Why you should look at SaaS businesses with no EBITDA
The best SaaS businesses are investing their gross profits into growth because they know that bigger businesses get higher multiples. So the smartest SaaS founders and CEOs are not taking profit – they are focused on growth and investing the money that could be pulled out on either marketing experiments or proven marketing strategies.
The majority of SaaS businesses are investing their gross profits into growth because all the upstream buyers are interested in revenue, not profit. Given that VC’s, institutional investors and public companies don’t care about profit, the metric that most SaaS businesses focus on is growth.
There’s an arbitrage opportunity right now in this industry. As traditional PE firms run out of brick and mortar businesses to acquire, more and more of them will move into this space
If you limit your search to only companies showing a net profit, this will significantly reduce the number of businesses you can look at. Essentially, you’ll be limited to lifestyle businesses that have bootstrapped slow or no growth over time. Opening your search to businesses not showing a profit, will significantly increase your deal flow.
Many SaaS businesses that don’t show EBITDA on their P&L’s are still extremely healthy. The industry wisdom is the Rule of 40, which essentially says that if a SaaS business’s annual growth rate + net profits add up to 40% or more, then the business is healthy. A lot of SaaS businesses have gross profit margins above 70%. So if the growth rate on a $0 EBITDA business is above 40% and the gross margins are above 70%, some or all of the money being used to fuel growth could instead be taken as profit immediately.
Alternatively, since many upstream buyers are looking for revenue, if your business model is to buy, grow and sell, then you have a bigger opportunity in maintaining the growth. If a business has proven their growth rate, you can continue the trajectory and exit at a higher multiple down the road because the multiple increases as the revenue increases. You could also continue the growth for 2 years and then start taking profit for 3 years, for example, if your strategy is to sell to profit-driven buyers.
The metrics you should be looking at are Gross Margins and Growth Rate – not EBITDA.
Additionally, there’s an arbitrage opportunity right now in this industry. As traditional PE firms run out of brick and mortar businesses to acquire, more and more of them will move into this space. They are currently paying 12 – 15x EBITDA for traditional businesses, and once they saturate the online space, the multiples of today will be pushed up to those levels. So a business that you can buy today on a multiple of ARR with no EBITDA, can be converted to profit-taking now (given the gross margins explanation above), and sold for a higher multiple 5 years down the road even without additional growth.