Asking Great Questions

Pushing oneself to ask great questions is extremely important. It forces you to think critically, accelerates your learning, improves decision-making, and helps build trusting relationships. Here are some things that have helped me ask better questions:

Tell yourself a story and use questions to fill in the gaps.

When I'm interviewing someone, being interviewed, or just having a conversation with a colleague or founder about a business problem, I typically take what the other person is saying and try to tell a story that makes sense in my mind. If someone is explaining a new company they'd like to start, I'm listening, but as I hear them talk, questions pop into my head about things I want to know more about or inconsistencies with my preconceptions. This is the trigger for most of the questions I ask, and it’s a useful way to generate dozens of questions in a single conversation.

Of course, you have to temper your questions and prioritize the most important ones so you don't sound like a nut. But forcing yourself to tell your own story based on what you're hearing—and fitting it into your worldview, or using it to learn something new and adjust your worldview—is a great way to ensure you're asking high-value questions.

Be ruthlessly authentic and ask “dumb” questions.

Have you ever noticed that whenever you ask a “dumb” question, it often turns out to be a great one? Dumb questions are wonderful. They typically simplify the topic, challenge assumptions, align the conversation at a high level, and enhance inclusivity. The trick is having the humility and courage to risk showing that you don’t know something that others do. This is definitely a risk worth taking. Try to never hesitate to do this. Be authentic. The best questions are about the things you really want to know. As someone once said, “Not knowing is not ignorance; not seeking to know is.”

Ask what people think, feel, or would do—not what they know.

I almost always find that opinions based on facts are way more interesting than simple facts. Instead of asking a job candidate, “What is our competitor's product strategy?” try asking, “What do you think of our competitor's product strategy?” Similarly, don’t ask your real estate broker, “How can I get a better price?” Instead, ask, “How would you go about getting a better price?”

This tactic encourages the person to really think about the answer and provides you with genuine insights rather than just reciting what they know. Also, give them time to think and express their full answer. Rushing them only leads to less interesting responses.

Tradeoffs

Over the years, I've found that leaders (and people in general) are often resistant to facing the tradeoffs that come with the difficult decisions they make.

You see this a lot with public policy. A simple example is governments mandating that tech companies implement encryption to protect user data and sensitive information. On the surface, this is a great thing. However, several tradeoffs come with encrypted data, the most noteworthy being that law enforcement can't access information related to criminal activities by users or the company itself. So regulators will also ask companies to encrypt their data and provide a back door so it can be accessed when required by law. But, of course, you don't have encryption if you have a back door. Regulators are often unwilling to face the natural tradeoffs associated with the regulations they create.

Similarly, I recently talked with a small group about Chapter 11 bankruptcy (the legal process that allows a business to reorganize its debts while continuing to operate). Some were arguing that it shouldn't be allowed. If someone is going to run their company into the ground, they shouldn't be allowed to have a court step in and save them. At first glance, this also makes sense. So perhaps we should do away with Chapter 11 bankruptcy? Maybe, but only as long as we're willing to face the painful tradeoffs.

With Chapter 11, a business leader is incentivized to raise their hand and ask for help before they become completely insolvent and run out of cash so that debtholders can salvage at least some of their money. Without it, if a leader knows there's no way out, they'll keep the company going until it’s down to its last dollar, hoping to survive somehow, meaning debtholders get nothing. Ironically, Chapter 11 protects debtholders. Further, what would happen to innovation in America if founders of companies knew that if they failed, they were done for good? What would that do to the amount of risk entrepreneurs take? How many companies never would've been founded? There's a reason you see a lot more innovation come out of countries that provide some form of protection to risk-taking inventors. 

Of course, one of the most common tradeoffs in business is deciding how much to invest in growth versus how much to expand profit margins. If a leader asks their board, the advice is very often to do both. Said differently, ignore the tradeoffs.

A large part of leadership is making difficult decisions, which are typically just a set of tradeoffs that must be managed. Great leaders know that it’s not just about what you gain; it’s also about surfacing and dealing with downstream consequences and what you’re willing to lose.

