Prepping for Exit - a Founder’s Perspective on M&A - Issue #27

At a Glance Large software companies are, increasingly, measured against the Rule of 40: the idea that growth rate plus profit margin should exceed 40%. Young companies often beat that mark with their rapid growth. But older companies, whose growth has tapered off, need to improve performance and profit margins to hit that metric. Beating the Rule of 40 in a single year is admirable, but the greater challenge is balancing growth and performance year after year.

The Rule of 50 In software and SaaS, it’s well understood that growth is rewarded with high valuations, and high profile exits. However, too often, this results in a “growth at any cost” mentality. For the best software businesses, growth is profitable, and private equity investors rightly invest heavily in growth. When the underlying cost model is profitable, and scaling well, the best companies can over-invest in growth and run at significant burn rates for extended periods. However, the growth imperative becomes a speculative strategy when a company’s underlying cost model is unprofitable. Some companies exit before the flaws in their business model are exposed, but most do not. When growth proves elusive, financing options become scarce, and company leaders can find themselves in a vicious cycle.

Fewer startups are pulling off an exit and achieving liquidity, and the pandemic could make the situation worse for growth-driven startups.

Venture capital activity has persisted in the COVID-19 era, as investors and founders have accepted virtual meetings as viable alternatives to the in-person standard.

What comes next: If society returns to “normal” at some point next year, will that also apply to pitch meetings, board meetings, etc?

Why it matters: One positive byproduct of the pandemic has been that investors have been more willing to entertain deals outside their ZIP codes.