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 post, written in collaboration with Pavel Prokofiev, ACA from RollUpEurope, 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.
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 unrooted in value creation.
Key Metrics
Next, we will discuss key metrics that should be the primary focus of SaaS rollups and best practices for utilizing these metrics effectively.
Invested Capital
A key factor in determining the return on invested capital (“ROIC”) is invested capital, which refers to an acquisition’s purchase price when considered on a debt-free and cash-free basis and can serve as an avenue for creating additional value.
For instance, consider the scenario of acquiring a software business with an average net working capital equal to 0% of its net revenue. In contrast, suppose similar businesses operate with a net working capital deficit of 10%. Suppose the purchase price is set at 1x net revenue and proactive management strategies are employed to reduce net working capital to negative 10% post-acquisition. In that case, it is possible to generate excess cash that can be extracted after closing the deal. This excess cash flow amounts to 10% of the purchase price, effectively reducing the invested capital and boosting the return on invested capital.
Hurdle rate
The hurdle rate or internal rate of return (“IRR”) represents the yield on each acquired asset. It comprises two key components: ROIC and the terminal value. For buy-and-sell investors like private equity firms, the terminal value coincides with the exit price. In contrast, for serial acquirers that reinvest capital perpetually rather than return it to investors within a given timeframe, this value is often assumed based on a terminal value multiple or a perpetual growth model. Crucially, serial acquirers should be cautious about assuming substantial multiple expansion over the investment horizon and aim for the most returns to derive from free cash flow (“FCF”) growth.
Top-tier serial acquirers consistently achieve IRR exceeding 20%, mirroring the performance of private equity firms, and sustain these returns indefinitely.
Return on Invested Capital (ROIC)
ROIC, or return on invested capital, is an elegantly simple metric. While there are various definitions of ROIC, its straightforward form involves, as defined earlier, dividing after-tax cash flow by invested capital.
For instance, if you purchase a business with $1 million in EBITDA at 5x EBITDA with a 30% corporate tax rate, your immediate ROIC would be $0.7 million divided by $5 million, a 14% return. Essentially, this metric measures the cash return on your investment. ROIC serves as a fundamental element of perpetual acquirer return. Even if you were to sell this asset in 5 years for the same price, maintaining the same EBITDA each year, the internal rate of return would remain at 14% on an unlevered basis.
Going a step further, a serial acquirer who refrains from distributing free cash flow can leverage this 14% return to acquire another business, ideally with a comparable ROIC, thus compounding returns indefinitely, which is what Constellation Software has been doing for over 20 years.
ROIC + Organic Growth
This metric represents an evolution of the ROIC formula. In scenarios where a rollup’s strategy involves acquiring a stagnant business, both key performance indicators essentially align. However, when dealing with a growing business, it’s common to observe a lower ROIC at the time of acquisition or during the initial years because the EBITDA of a growing business tends to be less than that of a stagnant one partially due to higher reinvestment.
Additionally, a business experiencing a 20% annual growth rate often commands a higher EBITDA multiple than a stagnant counterpart. As a result, by amalgamating ROIC with organic growth, a roll-up can factor in both the FCF yield on the investment and top-line growth. This combination can positively impact future FCF, ultimately enhancing the terminal value.
Per share metrics
Publicly-listed acquirers highly value per-share metrics. Their importance lies in the fact that most serial acquirers are highly profitable, allowing them to reinvest all their excess cash flow into acquiring more businesses. This distinguishes them from other enterprises that must continually seek equity financing for new acquisitions. While debt can also enhance per-share earnings and cash flow, it’s crucial to consider the interest and tax implications of taking on additional debt.
For top-tier serial acquirers, metrics like FCF, earnings per share, and others should consistently demonstrate growth. Share buybacks should be used judiciously, typically only during turbulent periods or recessions when market valuations significantly deviate from their long-term averages.
SaaS metrics
While financial metrics are helpful, they are often lagging indicators. Understanding the underlying economics of how SaaS metrics such as customer growth rate, time to value, and churn affect financial performance is critical. Properly analyzing data by being cautious of averages, splicing data in different ways, identifying whether there are different trends at varying price points, and understanding product stickiness across different cohorts are all sound principles to follow when analyzing SaaS metrics.
Using metrics effectively
There is no one-size-fits-all approach to acquisitions because every opportunity is unique. At SureSwift Capital, we apply an assortment of metrics such as gross margin growth, the ratio of customer acquisition cost and lifetime value of a customer, year-over-year annual recurring revenue growth, a 20% cash-on-cash annualized return target, and weigh metrics according to each opportunity. No single metric tells the whole story, and analyzing a combination of relevant metrics to see if they all point in the right direction helps identify opportunities that generate long-term value.
Beyond metrics, it is also important to have the right culture and operational processes to ensure employees follow the due diligence process appropriately. Monthly reviews, quarterly business performance and strategy discussions, meaningful incentive compensation based on personal, business unit, and group performance, identifying and communicating values, and including data-driven accountability are all measures that promote transparency, accountability, fairness, and responsible governance that translate to reliable investment returns in the long term.
In conclusion, SaaS rollups must avoid vanity metrics and focus on the metrics that matter for the investor, use a combination of key metrics, deeply understand the underlying economics of the business and the drivers of financial performance, and uphold transparency and responsible governance to create a culture that can implement these best practices effectively.
For additional insights, please visit the SureSwift Capital website or check out RollUpEurope’s blog which dives into how SaaS rollups should operate and utilize metrics effectively and other helpful topics.