A Finance Deep Dive

A couple of weeks ago, I completed a Finance for Senior Executives course at Harvard Business School. I took the course because, while I feel like I have a pretty good grasp of finance from business school and work experience, I wanted to refresh my brain on the fundamentals and go a bit deeper than I've been able to over the last several years. The course was excellent, and I highly recommend it for operating executives who find themselves in a similar spot. The content was designed for senior executives who don't work directly in the finance function. The course had a virtual portion followed by four days of in-person living and studying on the HBS campus. The class was grounded in the case study method, with 13 real-life case studies (including a great one where we had to try to rationalize Peloton's stock price in the Summer of 2019...). The class was filled with an incredible group of intelligent, thoughtful, energetic, and self-motivated students who were really fun and inspiring to get to know — 89 students from 21 countries. Just a great group. The syllabus covered six primary topics:

• Measuring Performance and Financial Ratios

• Discounted Cash Flow 

• Valuation

• Capital Structure and Leverage

• Mergers, Distress, and Recapitalizations

• Capital Allocation and Pursuing Margin and Growth

As we went through the coursework, I made a note of some of the more insightful reminders, ideas, concepts, and topics that stuck with me. I thought I'd share some of them here:

1/ The primary job of finance is to ensure that the company doesn't run out of cash and makes good financial investments. Watching working capital (current assets - current liabilities) closely is crucial — lots of very profitable companies run out of cash. I’ve seen this quickly become an issue for tech companies that don’t hold inventory and have taken their eye off working capital, as well as tech enabled healthcare service companies that have a revenue cycle lag.

2/ Terminal value of a company (its value in perpetuity) should be used carefully, as there's never really a company that runs forever. That said, over the long term, the discount rate will balance this and make the calculation more reasonable. The terminal value of a company should be calculated after growth and margin have stabilized.

3/ Net present value measures the dollar value an investment adds or subtracts by comparing the present value of cash inflows and outflows. Internal rate of return calculates the percentage rate of return that makes net present value zero.

4/ There's really no such thing as a "good" growth rate or margin or financial ratio. It all depends on the context and the particular situation. It's sort of like a size 10 shoe. Does it fit? Well, it depends. 

5/ You should care a lot more about the market value of a company than the book value of a company as that’s the value that investors will pay assign to the firm, though the latter is a lot easier to calculate and make sense of.

6/ Bad economics in an industry almost always beats great management over the long term. 

7/ Don't discount the fact that your debtholders are important stakeholders and investors. While interest payments cap their upside, they are the first investors to get paid in a liquidation, and returning their capital and providing them with interest payments drives substantial value. Too often, we only consider equity holders when we think about enterprise value creation.

8/ A good formula to memorize is valuing a company using its free cash flow projections. As I've written here many times, the value of a company is the present value of the discounted free cash flow you can take out of it. Free cash flow can be calculated using the balance sheet and income statement with the following calculation: EBIAT (earnings before interest after taxes) + depreciation - cap expenditures - change in working capital. It's not about memorizing the formula; it's about understanding how the balance sheet and income statement interact and how to use them to calculate the cash flows a company will generate.

9/ Debt is a government-subsidized form of capital. The tax deduction on interest is the major value in financing an investment with debt over equity. This is really meaningful. Obviously, it is less relevant for startups that still need to produce profits. 

10/ The "irrelevance hypothesis" says that in an ideal world with no market imperfections, the dividend policy of a company is irrelevant to its overall valuation because shareholders can create their own homemade dividends by selling their shares. Of course, real-life market imperfections always need to be logically applied when creating a dividend policy. 

11/ Operating leverage is an important metric to watch over the long term. High operating leverage means that small changes in sales lead to disproportionate increases in operating profit because fixed costs remain constant while revenue increases. 

12/ Businesses can be placed on a spectrum from "high tech," which are high growth/low profit, to "cigar butt" businesses which are low to no growth/high profit (companies that only have a few puffs left). There’s nothing thing wrong with a company that isn’t growing but is throwing off cash and not all companies need to stay in business forever. It's important to understand where a company is on this spectrum to guide where to place capital — invest in growth, return to shareholders, or pay down debt. 

13/ Dividend payments are effectively the same as a corresponding investment in growth when the dollars generated and value creation are the same (the only relevant difference is that in one scenario, the money is in the investor's pocket versus the company's pocket). But the value is the same. This is a good reframing, similar to the importance of returning capital to debtholders. Capital is capital regardless of whether the investor holds it in your company or puts it in an index fund.

14/ Generally, markets value growth increases over margin increases because growth compounds on itself. The exception is low-margin businesses. You'll get more upside there from growth. All should be calculated through discounted cash flow analysis.

15/ High discount rates favor high-margin businesses, and low discount rates favor high-growth businesses. 

