Last week, the mobile-payments giant Square revealed its IPO prospectus and, on the surface, things looked great: Revenue jumped more than 54% (to $850 million) in 2014, and showed no sign of slowing. For a company started in 2009, that’s a lot of revenue. We should expect another record-breaking IPO, right?
Maybe not. Hidden below the jaw-dropping top line are a lot of signals that Square might not be on as solid financial ground as it appears. While revenue is indeed an all-time high, so are losses, which climbed to $150 million in 2014. The New York Times quoted critics arguing that Square’s core business doesn’t bring in enough money to justify its valuation, that it’s losing too much money on a per-customer basis, and that it’s vitally important partnership with Starbucks is rocky. In other words, the golden child of software-based payments is on shaky ground at best.
So what are we to make of Square’s prospectus? How do we evaluate a company that in so many ways dominates its market but is nevertheless bleeding money?
“A Number of Perspectives”
As the SaaS/tech marketplace has matured, one thing has become abundantly clear: Evaluating SaaS finances is a multifaceted and nuanced endeavor. There is no single number that measures financial health and, in fact, many are contradictory. Revenue must be tempered by profit margins, which in turn must encompass lifetime value and acquisition costs. As Square’s IPO filing shows, a robust revenue trend is only valuable if it is matched by strong unit economics.
The question of whether Square has the right unit economics to make it profitable long-term has always been top of mind. A recent article from Fast Company discusses the doubts around Square’s business model, and explains how the subtleties of software startup economics are perfectly exemplified by Square’s financial revelations.
“Square’s story has always been a nuanced one that defied simplistic narratives,” the article explains, “and its business can be looked at from a number of perspectives.”
What are those perspectives? The article singles out cash burn and profit margin as two of the most important ‒ and squirrely ‒ metrics that expose risks for Square. Like many tech companies, Square has long been thought to burn through cash and to be overly dependent on the thin margins common in the payment processing industry.
These concerns have dogged Square for years, and they’ve become even more worrisome (to investors, at least) in light of the company’s recent financial disclosures. These concerns are compounded by the fact that Square is a unique and (and uniquely complicated) case. The company is an interesting combination of software and hardware, and it is a nimble disruptor in the entrenched and heavily regulated payment processing space.
But hidden inside these financial revelations are some important insights for the larger SaaS/tech world. In this post, we look at the 3 SaaS finance questions that emerge from Square’s forthcoming IPO.
Are You Burning Through Money Too Quickly?
If there’s one principle that has held true throughout the SaaS world it’s that you gotta spend money to make money. Businesses, especially software companies, have a lot of startup costs, and they’re not expected to be profitable from day one (or, often, day one thousand).
But, with Square, the question of cash burn becomes even more complicated. The recently released numbers reveal that Square is churning through a lot of money. Like, a lot.
Here’s what a recent article from The Motley Fool has to say about Square’s operating costs.
“Like most startups, Square is incurring a larger amount of operating expenses, mostly related to product development that should ideally support future growth. Operating losses over the past four quarters has been about $145 million, and net losses have been $152 million.”
And it gets worse. A recent article from Inc. reports that Square is burning two-thirds of every single dollar it brings in through payment processing, which (unfortunately) makes up 95% of Square’s revenue. But it will get better, right? This is just the normal case of a tech company frontloading its spend to ensure market capitalization, right? Right?
Maybe not. Per Inc: “This isn’t the typical tech startup burn rate that will diminish over time; these aren’t startup expenses to hire lots of people, build up sales and marketing, or develop shiny new products,” the news source writes. “Square has some of those, too, but they’re outstripped by the fixed transaction costs that are growing along with the company’s core business.”
And there’s the important lesson for tech startups: high cash burn is ok (even preferable) if it is done early with a well-constructed plan for achieving more profitable growth down the line.
This is why SaaS startups, even if they’re years from going public, need to monitor their cash flow, and identify where it is going. If generating revenue at any cost is the goal, young companies will spend wildly to attract new customers. In the short term, this strategy makes sense. But, as Square shows, it’s not always sustainable.
Instead, growing software companies need to carefully track where their money is going, and how efficiently that spend is turning into revenue. Identifying cost centers that are not translating into revenue is one of the best ways for growing companies to straighten out their finances before they become too (or even irreversibly) out of whack.
Are You Growing in the Right Ways?
Burning through cash is just one part of the equation, though. Another thing Square’s disclosure made clear is that growth is only good if the ratio of revenue to losses is balanced (or at least trending in the right direction).
What affects this ratio? Well, in Square’s case, it’s the losses incurred from acquiring new customers and the amount of money paid for every dollar of revenue. For many startups, churn rate is also an essential factor in accurately assessing growth.
If your SaaS business is bringing in tons of new customers every month, but those customers aren’t staying customers ‒ or if they’re not profitable customers ‒ you’re going to have a problem. Churn kills subscription-based companies, and if you are growing your base but losing it just as quickly, you’re set up for disaster.
In Square’s case, churn rate isn’t as important as how much money it costs to bring in a dollar of revenue. Sure, Square experienced astronomical growth, but it did so by emphasizing rapid user-base growth over long-term profitability. Unwise partnership decisions and thin margins are likely to spook investors and position Square as a revenue giant that may never become a truly profitable one.
To avoid a similar fate, SaaS executives need to ensure that they are not just growing revenue, but growing healthfully.
Mamood Hamid, SaaS expert and venture capitalist, came up with a simple formula to measure this called the SaaS “Quick Ratio.” Instead of just measuring Monthly Recurring Revenue (MRR) growth, he looks at MRR growth compared to churn. This way, he can tell whether a company is growing so fast it’s hurting itself down the road, or whether it is doing so with an eye toward sustainable profitability.[contentblock id=153 img=gcb.png]
Are Your Unit Economics Scalable?
In the rush to build a customer base, many SaaS startups spend more to acquire customers than those customers give back in revenue, at least in their first year or two of their contracts.
In the software startup world there has always been a generally accepted philosophy that finding a market and acquiring customers is much more important than being profitable. This argument is based on sound logic, but it can also swing too far in that direction. In truth, software companies ‒ especially B2B ones ‒ need to find a balance between rapid growth and sound unit economics.
At some point, your company will be judged by its profitability (I know ‒ scary, right?), which means that, even early in the game, you need to make sure you have a plan for not just attracting new customers, but ensuring that every new customer has a positive impact on your bottom line, not just your top line.
None of this is to say that Square won’t be profitable, or that its unit economics will prevent it from being successful. It’s just a reminder that it’s far too easy for startups to focus on growth at the expense of long-term profitability. Not every startup has a celebrity CEO, mountains of venture capital, or friends in high places. Most startups have to be both scrappy and prudent, aggressive and farsighted. And, more often than not, this means carefully balancing early growth with unit economics that ensure profitability.[contentblock id=169 img=gcb.png]