Yesterday, I was in a meeting with the CEO of a $6m SaaS company. In the context of his shareholders plan to exit in the next 18 to 24 months, he asked a classic question:
Prior to our near term exit, should I focus on growth or profit in my business planning?
He said he could increase sales and marketing by $1m to accelerate growth, however, it would reduce profits. In a SaaS business, it could be wise to invest $1m in sales and marketing if it brings only $0.6m worth of revenues during the year. If you enjoy 90%+ retention rates, as his company does, even calculating out just three years makes the investment look smart as it generates $1.6m in revenues and still leaves the company with an annual subscription business of roughly $0.5m in year four and beyond. The NPV of the future cash flows makes the sales and marketing investment - economically speaking - a wise decision.
However, what is the impact on next years M&A process? To answer the question, we need to look at the market segment the company is operating in, its competitive landscape and its potential acquirers. For instance, if you are the first mover and clear leader in a newly emerging market, you would probably be best off focusing on growth. If you, as our CEO, are operating in a mature market that is very fragmented and in a consolidation phase, you need to more heavily consider what the negative impact might be on the companys valuation when increasing growth at the expense of profits.
As per our CEO, his company will grow faster than his industry peers at 15-20% while maintaining sales and marketing spend at current levels, and will generate approximately 30% EBIT next year (lets call this plan SQ for status quo). He and his board are pondering an alternative strategy to accelerate growth as discussed above. Our CEO estimates he could increase growth to an impressive 30%, however, the profits would then only come in at 10% (lets call this IG for increased growth).
Does the higher growth rate in plan IG help increase the value of the company versus the stronger profitability in plan SQ?
The value to a strategic buyer not already possessing similar technology should remain high relative to revenues regardless of the profit levels, as the acquirer should be winning a lot more than just a profit stream (i.e., entry into a complementary market, securing a must-have technology in order to stay competitive, establishing leadership in new geographies, etc). Nevertheless, CEOs and CFOs of acquirers will have an easier time to get approval on an acquisition that is also accretive, so you do need to concern yourself with profitability.
If an acquirer is willing to pay 3x revenues for the company next year, that would translate to a 10x profit multiple in the case of plan SQ. To achieve the same valuation with plan IG, the buyers board would need to approve paying a slightly less 2.7x multiple on revenues, HOWEVER, a whopping 26x EBIT multiple. You answer yourself, with all other things being equal, which formula will be more comfortable for a buyer when evaluating the acquisition of a target in a consolidating space with a larger number of players?