16/ Detailed discounted cash flow rates often aren’t used on a practical basis inside of companies. The reason, generally, is that there are often more ideas that exceed the discount rate hurdle than can be executed. That said, it’s crucial that all leaders understand discounted cash flow, NPV, and IRR.

I'm really glad I took the class. I'll look into other courses like this to deepen my knowledge in areas where I haven’t gone as deep as I’d like in recent years.

Salesforce’s Pivot & The AI Business Model

Back in October, I wrote a post titled Selling Software vs. Selling Work, in which I noted that AI may begin to disrupt the traditional SaaS business model. As a reminder, the traditional SaaS business model allows software companies to sell their software as an ongoing service with annual recurring payments. Typically, the software is billed on a "per-seat" or "per-employee" basis. Pioneered by companies like Salesforce, this model has been enormously lucrative for large SaaS companies because they can grow as they sign up new logos, but they can also grow organically and naturally as their customers hire more employees (more seats). This has been a boom for the SaaS industry as most customers have grown headcount substantially over the last 10 to 15 years.

However, a large part of AI's promise is that it will likely eliminate a huge number of white-collar jobs, such that productive companies might start materially reducing headcount in the aggregate, posing a fundamental challenge to the per-seat SaaS model.

This is starting to become a lot more real. A couple of weeks ago, at their annual Dreamforce conference, Salesforce's CEO Mark Benioff announced a major pivot, at least in their AI product strategy. They are moving away from a per-seat model to a per-conversation model where the company will charge $2 for each customer service or sales conversation held by one of their AI assistants. This shift, in theory, will allow them to continue to thrive as companies begin cutting headcount and amping up investments in AI. For those who have read Clayton Christensen's Innovator's Dilemma, this is a pretty big deal and a brave move for Salesforce.

From the Innovator’s Dilemma:

"In essence, the dilemma is that successful companies often focus on improving existing products or services to meet the demands of their most profitable customers. This focus leads them to overlook or dismiss disruptive innovations, which typically start as lower-quality or niche products but eventually improve and take over the market. By the time the established company recognizes the threat, it is often too late to adapt."

Benioff must have read the book.

More broadly, as we consider an industry shift in this direction, it raises several important questions:

1/ Does it work? Can the AI fully replace a human or is it more of an assistant? Surely, for basic tasks, it will, but how far up the stack of human intelligence will this go?

2/ Given the low cost of supplying this kind of AI once it's built, will customers be willing to pay a price that preserves the revenue and profits generated from the per-seat model, or will SaaS companies take a significant hit? In many ways, this will come down to competition and the proprietary nature of the software. Companies like Salesforce have thrived via their scale and the fact that there wasn't a better place to go. Is AI a real, novel, differentiated technology that can't be recreated, or will it be easy to copy and will margins quickly contract?

3/There's an old saying in software that you can turn any task that you do in Microsoft Excel into a SaaS company (expense reports, project management, budgeting, sales pipeline management, etc.). What's the corollary for AI? Will thousands of point solution AI companies be built around LLMs?

4/ What does this do to white-collar employment? We've seen over the course of history that new technologies disrupt employment in the short term. Though in the long term, the shifts from the agriculture age to the industrial age to the services age to the information age, have led to long term increases in wages and employment. Is it different this time? Will AI get so high on the totem pole of human intelligence that the work humans do is materially reduced? A nice proxy for this might also be the spreadsheet. Prior to the invention of spreadsheet software (VisiCalc in 1979), there were large buildings full of white-collar analysts doing the calculator work that Excel does for us today. That shift only created more analyst jobs because high-quality analysis could be done more cheaply. When something gets cheaper, we typically do more of it.

Just when I thought b2b software was getting kind of stale…here we go again…it seems AI is going to be driving a new platform shift, and it's impossible to know where it all lands. But it's great to see companies like Salesforce protecting their shareholders by resisting the innovator's dilemma and getting out in front of what could be a massive new chapter for b2b tech.

Growth Without Capital

In the early days, startups are very capital-intensive. They don't have a product generating positive cash flow, so they often rely on some outside capital (debt or equity) to grow their top line. This is a necessary evil in the early days to get a company up and running. With the need for capital underscoring the financing strategy for most startups, it's easy to forget that the best companies are companies that don't need capital to grow. An excellent example of this is a franchise like Subway that leverages franchisees' capital to open new stores and expand its footprint. In addition to a franchise model, there are lots of other business models that companies can use to grow without capital:

1/ Preselling or securing customer deposits: getting a customer to pay in advance or fund the development of a product. 

