Executives of enterprise software and tech-enabled organizations are beginning to shift their attention to the profitability—instead of the growth—side of the Rule of 40. The rationale? Compressed valuations, rising interest rates, and the looming prospect of a recession—even if economists present mixed views about the potential severity and duration of it.
The growth-over-profitability mindset that prevailed over the past decade is now giving way to a preference for “intelligent scale” through efficient, profitable growth.
The current environment is focused on preserving—or even improving—margins. Given that reality, software and tech-enabled companies that understand key metrics and then utilize them to guide business decisions are more likely to emerge from the current conditions in a position of strength.
Retention—in particular, net revenue retention (NRR) and gross revenue retention (GRR)—has become the critical north star for SaaS/subscription businesses. New logo acquisition will become even more challenging as IT spending slows from 2021 levels: Gartner revised its projected 2022 increase in IT spending downward from 5% to 3% due to expected spending cutbacks.
It’s critical, then, that executives focus on retaining and expanding their current install base in order to drive profitable growth during an economic downturn. Protecting and growing wallet share of existing customers is the most efficient way to achieve profitable growth, leveraging the true flywheel power of the subscription business model.
In West Monroe’s High-Tech & Software Executive Poll—Q2 2022, 21% of executives said their primary vehicle for new growth was increasing the user base at existing clients—the second-highest response behind selling new features and functionality.
Revenue efficiency metrics should guide go-to-market capital allocation. Customer acquisition cost (CAC) ratios and payback periods tend to command the most attention in measuring how efficiently software and tech-enabled companies acquire recurring revenue. Leaders who understand the cost to serve across the customer journey can allocate capital more effectively toward go-to-market activities that generate the highest return on invested capital. Segmenting costs appropriately between acquisition (CAC), retention (customer retention cost, or CRC), and expansion (customer expansion costs, or CEC) provides leaders the visibility they need to make prudent investment decisions.
Unit economics tie everything together to guide profitability. Customer lifetime value (LTV) divided by acquisition cost is arguably the most important long-term measure of profitability and go-to-market effectiveness. SaaS/subscription businesses that have deep insight into churned and lost annual recurring revenue (ARR) through gross revenue retention are able to create strategies to mitigate churn, a key input into LTV calculations.
Prioritizing uplift in NRR rates drives higher average contract values (ACVs), which result in higher LTV/CAC multiples. With a greater proportion of near-term growth likely to come from current customers, companies that do well in prioritizing and executing upselling and cross-selling strategies will find themselves on a more efficient path to profitability.
Pricing power: Companies with defensible market positions and strong competitive advantages should continue to employ annual price escalators in contracts. Leveraging the durability of pricing power to apply price increases flows directly to gross margin and, at a minimum, helps offset higher costs. In West Monroe’s recent poll, 14% of executives said their primary vehicle for new revenue growth in the quarter was to raise prices.
Companies facing pricing challenges should also reevaluate their market positioning/value proposition, offering portfolio, and post-sales customer experience to help identify opportunities for delivering more incremental value. This can help align price increases with customers’ perceptions of value received and increase their amenability to price increases.
Finally, although acquisitions are often catalysts for expansion through whitespace opportunities or adjacent market opportunities, it is particularly important not to lose sight of existing customers. Companies pursuing growth through acquisition should carefully evaluate product/platform strategy during due diligence and post-merger integration to make sure they are consolidating legacy products in a manner that protects and/or expands current customers’ perceptions of value and willingness to accept price increases.
Data and insights: More than ever, decisions-makers need timely and comprehensive access to the key metrics that drive enterprise value and competitive advantage. For example, data is essential to activating the right upsell and cross-sell opportunities with the right customers to drive profitable incremental growth and improve unit economics. While there may be pressure to cut costs in the short term, it is critical not just to maintain but double down on initiatives related to delivering an integrated technology environment with robust analytics and business intelligence capabilities.
Operating efficiency: High-tech and software organizations are at the center of making businesses digital—but they haven’t fully tapped their own potential to be digital, themselves. Revenue operations—or RevOps—is a coordinated approach to processes that span the customer journey and connect go-to-market systems to increase the velocity and efficiency of revenue moving through the lead-to-expand lifecycle. Introducing a RevOps methodology allows companies to increase front office efficiency by aligning elements of the organization’s operations that touch existing customers.
These steps will not only help you achieve profitability today—they’ll contribute to a more agile operational infrastructure that will be equally beneficial when economic conditions eventually improve and it is time to shift back to a growth-oriented strategy.
Additionally, by providing greater insight into the business, they can position your organization more effectively on either side of a merger and acquisition scenario. Acquisition activity remains high in the sector even during periods of economic downturn—tech giants buy more businesses to emerge strong, and smaller companies and start-ups become ripe for acquisition.
Buyers can rapidly assess how a potential target will fit into their business. Sellers can quickly provide prospective investors the data they need to conduct due diligence—and ideally command higher valuations through quality that backs up management estimates.
While no one has a crystal ball that will tell us where conditions stand a year—or two or three—down the road, these are well-tested strategies that can help you drive profitability in the near term while also putting your organization in a position of strength for the longer term.