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VIRTUA INSIGHTS
Nov

22

Mostly made up: Growth adjusted gross profit per employee

I made up a metric

First off, thanks to everyone who joined the “Mostly talent collective”. We had over 50 people join in the first week 🤯. The collective now includes candidates from companies like PwC, Bain, and McKinsey, all looking to join high growth startups🧠.

So, of course, I had to take the good boy for ice cream🍨 to celebrate.

Mostly metrics’ editor and chief: Wally

If you’re an employee looking for your dream job, you can get on board 👇🏾

And if you’re an employer looking to supercharge your finance, strategy, or operations muscles, find them here 👇🏾


Now on to the meat🥩and potatoes🥔 of today’s post - I teamed up with my friends at Virtua Research to bring a metric I’ve had bouncing around in my head for a couple of years to life.

It’s called Growth Adjusted Gross Profit per Employee.



Here’s how it works:

  1. Take a company’s Gross profit (Revenue less Cost of Goods Sold)

  2. Divide that by the number of employees they have on board (total headcount)

  3. Multiply that by (1 + y/y revenue growth)

Here’s an example comparing two fictional companies:

Company A:

  • Revenue of $120M

  • Gross Margin of 74%

  • Employee count of 500

  • Revenue growth rate of 30%

  • Step 1: $120M x 74% = Gross Profit of $89M

  • Step 2: $89M / 500 employees = $178K Gross Profit per Employee

  • Step 3: $178K x (1 + 30%) revenue growth rate = $231K per Employee

Company B:

  • Revenue of $200M

  • Gross Margin of 62%

  • Employee count of 1,500

  • Revenue growth rate of 60%

  • Step 1: $200M x 62% = Gross Profit of $124M

  • Step 2: $124M / 1,500 employees = $83K Gross Profit per Employee

  • Step 3: $83K x (1+ 60%) revenue growth rate = $133K per Employee

Company A comes out as the more efficient operator, and a potentially better bet. Even though Company A isn’t growing as fast as Company B, it has a healthier gross margin and is generating more Gross Profit per employee.

With that example under our belts, let’s get familiar with the formula’s components and why they’re important.



Gross Profit:

  • At the end of the day, the higher your gross profit, the more money you have to run the rest of the business.

  • A gross margin of 74% (a rough median for software companies) means that for every $1 the biz brings in, 74 cents is left over for salaries, rent, and other OPEX (including those ugly laptop backpacks they give out each year at your company sales kickoff).

  • Margins matter - take it from my friend Kyle Harrison, who dove into why Twilio is trading at a MASSIVE discount to other high growth SaaS companies like Atlassian and DataDog:

So when companies like Datadog and Atlassian are trading at ~10-15x revenue, why is Twilio down at ~1.5x revenue?

In part? Gross margins.

Remember that Twilio has ~50% gross margins.

Datadog? 77%
Atlassian? 84%
Cloudflare? 78%

Right out of the gate, that $2.8B in revenue? It’s costing Twilio ~2.5x more to get it.

-Kyle Harrison, Contrary Capital

I believe we should STOP talking so much about revenue multiples and START talking more about multiples of Gross Profit.

Why?

Well, as a friend of mine likes to say:

“I love Revenue, but if I fed my dog Revenue, he’d die. He needs Gross Profit to survive.”

Gross Profit is the lifeblood of any business. Companies can’t just trade a dollar for a dollar forever (unless it’s the Costco $1.38 hotdog).

Now, with that being said, you might say why don’t we just look at profitability?

I don’t want to over rotate and only size up companies based on their profitability. I think that too misses the forest through the trees when you are talking about high growth tech firms.

EBITDA multiples are cool, but there are times when you are chasing a market opportunity and it makes sense to burn cash, IF you can still protect your gross margin, which will eventually be your route to scalability. Tech markets come with windows of opportunity, and the difference between being #1 vs #2 in a market is huge.

Gross Profit per Employee

  • This is a remix of one of my favorite metrics, Revenue per Employee

  • Revenue per employee is a simple metric that cuts through all the noise

  • There’s no hiding from it - just take the amount of revenue you’re generating and divide it by the number of people on board

  • This should go up over time, and demonstrate leverage in your business model.