2/ Joint ventures and strategic partnerships where a partner provides the capital to grow. 

3/ Government grants and contracts.

4/ Revenue sharing and licensing agreements. Getting your own sales team to sell other people's stuff.

5/ Supplier financing. Getting very favorable payment terms from your vendors such that they can use funds elsewhere for some period of time.

6/ Revenue from Licensing Technology or IP: Companies can license their technology or intellectual property to other firms, generating revenue without direct investment.

7/ Network effects. Building a product that’s more valuable as more people use it, so there’s a built-in incentive for customers to market it for you.

Early-stage companies will be inclined to rely on organic growth as they get off the ground. But it's important to incorporate — or at least be thinking about — less capital-intensive growth strategies and business models as the company matures. Again, the best companies out there are those that can achieve high growth rates without a corresponding need for capital investment.

Complexity As A Moat

Judy Faulkner, founder and CEO of Epic, had a good blog post the other day titled More Complex Than Rocket Science where she talks about the complexity involved in healthcare IT. From the post:

"My favorite t-shirt says, “Healthcare IT is more complex than rocket science.” The three Epic employees who used to work in rocket science agree."

Healthcare IT is absolutely super complex. And that complexity creates a ton of challenges for founders trying to get their idea into market. But that complexity is also an advantage in that it creates a moat around a business where it's very difficult for a copycat to come along and recreate what the company is doing. For example, if you're doing automated care management for cystic fibrosis (CF), you need to wrap your head (and your product) around specific nutrition insights, medications, lung function testing, infection management, psychological support, financial aspects of CF care, and then roll that into a service with some technology wrapped around it. And that's just to build a useful product, never mind the challenges associated with taking it to market.

The upside of the pain in taking a healthcare product to market is that often the product/market fit you’ve found is its own moat.

Perseverance As A Competitive Advantage

One of the questions startups frequently get from prospective investors is: why won't the big incumbents (Epic, Cerner, or whoever) just do what you're doing and put you out of business? This is always a difficult question for a founder to answer because the reasons often aren't obvious and can be hard to describe. The difficulty of bringing something new to the market is typically underestimated, and the details really matter. And often, these details aren't well understood by a casual observer. See this excellent post that Chris Dixon wrote back in the day on what he calls the Idea Maze to understand why the answer can be hard to understand from the outside.

I was chatting with an investor last week who had a good way of summarizing why startups have one fundamental advantage over incumbents: they simply can't afford to quit.

For a startup, failure isn’t just a setback—it can mean the end of the business, the loss of investor money, and reputational harm to the founder. This makes persistence almost a necessity.

Large companies, on the other hand, often have a lower threshold for pulling the plug. If a new product doesn’t show quick growth or the market looks small, they cut their losses and move on. For them, it’s just another line item in their budget; for startups, it’s survival.

This urgency forces startups to be more resourceful, nimble, and focused. Where big companies might give up too early, startups are far more likely to push through.

And very often, that’s where the real breakthroughs happen—not because they have more resources, but because they have no choice but to persevere.

Of course, this topic is way, way more complicated. And I'll write more about it at some point. But sometimes, it's simply the refusal to quit that makes all the difference.

Thoughts On Founder Mode

Paul Graham's essay on Founder Mode made the rounds around tech Twitter and other places this week. The thesis, in short, is that there are two distinct ways to run a company: "founder mode" and "manager mode." The latter — which says, broadly, hire good people and give them room to do their jobs" is the conventional method taught in business schools, but it often fails for founders. Founder mode, still largely undefined, involves more direct engagement and breaks traditional management principles. The founder should dig into all of the important stuff and, in a sense, micromanage it. 

There are a ton of opinions flying around about this, which is somewhat surprising given how short and vaguely the concept is described. After reading it, two thoughts came to mind:

1/ Leaders are measured on the output of their organization. There are multiple ways to achieve an outcome based on the leader's skills, talents, organizational structure, markets, competitors, environment, etc. Concluding that one style is better than another in all cases, or even most cases, seems like a mistake. 

2/ Personally, I've found that one of my greatest skills is recruiting, engaging, and retaining incredibly driven and talented leaders. I spend an enormous amount of time and energy on doing so. The result for me has typically been to have teams that don't need to be micromanaged and can produce results at extremely high levels while feeling empowered, engaged, independent, and supported to do great things. If I didn't have this skill — or I didn't focus on improving it — I might be more inclined to micromanage as that would be the thing that would drive results.

