Silicon Valley rule of thumb points right way

August 31, 2015

By Christian Zhang

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Silicon Valley is double-checking its math. In a land that fetishizes growth over profitability, there’s a new rule of thumb for software firms that establishes a relationship between the two rates. A Breakingviews analysis suggests it can be a useful guideline. Investors should just be wary of extrapolating too much from it.

Technology entrepreneurs and their backers typically pay more attention to the top line than the bottom line. That’s starting to change a bit, with venture capitalists buzzing about a new back-of-the-envelope calculation. Brad Feld of Foundry Group and Fred Wilson of Union Square Ventures both have blogged about the idea that annual revenue growth plus operating margin – call it GAMS, for growth and margin sum – should equal 40 percent.

That would help a company go some way to justifying losing money. If revenue is growing at, say, 75 percent, then it could burn cash at a rate of 35 percent of sales. Similarly, if growth slowed to 30 percent, an operating margin of 10 percent would suffice.

Just as some investors look to quotients like the PEG ratio, which measures a price-to-earnings multiple against a company’s growth rate, GAMS could be a useful gauge for fast-growing but unprofitable firms selling shares in an initial public offering. A Breakingviews analysis of 27 publicly traded, subscription-based software companies found that ones that became profitable within three years of their IPO on average had previously generated higher GAMS than those that remained unprofitable.

40 percent rule

The 40 percent threshold does not necessarily portend investment success, which may be a relief to owners of Box and Zendesk, both of which fall short. Jive Software tallied a sum of negative 4 percent before its 2011 IPO. Since then, its growth has slowed and its deeply negative margins haven’t improved. Jive’s share price also has tumbled by 75 percent. Marin Software’s stock has suffered similarly even though it could tout a pre-IPO GAMS of 44 percent.

Any rule of thumb runs the risk of being corrupted or distorted. There’s no special magic to the 40 percent figure. And there’s even less evidence the model suits social media, online commerce or other sorts of tech business models. Even so, a reasonable inference from the analysis is that software developers and their investors can afford to look beyond just runaway growth and needn’t fear turning a profit. A healthy balance between the two will work.

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