In the software world, a “growth at all costs” mindset has given way to “profitable growth.” Building a venture-backed business was easier when only growth mattered. But now CEOs need to drive both growth and profitability. In the public markets, the companies with the highest growth efficiency (which we define as ARR growth rate + free cash flow margin) command the highest multiples:
In this guide, we unpack a software profit and loss statement (P&L) into its component parts. Much has been written about how to drive growth, but here, we provide tactical steps for CEOs to follow in order to drive more efficiency and profitability.
I: Gross Margin
Gross margin acts as the limit to the ultimate profitability of your business and has an enormous impact on your valuation. It’s a great place to start because improving gross margin rarely comes at the expense of investment in growth.
The median gross margin for high-growth public cloud companies is 77%.
Case example: Take two identical software businesses. One is an 80% gross margin business that operates at 40% profit margins at scale. Holding all other factors constant, that same business with 60% gross margins will have only 20% profit margins. The difference between 80% gross margin and 60% gross margin cuts the value of the business by at least 50%.
Tactics to grow gross margin
Cloud Hosting Costs
- Negotiate with hosting providers to take advantage of reserved instances, pre-purchasing programs, and multi-year contracts to reduce cloud spend.
- Monitor and optimize cloud usage. Once your annual cloud hosting bill crosses over $1 million, consider having a dedicated full-time employee (FTE) responsible for monitoring spend, capacity planning, reviewing potential redundancy, restricting access, and reducing unnecessary usage. Consider applying FinOps or Cloud Cost Management tools such as Aimably, Bluesky, Cloudhealth, Datadog, Finout, HashiCorp Terraform, Infracost, Kubecost, Spot, Vantage, or Zesty.
- Improve code to unlock performance and cost improvements. Review your code base to understand the most ‘expensive’ components (in terms of consumption of compute, network, or storage) in the architecture and review potential optimizations. Explore refactoring the code, changing the database architecture, and using different instance types to drive performance through strategic caching and cost gains such as limiting data transfer fees, especially if you’re in a multi-cloud environment.
- Automate implementation to reduce the work required to get customers up and running. Build data migration tools, great onboarding materials, out-of-the-box integrations, self-service experience, and customer templates to increase speed to go-live and reduce implementation expense.
- Charge more for implementation as most software companies fall into the habit of giving away implementation for free as a sales incentive. Experiment with charging more for implementation to see if you can get professional services margins breakeven at a minimum. For instance, Veeva has been able to deliver 20%+ gross margin on its professional services. If you are losing money on flat fee implementations that balloon in scope, consider shifting to an hourly billing model where you are targeting 80%+ utilization of your available professional service hours.
- Shift implementation work to third parties so you don’t have to worry about losing money on implementation work. Customers can contract directly with service providers and you avoid losses on implementation work. This approach has the added benefit of scalability since you don’t have to worry about growing your services team.
Customer Success and Support
- Benchmark your ARR per CSM by leveraging these benchmarks by Gainsight. If you are off the mark, consider reducing your CSM headcount or freezing CSM headcount to “grow into” the appropriate benchmark.
The median amount of ARR that an Enterprise CSM manages is $2 million to $5 million.
- Reduce the burden on customer support resources by creating a) self-serve motions, b) online documentation, c) customer forums, and d) in-app tooltips for lighter touch customers to self-onboard. (Here is a case example from Netlify on how to embed such self-serve levers into product architecture.)
- Explore customer support automation using platforms like Ada to automate support using AI or leverage recommendation engines to increase support rep productivity.
- Monitor support agent activity and utilization to make sure you are efficiently staffed. The goal is to find a balance between responsiveness and profitability.
- Explore a premium support subscription to help subsidize your customer support staffing. For example, consider “Standard Support” for normal business hours (M-F, 8am-5pm), and “Premium” for 24/7 Support.
- Review each customer’s profitability and develop a plan for how to increase your lowest margin customers. This is typically done by changing the customer’s pricing (see Part V).
