Investors have fallen back in love with profitability.
This followed an almost two decade love affair with top-line revenue growth. The growth-at-all-costs paradigm enabled what I call cost-agnostic innovation: If it brings in more customers and revenue, build it — no matter how much it costs.
When cash is abundant, investors can afford long-term risk, and cost-agnostic innovation works.
But in the context of global crisis — pandemic, inflation, political gridlock, rising interest rates, war — big risks lose their luster, and investors change their tune.
In 2021, profitability correlated more positively with stock returns than revenue growth in the software sector for the first time in years. Especially for growth-oriented companies, the writing is on the wall: Margins matter.
The era of cost-agnostic innovation is over. Now, SaaS companies and digital-native brands in particular need to pivot to cost-conscious innovation. Here’s how.
3 Steps To Cultivating Cost-Conscious Innovation
1. Understand — and commit to — your key metrics
About seven years ago, when I was with EnerNOC (a demand response and energy intelligence software company that has since been acquired and rebranded as Enel X), our leadership team met with investment bankers who drilled top-line revenue growth into our heads. According to them, it was the main — if not the only — path to a meaningful valuation.
Fast forward to 2022 and I am attending a conference led by the same investment bankers and the dinner conversation is around the renewed focus on profitability. Meanwhile, I am getting questions from potential new investors on my gross margin adjusted CAC payback.
What does that mean? Were they wrong seven years ago when they sang the gospel of top-line revenue growth? Is profitability the inherently more valuable metric?
Of course not. All it really meant was that market conditions had shifted. Top-line growth mattered then; profitabile top-line growth matters now.
The truth is, the best-performing companies understand the key metrics that drive their business regardless of market conditions. Your metrics — in view of, but not exclusively defined by, market conditions — determine what cost-consciousness means. If you focus on ways to build value that transcends the formula, you’ll get rewarded in good times and bad.
2. Clarify your unit economics
It’s impossible to optimize your operating metrics if you don’t know what it costs to run different aspects of your business. A great place to start is getting visibility into your unit economics…though for SaaS and digital-native companies, that’s (a lot) easier said than done.
If you sell a small group of products to one main customer type, it’s relatively easy to calculate unit economics. You know who your customers are, what it costs to reach them, how much your product costs to build, and therefore how much you need to sell (and at what price) to turn a decent margin.
SaaS companies and other digital-native businesses don’t have it so simple. They often work with a range of customer types — individuals, SMBs, mid-market companies, enterprises — each of which costs a different amount to attract, convert, and retain. (This challenge is compounded by steep, variable cloud costs, which solutions like CloudZero help make clear and predictable.)
Clarifying your costs in a granular way and with business context is an essential step in clarifying your unit economics. Understand:
- Specific customer costs
- Different product costs
- Individual feature costs (if possible)
…and whatever other expenses it takes to sustain a great service in the cloud product. If that hasn’t been a priority in the past, it should be now.
3. Empower your people to make cost-conscious decisions
In a top-line world, engineers are encouraged to prioritize things like speed and new features over the financial impacts of their decisions. As long as it leads to a better product, finance teams will eat the AWS bill. No one gets fired for spending too much in the public cloud.
But in a margins world, cost-consciousness is non-optional. Because engineers drive nuts-and-bolts innovation, the onus falls on leadership teams to empower engineers with relevant cost information. When engineers understand the financial implications of their decisions, they can innovate in a more efficient and cost-conscious way.
Pivoting to a margins-oriented mindset might seem unnatural after years of focusing on growth. But doing so successfully boils down to fundamentals: committing to the metrics essential to your success, refining your unit economics, and spreading this information throughout your organization.