those that do not have significant revenue or other quantifiable metrics that measure success. Critically, startups’ high chance of failure necessitates high payoffs for the few that succeed. Early-stage investors, therefore, must determine if the companies they invest in have a large enough market to support potential outsized gains as multi-baggers. TAM is frequently used to evaluate this market potential

Without digging too deeply into issues regarding the viability of capturing TAM and how changes in assumptions can drastically alter estimates of the metric, many companies become successful by focusing on core features that distinguish the product for a niche, which theoretically lowers TAM, instead of attempting to appeal the broadest user base possible. Furthermore, shifting macroeconomic conditions, changes in interest rate policies, and a renewed focus on profits can quickly alter perceptions of the importance of TAM. While TAM may deserve a brief mention on a single slide in a pitch deck, any more emphasis on the metric is likely unwarranted.

Synergies

The benefits of synergies are often cited to justify acquisition premiums in both public and private markets. However, a survey by Bain & Company of 352 global executives shows that overestimating synergies was the second most common reason for disappointing deal outcomes. The truth is that estimates of synergies tend to be overly optimistic, and SaaS rollups that assume these benefits overpay for their acquisitions.

The reasons for overestimation are complex and include overestimating the benefits of increased scale, underestimating overhead costs or cultural differences that can cause organizational friction, and other unexpected issues. As a rule, SaaS rollups should not pay for estimated benefits of synergies that generally do not materialize and should focus on cost-cutting, cross-selling, and other operational efficiencies.

Rule of 40

Rule of 40, the principle that a software company’s combined revenue growth rate and profit margin should equal or exceed 40%, has gained more widespread usage in the SaaS industry in recent years. Breaking down the metric into its components, revenue growth may not indicate that value is added if growth is generated purely for the sake of growth. Profit margin implies value creation and a potential increase in shareholder value. However, because the rule of 40 does not measure profitability and growth per unit, such as profit per share, the metric is more applicable to individual SaaS companies instead of SaaS rollups where return on invested capital is critical.

Full-time employees

The growth in the number of full-time employees (“FTEs”) is another metric frequently used to convey company performance. Creating jobs in one’s community, providing opportunities for new graduates, empowering hard-working employees to climb the career ladder, and fostering an inclusive environment where people of different backgrounds can thrive are noble goals for any organization. However, as a standalone metric, it does not help determine if an increase in FTEs is creating value over the long term or improving the satisfaction of employees in the organization.

When analyzing the financial impact of FTEs, the metric should be expanded to revenue per full-time employee combined with metrics such as profit margins to determine efficiency. When assessing factors relating to employee satisfaction, pay equality, opportunities for professional development, results from employee satisfaction surveys, and feedback from 1-on-1 meetings should be considered. Without additional context, the number of FTEs can create a false sense of growth not grounded in value creation.