II. Sales & Marketing
As a guiding principle, we suggest you use CAC Payback benchmarks to assess your GTM efficiency. CAC payback benchmarks range by scale of the business and whether you are selling into an SMB or enterprise customer base, as sales cycles differ across segments. Here are the good-better-best benchmarks we have aggregated from private cloud companies:
At scale, one of the most powerful drivers of S&M efficiency is improving retention. It is always cheaper to retain and upsell existing customers than to acquire new customers. Moreover, if gross retention is low, refilling a leaky bucket makes it tough to maintain profitable growth.
Tactics to improve S&M efficiency
- Review your sales attainment on a rep-by-rep basis. A good rule of thumb is that a well-functioning GTM organization should target 80%+ quota attainment for ramped reps. Most software companies transition out sales reps who have over two quarters of underperformance.
- Review non-quota carrying sales team headcount for potential efficiencies. A good rule of thumb for enterprise organizations to target is a 1:1 ratio of quota carrying to non-quota carrying expenses. In mid-market, this ratio should be ~2:1 and in SMB ~4:1.
- Review your quotas and sales comp with a common benchmark that on-target earnings:quota should be 4-5x.
- Clearly define and relentlessly focus on core ideal customer profile (ICP) since these are likely to have the highest conversion yield. This also means having the discipline to say no to low-converting prospects. (Here is a case study from Imply Data on how to crystalize your ICP). You could also consider giving your highest quality inbound leads to your best reps to increase sales conversion. Your best leads are precious and may be best served by your sellers with the highest close rate.
- Leverage enablement and standardization to boost productivity. (Here is a case study from Teleport on how to transition to a ‘process-driven’ environment where scalable strategies are leveraged over bespoke motions)
- Invest in product-led growth (PLG) efforts in order to reduce your CAC. While PLG has proven to be particularly effective in the developer economy, this strategy has gained momentum in many other categories, including collaboration tools and customer engagement software. (Recommended reading: 10 Product-Led Growth Principles and Software Powering the PLG Era.)
- Review CAC at a channel-by-channel level to understand which channels are performing best and shift spend accordingly. In general, marketing organizations should be tracking spend-to-pipeline ratio as the ultimate test, with 8-10x as the ideal target.
- Consider reducing marketing spend that is tough to measure, such as PR, brand marketing, and in-person marketing.
- Align marketing and sales goals and processes to tie them closely to ARR goals. Unweighted pipeline out of period (based on deal close date) ideally should be 3-5x ARR goal, and in-period weighted pipeline would be 2x+. Closely monitor your sales-accepted pipeline generation each month/quarter to make sure that marketing is delivering strong pipeline growth.
Research & Development (R&D) is the most fraught area to cut spending to drive profitability: overcutting in R&D can lead to short-term wins but degrade competitive advantage over the long-term. Management teams should apply discretion when looking at R&D benchmarks given unique factors such as product complexity and market competitiveness.
The median R&D as a % of revenue is 20% for high-growth public cloud companies.
Tactics to improve R&D efficiency:
- Drive product roadmap prioritization by force-ranking all current projects, cutting lower ROI projects, and reallocating resources to the highest ROI projects. ProductBoard has a number of helpful frameworks to structure thinking around product prioritization.
- Blow up everyone’s calendars. Stop all recurring meetings (except for quick stand ups) to give your products and engineers time to build. They can schedule meetings on an ad hoc basis.
- Drive engineering effectiveness through better performance management. Engineering contributions can be hard to measure. Metrics-driven heuristics like DORA) can help. However, McKinsey’s Relative Contribution framework is valuable in its simplicity. Start by looking at the relative contributions of each individual on a team. For example, on a five-person team, we would expect each individual to contribute 20% of the work in each sprint. You should be managing out those who are contributing far less than 20% and promoting and heavily retaining those who are contributing far more than 20%.
- Consider using tools to visualize, assess, and benchmark engineering productivity or developer OKRs such as Allstacks, Faros.ai, Jellyfish, LinearB, or OKAY.
- Create a culture that values ingenuity over headcount growth. When your R&D team finds clever ways to build something with limited resources or eliminates a low ROI project, make sure they are celebrated. Build a culture that understands that profitability drives company value and ingenuity is rewarded over headcount.
G&A is a ripe target to drive efficiency given that it is a cost center.
The median G&A as a % of revenue is 12% for high-growth public cloud companies.