I wrote about my approach to this in my User Guide six years ago, most of which remains true today. Relevant excerpt:

“Micro-management vs. Hands-off:

I definitely fall on the hands-off side of this spectrum. My high-level theory is that I try to hire superheroes that are going to figure out what needs to get done and will go get it done. When we aren’t hitting goals I will seek more information and transparency. There’s a see-saw dynamic here: good results means I need less information and transparency, poor results means I need more information and transparency. Understand this and manage to it. Get ahead of my concerns.

I don’t like micro-management and I don’t need all the detail. I’ll generally let you decide how much detail I need. I prefer that you consider me your thought partner and you should provide me with enough detail to do that. I don’t want to measure your inputs but I want to understand them.

Frameworks are very important to me. I’ll often be less interested in the decision you made and more interested in the framework you used to make the decision.”

As leaders, we need to leverage our strengths, minimize our weaknesses, and operate in a way that's going to produce results. There are probably a thousand different styles and equally as many ways to brand those styles. The fact is, most of us pick from them as needed. The real skill isn't in choosing a management style and sticking to it; it's using the style and management tools that work for us in the right place at the right time to produce the most optimal outcomes.  

Growth Endurance, Benchmarks, & Horizontal SaaS vs. Vertical SaaS

Investors will often refer to SaaS benchmarks to gauge how well their portfolio companies are performing. They'll look at things like growth rate, CAC/LTV, gross margin, EBITDA margin, net revenue retention, etc. They'll often cite the most successful companies like Monday.com, Zoom, Hubspot, ServiceNow, and Zendesk. These are all top-tier SaaS companies, and investors like to have their companies aspire to have similar metrics. 

These companies, and nearly all of the top-tier SaaS companies, have two important things in common:

1/ They can sell into virtually any company in any industry (horizontal SaaS). 

2/ They can sell into virtually any country. 

As an example, in theory, Zoom could sell a license to everyone over the age of 18 with an internet connection — let's call that about 3.5 billion people. So their overall total addressable market (TAM) is 3.5 billion multiplied by, say, $100 per year. So Zoom's TAM is something like $350 billion.

Now consider a healthcare technology company that operates within the complex, highly regulated US healthcare system (vertical SaaS). They have a much smaller TAM than Zoom. There are about 21 million US healthcare workers, so, in theory, if a health tech company could get its product into every healthcare worker’s hands at $100 per year, their TAM would be $2.1 billion, about 0.6% of Zoom's TAM. Obviously, I'm using ridiculously simplistic numbers.

This becomes relevant when we start thinking about benchmarks, particularly with regard to growth and growth endurance (the ability of a SaaS company to sustain consistent growth over time).

Consider Everett Roger's Technology Adoption Curve, which illustrates how different groups adopt new technologies over time. 

You start by acquiring the innovators, then the early adopters, etc. As you move through the curve and gain more and more customers, each sale typically gets more and more difficult. The first two parts of the curve (innovators and early adopters) generally represent about 16% of the addressable market for the technology.

So, using the examples above, when the health tech company gets to 16% of the market, its revenue is $336 million. When Zoom gets to $336 million in revenue, it hasn't even made a dent in the innovators and early adopters. It has another $349,664,000,000 in innovator/early adopter revenue to go get. 

If an investor benchmarked the health tech company against a horizontal SaaS company like Zoom on things like growth, growth endurance, or the cost of acquiring a marginal customer, they'd be very, very disappointed. To say the least!

Now, obviously, it’s on the health tech company to figure out how to innovate, sell its product to a wider audience, and go international, but the point here is that we're not talking about apples to apples. Benchmarks that don't take into account the uniqueness of a business or a particular industry are, at best, a waste of time and, at worst, create really bad incentives for founders and management teams. 

Who Should A Company Serve?

A reader responded to my Hospitals & Financial Engineering post, where I made the case that hospitals should be protected from various financial engineering tactics that allow for short-term profits for investors that result in major challenges for the company in the long term. From my post:

”I'm a big fan of capitalism, and I generally support the work of private equity firms in delivering returns to their shareholders, many of which are large pension funds, endowments, and foundations. But Steward's collapse is an important signal that our most important and prized institutions shouldn’t be operated as attractive targets for short-term, financially engineered profits.

