Is It a Bubble?

In a recent Wall Street Journal article, Bill Gurley, a successful Silicon Valley venture capitalist raised the very real possibility that the valley was entering a period of irrational investing as it is prone to do from time to time. Gurley specifically pointed out high pre-money valuations and the high burn rates of SaaS businesses as one of the indicators of the bubble-like environment.

On the valuation front, he might be right. According to Pacific Crest’s latest report, there are now over 44 public SaaS companies with an average valuation of 6.8 times projected 2014 revenue. Overvalued? Possibly?

As it relates to the burn rate, however, I seriously doubt it. Gurley sited a SaaS business with a $4 million burn rate as a prime example of the bubble atmosphere.

I don’t know what company he is talking about obviously, but I do know this. If that business is acquiring customers at a cost that is less than 50% of their lifetime value, that company will do just fine. (LTV to CAC ratio of above 2.) SaaS businesses have their costs front-loaded and their cash-flows spread-out over time. If they stop investing aggressively in growth, they automatically become profitable (assuming the LTV to CAC ratio above.)

Mr. Gurley knows this, of course, and I’m also betting the investors and managers in the “high burn” SaaS businesses do as well. Not everyone does, however, and customer acquisition cost and lifetime value metrics are not easy numbers to get a hold of from outside the company.

I point this out simply for the benefit of others who are dealing with SaaS companies such as potential new hires, suppliers, or even customers. Understanding the inherent stability and viability of a SaaS business is difficult to do with traditional financial reports and metrics. Unit economics are the key to understanding the “real” companies from the ones about ready to go “pop.”

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