Short-term vs long-term correlation between cash flow and ARR.

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Welcome to the 42nd edition of The Growth Elements Newsletter. Every Monday, I write an essay on growth metrics & experiments and business case studies.

Today’s piece is for 5,100+ founders, operators, and leaders from businesses like Shopify, Google, Sage, Hubspot, Servcorp, Zoho, Apollo and more.

Happy Monday!

Short-term vs long-term correlation between cash flow and ARR.

[1] 𝐒𝐚𝐚𝐒 𝐌𝐨𝐝𝐞𝐥 𝐂𝐡𝐚𝐥𝐥𝐞𝐧𝐠𝐞𝐬

► Model challenges are when valuing SaaS businesses, mainly due to the focus on recurring revenue and rapid growth.

[2] 𝐈𝐦𝐩𝐚𝐜𝐭 𝐨𝐧 𝐏&𝐋 𝐚𝐧𝐝 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰

► Faster growth in acquiring new customers can impact P&L and cash flow in the short term.

► It is mainly because the SaaS business's CAC is much higher, and it needs to make substantial upfront investments to acquire customers.

► This leads to higher expenses upfront and a delayed recouping of profits over a more extended period.

[3] 𝐕𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 𝐌𝐞𝐭𝐫𝐢𝐜𝐬

► High growth rates can result in lower current earnings and cash flow, as revenue generated from new customers may not immediately offset the initial CAC.

► However, despite the apparent strain on short-term financial metrics, the strong foundation of recurring revenue and KPIs signals the potential for significant future profitability.

[4] 𝐀𝐑𝐑 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞𝐬 𝐯𝐬 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞𝐬 

► Traditional valuation metrics, such as earnings multiples, may not accurately reflect the value of fast-growing SaaS start-ups.

► Instead, alternative metrics like ARR multiples have gained popularity.

► ARR multiples consider the predictable and recurring nature of SaaS revenue streams, providing a more accurate representation of the business’s long-term earning potential.

[5] 𝐕𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 𝐟𝐨𝐫 𝐒𝐦𝐚𝐥𝐥, 𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐥𝐞 𝐒𝐚𝐚𝐒 𝐂𝐨𝐦𝐩𝐚𝐧𝐢𝐞𝐬

► For smaller SaaS companies that are profitable but not experiencing rapid growth, the impact on P&L and cash flow may not be as pronounced.

► In these cases, historical and current earnings remain important indicators for estimating future earnings potential

𝐅𝐢𝐧𝐚𝐥 𝐖𝐨𝐫𝐝𝐬

► In summary, the impact of faster growth on P&L and cash flow underscores the need for alternative valuation metrics like ARR multiples in the SaaS industry.

► These metrics better capture the long-term earning potential of fast-growing companies, which traditional earnings multiples may not accurately reflect.

That's it for today's article! I hope you found this essay insightful.

Wishing you a productive week ahead!

I always appreciate you reading.

Thanks,
Chintan Maisuria