Hospitals are different. They're a special thing. And regulators should ensure they're treated that way.”

The reader asked: Shouldn't these regulations apply to every company? Why just hospitals? Should private equity investors be allowed to hurt any company in the interest of taking their own short-term profits?

It was with this question in mind that I came across this piece in the WSJ, titled Private-Equity Firms Desperate for Cash Turn to a Familiar Trick. The piece points out that private equity deal volume is way, way down since the increase in interest rates. There just aren't that many deals happening in this environment which is making the investors that invest in private equity firms rather anxious. They'd like to start to see some returns and get some liquidity. Because private equity is illiquid and doesn't trade in the public markets, these firms can't get their investors liquidity until they sell the companies they invested in. But this isn't a great time to sell; it's hard to do because of the low volume, and you might not get a great price. 

So, to give their investors liquidity, private equity firms are doing what's called a dividend recapitalization. That is, some firms are having their companies take on a large amount of debt and then taking the cash and giving it to their investors in the form of a dividend. From the piece:

”Among the largest dividend recaps so far this year is a $2.7 billion recapitalization by auto-body repair center Caliber Collision, according to data from PitchBook LCD. The company is backed by investors including the private-equity firm Hellman & Friedman. A report from S&P Global Ratings said the money was used to pay existing debt and distribute a $1 billion dividend to its equity holders.

In March, rail and transportation services company Genesee & Wyoming completed a roughly $2.7 billion recapitalization. The company, backed by investors including Brookfield Infrastructure Partners, used the transaction to pay a $761 million dividend, according to S&P.”

So investors get some short term return and liquidity without the PE firm having to sell the company. This leaves the company with a new, potentially very large debt obligation without a corresponding asset to show for it. So you're potentially hurting the company in the long term in the interests of short-term profits for investors.

Similar to the point I raised in the hospitals post, are these transactions that benefit investors in the short term at the cost of the company's health in the long term ethical?

Rather than answering that question directly, I think it's worth first asking who a company is meant to serve. A company isn't a living thing, so it technically can't be hurt by or benefit from such decisions. What a company actually is is a set of stakeholders who have an interest in it: leadership, employees, investors, vendors, customers, and the community. 

That's a lot of stakeholders with different incentives and different desires and timelines for the company. Who should the company serve first?

The technical, business school answer is that a company's purpose is to maximize returns for shareholders. Not employees. Not management. Not future investors. So if you believe that, and the company's board believes that taking some cash out of the business — by putting a lot of debt on the balance sheet that might harm employees in the long term and might result in less return for future investors — is good for current investors, then that's what they should do. 

Again, without taking a side in these debates, the point I'm trying to get to is that as an investor or operator, it's important to zoom out and remember who the company is trying to serve. The answer can be different depending on a variety of factors such as its industry, stage, and the way it’s financed. And seeing these very public financial engineering tactics brings this issue front and center. Getting alignment and transparency around this point is crucial in aligning all stakeholders and managing difficult tradeoffs so management and boards can make good, consistent, clear-minded decisions in the short and long term.

Growth, Innovation, And Knowing Who You Are

On a podcast the other day, Ben Thompson made the point that Meta (Facebook) has taken a lot of heat in that they haven't innovated and built a great new product in a long time. Sure, they have Instagram and WhatsApp, but those were acquisitions, they didn't build those products themselves. 

He made the point that the mistake wasn't that Meta didn't create great new products; it's that they even tried.

Thompson noted that creating big, new products that scale is not only extremely difficult but also almost never works. Of all the ideas that new founders have and that existing companies try, very, very, very few make it. A better strategy for a mature and cash-flush company like Meta is to let its innovative employees leave, raise venture capital, build great products, and acquire the ones that work.

This last point is so important and can’t be overstated. Startups have such an advantage when it comes to innovation.

1/ They have full focus from their best people. When companies get big they have so many competing priorities that have nothing to do with innovation. I imagine a top 3 priority for Meta right now is dealing with international regulators. What an incredible distraction that no startup has to deal with.
2/ Failure isn’t an option. If a product leader inside a large company fails they move on to the next thing. If a startup fails, the company dies.
3/ They have unlimited freedom. They’re not constrained by customer commitments or burdens and processes and systems that were setup in the past. They have full freedom to be flexible and innovate.