- Reduce real estate expenses by reducing your physical office footprint, subleasing unused office space, and renegotiating rent costs.
- Negotiate and optimize vendor spend. Take rational action, such as consolidating or reducing the number of licenses, or switching to cheaper alternatives. Companies such as Zylo can help to rationalize your SaaS usage. You can also optimize vendor spend through contract re-negotiation. Make a list of all your vendors from largest to smallest and renegotiate contracts from top to bottom. Negotiation is not just about discounts, but can also incorporate flexible contract terms, extended payment terms, or moving from a subscription to consumption pricing structure. Companies like Vertice and Vendr can be helpful in negotiating lower prices for software purchases.
- Leverage software and automation to reduce the headcount needed to run a high performing finance, IT, and HR team.
- Explore ways to optimize net working capital, which can be accomplished through means such as extending vendor payments, initiating payment plans, or focusing on collections.
Throughout your company, people-related costs tend to be the biggest area of expense. Making sure you are staffed appropriately across the entire organization is critical.
Tactics to improve the overall efficiency of your people
- Freeze headcount for a period to understand the impact on business. This pause allows leaders to focus on productivity, performance management, and doing more with less. Growing revenue while keeping costs flat is also a straightforward way to drive profit growth.
- Look at your span of control (the ratio of managers to individual contributors). A rule of thumb for managerial span of control is five or more direct reports per manager. This varies widely organization to organization, but if your spans of control are below 3 direct reports per manager, there may be an opportunity to gain efficiency here.
- Require managers to make a case for any backfills by describing why they need to replace any team members who leave voluntarily. The process of having to make a written and persuasive case will help identify roles that do not need to be backfilled. This should not apply to involuntary churn because you don’t want to disincentivize managers from moving out underperformers. To this end, healthy involuntary attrition at a high performance company is generally above 5%. An involuntary attrition rate below 5% may be a signal that performance management could be optimized.
- Harness the innovation of your workforce by explaining the company’s profitability goals to the organization and asking all employees for ideas and suggestions on how to cut costs and drive free cash flow. The most creative ideas come from individual contributors who are educated on and aligned with the company’s profitability focus. Rewarding or publicly recognizing these contributions is a great way to rally the team around this exercise.
- Leverage zero-based budgeting and an incremental approach. Look at each department as if you were building it from scratch today and use that to determine the right org chart and headcount. If things are working, certainly double down, but if there are signals that spending isn’t providing a good return on investment on the margin, adjust quickly to reroute cash to other areas.
- Move to lower cost onshore and offshore talent to reduce cost while maintaining quality. Some practices we have seen work well include focusing on moving support/ops roles before engineering (as they are easier to offshore), hiring a local leader who has experience working with a US company, ensuring cultural and technological consistency in your chosen offshore location, and avoiding business process outsourcings (BPOs).
- Streamline overlapping projects. In large organizations, disparate teams are often working on similar problems. Remove duplicate efforts to get more performance from your organization.
VI. Pricing and Packing
Pricing is one of the most important drivers of revenue growth and profitability. It is one of the most efficient ways to drive margin because any price increase drops straight to the bottom line. If you’re a SaaS leader looking for new levers of revenue growth, take our B2B SaaS Pricing course.
Tactics to drive better pricing and packaging
- Experiment with raising prices for new and old customers. Experiment with a price increase for new customers to find the “right” pricing level. Many software companies neglect pricing because it is cross-functional and complicated. Make an effort to test pricing for new customers regularly. Bring your older customers up to parity over time while mitigating churn by explaining how the product has improved and giving them generous grace periods. You could also add an automatic annual price increase that auto-renews each year. Most customers understand that your costs are growing each year and are comfortable seeing a modest increase in price each year (e.g. 3%-7%).
- Consider adding volumetric or tiered pricing components (grows with volume, usage, revenue, etc. or “good, better, best” packages) to help align your pricing with the value you are creating for customers. Learn more about different usage-based pricing models in this report.
- Default to annual upfront prepayments charged immediately after contract signing. This will drive much stronger cash flow (see point 30) than other contracting models (e.g. paid monthly or quarterly instead of annually, or paid upon customer go-live rather than at contract signing). You can always add flexibility but start here as a default.