  • With Revenue per Employee, ideally you get close to $250K or $300k per person when you approach $100M in revenue

  • So for Gross Profit per Employee, ideally you get into the $200K to $250K range as you approach scale (on an annualized basis)

  • This is something companies should track closely to make sure they aren’t getting out over their skis with hiring during hyper growth

Revenue Growth Rate

  • Best measured on a TTM (trailing twelve month) basis

  • No matter how you slice it, high revenue growth covers up a lot of sins

  • The question this formula assess is… just how many sins?

So what’s the point?

The point of this formula is to balance business model scalability (Gross Profit) with operational leverage (Gross Profit per Head) and ability to execute on the sales side (Revenue growth rate).

When I look at a company to work for, advise, or invest in, I want to have faith in where they’re going. I’m very willing to accept that not all companies will be profitable RIGHT NOW.

Applying the metric in real life:

Here’s Crowdstrike ($CRWD) vs their Cyber Security sector cohort. You can see they are generating $15K to $25K above the industry median and average. It makes sense why investors are willing to pay a premium - not only is their Gross Profit healthier than most, they are generating it with a sensible number of employees on board, and growing faster than the sector. A few more examples…

A(nother) cybersecurity company outperforming: Palo Alto ($PANW)

A cybersecurity company on the rise: Sentinel One ($S)

A cybersecurity company underperforming: JAMF.

Putting it to use

This metric, in my (made up) opinion, is best used to compare high tech growth companies who are later in their lifecycles (+$100M ARR, post series C, or post IPO) with similar monetization models.

I think it’s also interesting to not only compare companies vs one another, but also check how a single company is trending over time - are they getting better at what they do?

I’m going to start tracking Growth adjusted gross profit per employee as my own personal “index” of sorts.

As a metrics wonk, it combines three of my favorite signals into one. I think looking purely at revenue multiples quarter to quarter is misleading. You can still go fast and grow like crazy, but have a rotten core that’s ripe for burn out.

And I don’t think we should only care about profitability. Like, how boring is that? If you want slow growth and high profitability, go buy a car wash or dry cleaning business. (I joke, I joke, I joke).

So there it is - Growth adjusted gross profit per employee.

Next time we revisit this metric we’ll size up the DevOps industry to see how companies are performing.


What I’ve been reading

As a business leader, you have a few big decisions that will 10x your growth or sink your business.

That’s why I’m a big fan of Brian and his newsletter. Every week he shares simple tips to help you make the big choices that grow your business.

Join 7,000+ business leaders and check out The Competitive Edge to help position your business to grow

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Quote I’ve been pondering

“At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.”

-Principal in Billy Madison

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Nov

08

Don't let the Rule of 40 rule your company

Why I think the Rule of 40 is lame

This Thursday I’ll be participating in a virtual event OpenView is putting on to roll out their 2022 SaaS Benchmarking Report. I’ve been a disciple of this report for +5 years, having built multiple annual operating plans off of the rich data set. To a CFO or FP&A professional in tech, it’s the holy grail of SaaS benchmarking.

Curt and Kyle at OV crunched the financial and operating metrics of 660 private SaaS companies so you don’t have to.

RSVP for the event and gain early access to the report here👇

In addition to the lucrative appearance fee I’ll be collecting, I also received early access to the data. While thumbing through it, their recent analysis on the Rule of 40 caught my eye. You may have heard of this metric - like the Undertaker, it’s risen from the dead during the latest tech market correction.

Im Back Wake Up GIF
Wakey wakey, Rule of 40!

At the risk of ruffling some feathers, it’s time for me to come clean - I think the Rule of 40 is lame. Let’s dig into why.

Disclosure: OpenView did not actually pay me anything to participate, however, I did stop by their office for happy hour two weeks ago and enjoyed two (free) Miller Lites and one (free) cupcake.

What’s the Rule of 40%?

Continue reading...

The Art:

Trying to measure efficiency when you’re losing money can be a mixed bag of burritos. Some businesses raise a ton of money so they can prioritize growth at all costs (see: Gitlab). Other businesses are designed to run like a money printer, spitting out free cash flow and fat dividends for shareholders (see: Qualcomm).

But for many businesses, the truth lies somewhere in the middle. Some investors validate a “good” balance between growth and profitability by checking if revenue growth rate plus profit (or loss) rate exceeds 40%.

The Science:

Source: OpenView 2022 Benchmarking Report
Rule of 40 = YoY ARR Growth + LTM EBITDA Margin > 40%

So, if you’re growing at 50% y/y and have a -15% EBITDA margin, your Rule of 40% = 35%…womp womp.