All of this is to make a larger point. You have to know who you are. I see this challenge a lot with companies that succeeded through the low interest rate period and are looking to get back to high growth. They look at Rule of 40 and say, let's get to 30% growth and 10% operating margin because investors still favor growth companies over profit-focused companies. Related, see this great chart from Logan Bartlett at Redpoint. It shows the multiple of the importance of growth vs. profitability. In February of this year, the market valued a point of growth 2.9x more than a point of free cash flow. Obviously, it's nothing like it was in 2021, but you can see that investors are still very growth-focused. 

Boards and leadership teams know this and are setting their companies up to plug into higher valuations. But, many of those companies have saturated the market for their core products and don't have a great second act. It's time for many of these companies to flip the switch to a focus on EBITDA and free cash flows. 

Obviously, every company is different. And if you have a great idea and a great team that can execute on innovative growth and the management capacity to go all in and the risk appetite for it, then, by all means, go for it. But remember that we all have egos, and it’s easy to get caught up in what’s exciting versus what we’re capable of and what’s best for the company. We all want to be on the growth side of Rule of 40. Operational efficiency isn't as exciting as launching a giant new product. That's a lot more fun, and you'll get a lot more credit. But it might not be right for you right now. 

You have to know who you are.

SaaS vs. SaaS Margins

The concept of SaaS was launched in the 1960s, though it didn't really gain traction until Salesforce was founded in 1999. It didn't get widespread adoption until the 2010s. Today, it's a standard for how businesses use and buy software. 

SaaS was distinct from traditional, on-prem software in 4 main ways:

1/ Deployment location. The software was hosted on the vendor's cloud servers rather than the customer's servers. 

2/ Subscription pricing. SaaS typically uses a subscription model where users pay a recurring fee that includes maintenance, updates, and support, as opposed to on-prem where there's a large one-time fee, and then additional charges for updates. 

3/ Accessibility. SaaS products can be accessed from any internet connection, whereas on-prem typically can only be accessed inside a company's network.

4/ Customization. SaaS customers rely on the vendor for new features and configurations, whereas on-prem offers far more flexibility to meet specific customer needs. 

As a result of these and other distinctions, SaaS has become extremely attractive from an investor perspective. These companies generate recurring, high margin revenue that grows consistently as the company's customers grow. That equates to higher cash flows than traditional software products, which result in revenue multiples of around 10x for high-growth (30%+) SaaS companies.

Regarding these attractive margins, the most relevant feature is the fourth point: customization. Internet-based companies can become enormously profitable because the marginal cost of adding an additional customer is near zero. It costs Google almost nothing to add an additional user or search advertiser. SaaS is similar. Adding a new customer to Zoom costs Zoom next to nothing. Compare that to an office supply company. In order to add a new printer, the customer has to source parts, manufacture, sell, and ship a printer to the customer. That's a lot more work than adding a new user to Zoom. 

In order to maintain SaaS-like margins, SaaS companies have to limit and constrain their customers' ability to customize the product, ideally down to zero. The moment a SaaS product starts to build custom features for its big, important, strategic customers is the moment the company starts to lose the high-margin, near-zero marginal cost benefits of the SaaS model. Even if it charges very high prices for these customizations, the margins can get lost over time because the customizations have to be serviced in perpetuity and aren't amortized across thousands of customers.

Inevitably, every SaaS company will feel pressure from customers to customize. The high-margin, successful SaaS companies have resisted this pressure by creating roadmaps and features that satisfy most customers and/or have built configurable products where the customer can make their own customizations. Ideally, the customer actually likes the lack of customization because they pay less, but that won’t always be the case.

You could break software up into three distinct categories based on the amount of customization allowed for and the corresponding margins. 

SaaS software - High Margin (Hubspot, Zoom, Docusign)
Enterprise software - Medium Margin (SAP, Cisco, Oracle)
Custom software - Low Margin (Accenture, Infosys, Tata)

All of this is to say that there's nothing wrong with lower-margin software as there's an enormous market for it, and the growth inside of those markets could easily offset the lower margins in terms of cash flows. But it's really important to know which market you want to serve and to make a deliberate decision and stick to it. I've seen lots of companies that think of themselves as SaaS because their software runs on the cloud and their revenue is recurring have a roadmap full of customer customizations. I suppose you can call that SaaS, but it won’t have traditional SaaS margins. And that’s ok. But the decision to do so needs to be made deliberately with eyes wide open to manage the difficult tradeoffs associated with growth and profit.