A note about stock-based compensation
The benchmarks we leverage for this article do not include stock-based compensation. However, it is important for founders to understand the impact of stock-based compensation. Although it does not immediately impact cash flow and profitability, it will inevitably at a future point. Further, looking at benchmarks inclusive of stock-based compensation also mitigates any noise resulting from different stock vs cash compensation structures across companies (e.g., the same company that gives 70% stock and 30% cash will look much more efficient than one that gives 50% stock and 50% cash). Lastly, the role of stock-based compensation is becoming an increasingly common topic of discussion for public market investors and has an increasing impact on valuation. We recommend benchmarking your business by including stock-based compensation or benchmarking against companies with a similar equity burn to fully understand relative cost structure and profitability.
Parting thoughts on achieving profitable growth
As a CEO, it is important to remember:
- Focusing on both growth and profitability is hard. Business was easier when only growth mattered. But a focus on profitability presents a new set of challenges and opportunities for your team to shine. The teams that can successfully transition from “growth at all costs” to “profitable growth” will make themselves richer. They will also walk away with the pride of having pulled off a transition that only the highest performing teams have been able to make.
- The gold standard is a 40+ efficiency score (ARR/revenue growth % + EBITDA/FCF margin % > 40). The scoreboard has changed and we’ve moved from a market that exclusively valued revenue growth to one where both revenue growth and profitability matter. The median BVP Cloud Index company has an efficiency score of 33%. Most software companies managed by experienced PE firms have an efficiency score of 40+. This is what investors and buyers of software companies have come to expect. If you find yourself deviating from this benchmark, it is important to assess why and whether you have a clear path to get there.
- Avoid death by a thousand cuts. As of Q1 of 2023, we are seeing a second wave of layoffs and cost reductions rippling through the software ecosystem. If you’re going to reset your cost structure, make the reset substantial enough that you can avoid making painful changes in the future.
- Culture and communication are key. Your team needs to understand that software companies are ultimately valued on their profits. Revenue multiples are just a proxy for future profit generation. If you can create a culture that focuses on growing revenue while keeping expenses as low as possible, it will be much easier to generate profit later.
- Give your executive team ownership over the problem. As you think about how to roll out a cost reduction plan, one approach is a top-down edict from the CEO or CFO. This can be effective but may create an adversarial relationship with your execs. Consider letting your team take ownership of the problem by framing the goal (e.g. “we need to get to rule of 40”) and challenging them to figure out how to get there. Use that as the foundation for a cost savings strategy.
Case Study from Sameer Dholakia: Former CEO of SendGrid on driving profitable growth
In this article, we tried to be as comprehensive as possible in ideating tactics CEOs can implement to drive efficient growth. As we wrote the piece, I wondered if it might be helpful to share how I applied at least some of these 40 different tactics to a real business. The case study below shows that these ideas are very actionable. They changed the trajectory and outcome for SendGrid—and can for you, too!
Fortunately, I worked with a very talented and mature team at SendGrid. Creating alignment on our need to drive to a healthier rule of 40 was like pushing on an open door, and our whole company (not just the leadership team) got behind this goal.
Ultimately, it was a collective effort from across the organization that enabled SendGrid to drive profitable growth. A few examples of notable initiatives included a finance leader branding a company-wide “Save to Reinvest” campaign, a vice president of support helping us create and monetize new customer support tiers, and a customer success leader helping us launch new add-on services
Focusing on profitable growth isn’t just the job of the CEO. Invite the smart and hard-working teammates of your company, who know your day-to-day operations best, to be part of the solution.
Our “Save to Reinvest'' campaign was one of the best examples of internal marketing I’d ever seen. We demonstrated to everyone in the company that we weren’t cost-cutting for its own sake, but rather so that we could afford to reinvest in growth levers for the business. This framing is what allowed us to both slash our burn and reaccelerate growth, what we later called the “SendGrid smile”; in other words, the graph that illustrates our growth rate over time which went down, then flat, then up and to the right.
