The 2 Metrics PE Investors Say Reveal Mission-Critical, Recession-Resistant Companies

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With inflation at a 40-year high, the Federal Reserve stepping in to raise interest rates, and fluctuating stock prices, many US economists and business leaders are asking tough questions:

“Are we in a recession?”
“Is a recession imminent?”
“What could a recession mean for company valuations?”

In a recent Washington Post report, Bloomberg Economics predicted there’s a three-in-four probability we will be in a recession by 2024. While most economists predict it will be mild or moderate, we could still see a sustained drop in GDP and rising unemployment.

Investors are also closely monitoring the economy, analyzing the potential impact on public and private markets.

While it’s worth remembering that private markets typically respond less severely to macro economic factors compared to the public market, these concerns do affect how investors evaluate potential portfolio companies.

As leading M&A advisors, Software Equity Group analyzes public market data, software M&A deals and investor sentiments to gain real-time insights about the software landscape. These insights help us deliver the best recommendations to software owners and CEOs considering their options.

Our latest survey of the top software focused private equity investors revealed how their priorities are changing amid economic uncertainty. Specifically, they are paying close attention to two key metrics as they evaluate software companies: gross profit margin and gross revenue retention.

The combination of both metrics is associated with stable, efficient, mission-critical, recession-resistant businesses. Here’s a deeper look at each metric and why they are so critical.

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The increased emphasis on gross profit margin

When asked to rank the top quantitative metrics they consider when evaluating a software company, 28% of investors rated gross profit margin as their No.1 criteria.

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Gross profit margin is the amount of money left to pay operating expenses and reinvest in future growth, so it serves as a good indicator of a company’s scalability.

“Gross profit margin is the first efficiency metric investors see on the P&L,” SEG Vice President Austin Hammer said. “A high gross margin sets the table for profitability and is typically a result of healthy operating metrics.”

Calculating gross margin is a simple, straightforward formula that subtracts the cost of goods sold (COGS) from total revenue and then divides that number by the revenue.

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Many software CEOs miscalculate the cost of goods sold by failing to account for less obvious expenses such as hosting, infrastructure, third-party software, and employees working in DevOps or customer support.

When you can clearly see what it costs to deliver each software license or subscription, you can better optimize those costs. Gross profit margin is also less likely to be affected by other factors.

Based on our experience working with hundreds of software companies, we see average gross margins of 75-85% as the benchmark and recommend aiming for a gross margin of 85% or higher. A gross margin below 70% could indicate your software implementations are too complex, time-consuming or costly or your customer support processes may not be as efficient as they should be.

Learn more about how gross margin impacts SaaS valuation.

Improving gross profit starts by understanding which types of customers or product offerings have the highest gross margin and increasing your focus on attracting more business in those areas. Finding ways to optimize costs by automating manual processes, improving delivery models and reducing unnecessary expenses can help in this area. Regularly revisiting your pricing model is another important strategy that can help you maintain a high gross profit margin.

Why investors see gross retention as a beacon of sustainability

High gross profit margin signals a company can efficiently, and typically quickly, onboard and serve its clients. That doesn’t mean it can keep them. Some software companies may have high gross margins but low retention.

Gross retention measures how successfully a company is maintaining its existing revenue by minimizing churn rates.

Gross retention is simply a measure of any lost annual recurring revenue (ARR) and contraction ARR, divided by the ARR the company had at the beginning of the year.

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Gross retention and net retention are both important metrics to evaluate, but gross retention may be a more accurate reflection of long-term stability. A strong sales team, whether targeting net new customers or expansion of existing customers, can make up for poor retention on the top line. But when sales start to slow down, customer churn will eventually catch up and create challenges for the business. A company with strong gross retention has fewer “leaks in the bucket,” so any future success only adds to its profitability rather than compensating for loss.

This explains why 31% of investors we surveyed rated gross retention as their top priority today, compared to just 11% last year.

“In an uncertain environment, if an investor is buying an asset for future revenue growth, they’re less sure that growth will materialize,” SEG Managing Director Allen Cinzori said. “They do know if the company has strong retention and is integral to the daily operations of their customers, those customers likely aren’t going anywhere. This creates a baseline for growth.”

SaaS companies hoping for a high valuation should aim for 90% or greater gross revenue retention.

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Companies can improve in this area by staying focused on their strongest customer relationships and ensuring they have a team of people dedicated to customer success.

The combination of high gross profit margin and high gross revenue is especially appealing to investors amid an uncertain economic environment because it indicates a strong potential for growth and stability regardless of external factors.

Our team of experienced M&A advisors can offer guidance on how to improve these metrics and others to ensure your company is positioned as an attractive opportunity when the time is right.

For more insights on the M&A market outlook for 2022 and how you can take advantage of the opportunities ahead, download our full report.

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