Where does the Rule of 40 go wrong?

I have four bones to pick with the Rule of 40:

  1. It ignores where you are in your business lifecycle.

  2. You can game it with superior growth.

  3. It’s a hard target to keep consistent in all periods, due to seasonality

  4. It’s a lowish bar if you want to be great.

I took a trip in the way back machine using Virtua Research’s lifecycle analysis tool to stress test a cohort of companies in the four quarters leading up to (Q-4 through Q-1) and immediately preceding (Q+1 through Q+4) their IPO (Q0).

The research is based on a selection of 60 PLG companies, in honor of OpenView.

Here are my arguments against a dogmatic adherence to the Rule of 40:

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It ignores where you are in your business lifecycle

WorkDay was a solid investment if you bought in when they went public, and maintains a strong financial profile to this day. However, their Rule of 40 took a major dip at time of IPO as they made some investments in the business to scale.

Nonetheless, their stock price jumped 72% on day of IPO. If you religiously followed the Rule of 40 you would have dumped them, and kicked yourself down the road.

Source: Virtua Research, $WORK Rule of 40

There are times to step on the gas pedal and say damn the torpedoes. There are also times to get to an efficient P&L in a hurry. Just because you are in one season rather than another doesn’t mean you are necessarily a “bad” company.

Takeaway: Not all periods are the same. And not all periods should be 40%.

You can game it by going big on just growth

I also think there are diminishing returns past a certain growth rate. Investors aren’t necessarily going to pay any extra for 125% growth vs 110% growth if you are losing 50% per year.

However, adhering to the Rule of 40 in a bubble would give you the vote of approval on growth of 140% and losses of 100%. Talk about false signals.

Takeaway: Not all growth percentage points are created equal.

It’s a hard target to keep consistent in all periods, due to seasonality

$SMAR Rule of 40

Here’s SmartSheet. They oscillate between a low of 35% and a high of 48%. It looks like one of those Inflatable Whacky Willys at the used car markets.

I highly doubt when they touched 35% their CEO yelled “HALT THE PRESS! We must get back to 40!”

It’s difficult to run your operations and stay at a consistent Rule of 40 output. Life just doesn’t work like that, especially if you skew heavily towards Q4 seasonality and an elongated enterprise sales motion.

Takeaway: The Rule of 40 is a a general target to work to in the long term, not something to nail period to period.

It’s a lowish bar

$SNOW Rule of 40

Peep Snowflake’s Rule of 40. They have every right to rename the metric the Rule of 60, since that’s where the Y axis starts. They were able to become efficient with scale, driving better bottom line margins at the same time their revenue grew leaps and bounds.

And here’s DataDog. It’s a similar story. The closest they come to 40% is 70%, a full 30% ahead of the “target”.

$DDOG Rule of 40

Finally, here’s the average and median across that cohort of 60 PLG SaaS companies.

PLG Average and Median Rule of 40

You can see the average is closer to 50% and median closer to 45%.

Takeaway: Hitting 40 is more average than excellent, and no one wants to build an average company.


Conclusion

As OpenView explains,

Rule of 40 has always been a solid gut check for the general balance of a company’s growth and profitability. However, it’s become increasingly important as a driver of how businesses are valued. For earlier stage companies, Rule of 40 can vary widely from quarter to quarter. Achieving 40 each quarter is not required. But, it is required to have a grasp on what caused a drop or spike, and what can be done to get to 40 long term.

I’d go a step further and amend the last phrase to: “what can be done to consistently operate above 40 in the long term.”

Maybe it makes sense for stock market pickers to use the Rule of 40 as a “sanity” check. But as someone responsible for making sure the trains run on time, I don’t think the Rule of 40 is very useful, for all the reasons outlined above.

Agree? Disagree? Come tell us at the event on Thursday November 12th at 12 EST. When you register you’ll get a copy of the report.

What I’ve Been Reading

Speaking of PLG… I was recently turned on to Top of the Lyne: Hard data. Deep research. Jaw-dropping insights. And the freshest memes. The art and science of product-led growth. Recommended by 7,000+ revenue leaders from Canva, Stripe, Notion, Figma, and 1,000s of other PLG companies.

Subscribe to Top of the Lyne

Quote I’ve Been Pondering

“If you can fill the unforgiving minute

With sixty seconds’ of distance run,

Yours is the Earth and everything that’s in it…”

-Rudyard Kipling, If

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