Over the course of six quarters, we took action on the following tactical steps throughout the organization. Incrementally, we moved from -30% to roughly breakeven, and then reaccelerated our growth as we scaled in 2016, ramping toward our IPO in the fall of 2017.
Tactical steps SendGrid took to improve its gross margin
SendGrid’s Gross Margin was in the 60s at the time I joined, and was mid-70s by our IPO, and mid-80s when I left Twilio. Unquestionably, some of that improvement was simply due to economies of scale—costs held flat as we increased our output. But it also was the result of many intentional, cost-focused initiatives across a number of areas, including:
- Cloud hosting/Infra: We found seven-figure cost savings by refactoring the most “expensive” pieces of our email infrastructure software. To do that, we had to balance two objectives: optimizing costs and developing new features. For example, the engineering team re-wrote a microservice in a more performant language; in another case, the team re-wrote and re-optimized the pieces of an old daemon over a multi-year period.
- Services: When we found out our customers had expected to pay for a service we had been providing for free—email deliverability—we created a set of services that our sales and customer success teams could sell. These ranged from one-time implementation services to a retainer model for on-call experts.
- Support: By implementing support tiers—”standard” during normal business hours and “premium” for 24/7 coverage—we found that many customers were willing to pay for premium support as an insurance policy, even though they didn’t use it often.
- CSMs: In the early days, our coverage ratios in customer success were more focused on a number of accounts and dollars, but often didn’t factor in account potential. We ended up segmenting, as the Gainsight benchmark suggests, along lines of account potential, and some customer success managers (CSMs) ended up with far fewer accounts, and some with many more. But productivity increased across the board.
- Sales and marketing: Because SendGrid had already benefited from an incredibly efficient CAC payback period of six months, we asked our revenue marketing team to experiment with prolonging that period, by investing, not spending, up to a 12-month CAC payback. This increased investment led us to double our paid acquisition budget and accelerated our net new monthly recurring revenue (MRR). It also helped us when we got clarity on our ideal customer profile (ICP), which enabled our sales teams to create more targeted lists of prospects. The names of the top 25 were posted around the office, so that everyone was aware and thinking of how we might get into those accounts.
- Research and development (R&D): When I first joined, I was tempted to hire additional developers to help turn my product ideas into reality. I was fortunate to have a board member suggest that I pause on hiring more engineers—after a period of rapid hiring throughout the company, I wasn’t sure we had the right management and processes in place to run the engineering org most efficiently. He was 100% correct: hiring more people into an unoptimized org would make changes more difficult and investment less effective. Instead, we hired a new senior vice president (SVP) of engineering and put all other hiring on hold—except for backfills of people who had been performance-managed out. Over the next six months, the new SVP helped us rebuild the engineering org, and then we started hiring again.
General and administrative (G&A) expenses:
a. Vendors: We found it helpful to align the whole team on being more disciplined about vendor costs and negotiations. I personally helped renegotiate our renewal for a event and data analytics platform, which had reached $1 million per year when I arrived—untenable for a $30 million ARR company like ours. This saved us a boatload of money each year. Importantly, it also showed the company that the CEO cared a lot about cost containment.
b. Real estate: When SendGrid expanded from its roots in Boulder to a larger presence in Denver, our CFO and COO championed the consolidation of our two Colorado-based locations. Economies of scale, again, saved us a lot of money as we hired more people into the same physical footprint.
- Pricing: We conducted a pricing study that led us to a significant price increase for our lowest-volume senders. Thanks to the help of Simon Kucher Partners and our pricing team, that represented a 50% price increase for tens of thousands of customers. We were simply underpriced relative to the value we provided. We had a few dozen unhappy customers—no one likes to receive a price hike—but out of 30,000+, it led to millions (~$5M-7M) dropping straight to the bottom line. We did this in 2017, so it wasn’t part of the initial cost focus.
The biggest takeaway for CEOs is to remember that there are opportunities to drive better margins and profitable growth in every aspect of the business. If you’re a SaaS leader fundraising in the near future and looking for ways to drive profitable growth, reach out to Brian Feinstein (Brian@bvp.com), Caty Rea (email@example.com), Janelle Teng (firstname.lastname@example.org), or Sameer Dholakia (email@example.com) to learn more.