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Lessons from Peaches 🍑
When SaaS metrics are a dime a dozen, how do you know if the juice is worth the squeeze?
If you know me, you’ll know I’m a diehard Philadelphia Eagles fan. One of my favorite fantasy football Twitter follows is Jakob Sanderson. Back in November, Jakob made an intriguing observation about… peaches.
“Peaches purchased in British Columbia taste best when they are cheapest to buy.”
I promise there’s a connection to cloud companies.
I didn’t realize this before reading Jakob’s post, but it turns out that British Columbia is known for peach farming. The peach harvest takes place from July to September, coinciding with the fruit's peak ripeness. This results in an abundance of peaches flooding the markets during these months. Lower shipping and storage costs during this period result in further-reduced prices. For a shopper in British Columbia, it would be reasonable to assume that cheaper peaches are tastier.
If I lived in British Columbia, and had a lot of time on my hands, I could bring a clipboard to the grocery store and record peach prices daily. When prices dropped to the bottom quartile, it would be an opportune moment to pounce and buy up all the less-expensive, perfectly-ripe peaches. This method would likely yield positive results for a peach connoisseur.
But, logically speaking, the price of a peach has no direct impact on its quality. The taste of the peaches would remain the same regardless of price: If there were a labor shortage driving up shipping and storage costs, for example, it would render the summer peaches more expensive, but no less delicious overall.
To extend the peach metaphor to cloud startups: When you buy a peach, you won’t know how sweet it is until the first bite. Similarly, you don’t know if the terminal value of your company has been maximized until it is achieved in the future. Founders must therefore focus on the variables that can be optimized in the short-term.
In the last market cycle, growth was prioritized by startup leadership and by investors. But it’s critically important to remember that revenue growth is only a proxy for success and not the sole causal determinant. As the investment cycle changes, it becomes necessary to re-evaluate the proxies we use for long-term value creation.
For the past several years, we’ve published analysis on the “Four Zones” of the Rule of 40, which are as follows:
Red Zone: the “Strivers” (Below the Rule of 40, <30% Growth)
Yellow Zone: the “Pacers” (Above the Rule of 40, <30% Growth)
Blue Zone: the “Sprinters” (Below Rule of 40, >30% Growth)
Green Zone: the “Compounders” (Above the Rule of 40, >30% Growth)
If you’re unfamiliar with the “Rule of 40,” it is a popular concept that states a SaaS company’s combined growth rate and profit margin should exceed 40%. The “Rule of 40” is a strong metric, but by definition it weighs growth and profitability equally. In different market environments, investor weighting can look very different.
There is a natural tradeoff between growth and profitability in the SaaS model. A great explainer for why comes from David Skok in the first blog post I read as part of my onboarding at Battery.
Because of the tradeoff between growth and profitability, it’s just not that useful or productive to tell a founder to “grow faster and be more profitable,” which is what the evocation to “get above the Rule of 40” feels like.
We think it is much more actionable for founders to use the "Four Zones" where companies are grouped +/- Rule of 40 AND +/- 30% NTM revenue growth as a tool to decipher investor sentiment when deciding where to lean in.
When we first started tracking this concept in 2019, the Sprinters (in blue) had a higher revenue multiple than the Pacers (in yellow).
In other words, fast growing companies below the Rule of 40 were valued more highly than slow growing companies above Rule of 40. Growth outweighed profitability, with investors seemingly showing confidence that the Sprinters of today would become the Compounders of tomorrow (which are valued most highly in any market environment). It wasn't prudent to optimize for Rule of 40 at the expense of growth.
This stayed true until Q1 2022, where the zones flipped. The Pacers overtook the Sprinters for the first time since we began this exercise. Profitability was valued more highly than growth!
This remains true today. Our proxy on value creation from years past — that investors would reward higher growth at the expense of Rule of 40 — has become less true and we needed to adjust our thinking as a result.
Let’s return to the peach example. Suppose others catch on to my strategy to get the tastiest peaches and decide to copy my approach. Suddenly, the grocery store is filled with people walking around with clipboards, tracking peach prices and buying them on low-priced days (with conviction!).
Eventually, soaring demand during this in-season period will drive summer peach prices up and the lack of demand for the higher-priced, out-of-season peaches will necessitate reductions in price. The peach market will adjust and price will no longer be a reliable indicator of taste to shoppers.
In recent years, venture capitalists played the role of clipboard-wielding shoppers — but for startup investments, not peaches. Instead of jotting down produce prices, investors tracked ARR growth rates and allocated dollars to the "best" companies accordingly. As capital flooded into a select group of startups, their valuations soared; Companies prioritized growth over profitability, consuming large amounts of capital in pursuit of rapid expansion.
Today, as investors increasingly prioritize efficiency, companies with the highest valuation multiples are now the ones facing the most significant challenges. It's not just that these companies with the highest valuations are taking the biggest hit. The "growth at all costs" approach led many companies to become structurally unprofitable.
Instead of transitioning from being a Sprinter into a Pacer, companies became Strivers as soon as market demand for their products weakened. Factors like poor unit economics or less-stable-than-anticipated customer bases made it impossible for these companies to become "profitable at all costs."
There's a risk that this could become a recursive loop: As investors shift their focuses to more profitable businesses (the Pacers), they may inadvertently invest in stagnating businesses with less promising future outlooks than their less-profitable, higher-growth peers.
Revenue multiple is itself a proxy for future value — these Pacers might eventually be assessed with an EBITDA multiple, causing them to re-rate downward.
Where does all of this lead us?
Founders should consume as much data as they can to figure out the best proxies for success. Alongside their board, they should come to their own judgment on which metrics are most predictive of long-term success, and keep a flexible mindset as things change. In the current market, we suggest using APE (“ARR per Employee”) as a north star alongside growth.
As an investor, the takeaway is certainly not to deprioritize high growth-businesses. But I am focusing not only on companies that are growing well today, but those that have a chance at becoming Compounder (30% growth and above Rule of 40). This is rarified air: Only four cloud companies — Cloudflare, CloudStrike, Snowflake and Zscaler — are in that zone today, down from fifteen at the end of 2021 (!), but they don’t go out of style.
Just like in the peach market, the best opportunities may not be found by following the clipboard crowd, but by staying adaptable and focusing on the fundamentals.
The information contained herein is based solely on the opinions of Brandon Gleklen and nothing should be construed as investment advice. This material is provided for informational purposes, and it is not, and may not be relied on in any manner as, legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or investment vehicle managed by Battery Ventures or any other Battery entity.
This information covers investment and market activity, industry or sector trends, or other broad-based economic or market conditions and is for educational purposes. The anecdotal examples throughout are intended for an audience of entrepreneurs in their attempt to build their businesses and not recommendations or endorsements of any particular business.
Content obtained from third-party sources, although believed to be reliable, has not been independently verified as to its accuracy or completeness and cannot be guaranteed. Battery Ventures has no obligation to update, modify or amend the content of this post nor notify its readers in the event that any information, opinion, projection, forecast or estimate included, changes or subsequently becomes inaccurate.