A company's value is equal to the present value of the cash investors can take out of it over time. Investors want to put their money into things that will provide them with lots of future cash flows. Technically speaking, they want to put money in companies whose return on capital exceeds their cost of capital. For an equity investment, the cost of capital for a company is the return that the investor expects; for a debt investment, the cost of capital is the interest rate the company has to pay.

Early-stage technology companies aren’t yet generating cash for investors. They typically lose money as they build up a set of products that can deliver cash back to shareholders at some point in the future. In the context of a new technology company and how an investor thinks about these financial returns, you could see two phases:

Phase 1: Building something that can deliver cash. Once a new venture has found product/market fit, it starts growing quickly. If you generate $1,000 in revenue in your first year, it's not that difficult to 10x that growth and get to $10,000 the next year. In this phase, companies aren't thinking about delivering cash back to investors; they're using all of their capital to invest in the company to grow their revenue and market share so that someday they have something that can deliver cash returns. In this phase, the cost of capital (the return the investor expects) exceeds the return on capital because there aren’t any returns yet. Investors are ok with this because they’re betting on big returns that will happen in the future.

This is why SaaS companies experiencing high growth don’t really worry too much about profits. They worry about growth so that they know they’re building something big, and they worry about unit economics (the profitability of providing a single unit of their product to a customer versus the cost of providing that unit). So, the high-growth SaaS company is happy to be unprofitable and burning through investor capital as long as it knows that it’s acquiring customers that will generate profits in the long term. So when the company has saturated the market and growth has slowed, they can pull back on sales & marketing expenses and R&D investments, and the unit economics then show up in the actual profitability of the company through previously acquired customers. So, this type of company isn’t yet delivering cash; it’s building something that will someday be able to deliver cash.

Phase 2: Delivering cash. Eventually, growth slows as the market saturates, and it gets harder to grow quickly on a larger base of revenue. Companies then find that continuing to invest investor capital and operating profits back into the business is no longer a good idea. That is, they can’t generate a return on capital that is higher than the cost of that capital. That’s when companies slow down their investments and start returning some cash to shareholders through dividends, share buybacks, or paying down debt, such that the investor can go invest in things that are more likely to exceed their expectations for an investment return.

The reason I’m going through all of this context is that one of the hardest things for a company to do, especially a technology company, is to identify the moment when it’s better to start returning cash to shareholders than it is to keep investing in new growth. There’s a saying that “profitable companies that have lots of cash have run out of ideas.” Leaders in companies don’t want to appear like they don’t have new ideas or that they can’t successfully execute them. And not investing in new stuff and just trying to get more profitable to pay out dividends isn’t nearly as fun as deciding to build a self-driving car or placing some other type of big bet. It’s even harder in today’s environment, where so many companies raised capital when growth multiples were super high. Case in point: ServiceTitan, which went public a few weeks ago, priced its IPO share price well below its last round of venture capital financing in 2021. Telling your investors that you think you’ve saturated growth when the company is likely valued less than it was when they invested is a really hard thing to do.

So, hundreds of companies have found themselves between a rock and a hard place. Growth has stalled as they've saturated their core market. But they’re a long way from getting above their last valuation (or “mark” in VC parlance), so they’re continuing to try to grow back into that valuation and, in some cases, destroying shareholder value in the process, where the investments they’re making will not exceed their cost of capital — especially because their cost of capital is now higher as their valuation has dropped. Some companies are betting too aggressively on their ability to produce high growth and are also speculating that if they do deliver on that high growth, the market will value it as it did in previous years. The median public SaaS company is now valued at 6x revenue, a long way from the 20x to 30x multiples of 2021. Getting a company’s valuation above its last mark is a a great thing to try to do, but destructive if done unprofitably.

I’ve simplified this issue a bit, as there are other options besides growing and returning cash. Companies can also invest in efficiency, reposition themselves strategically, and make profitable acquisitions. But all of this comes back to this super important topic of knowing who you are, knowing what’s best for your company right now, and having the courage to pursue that direction. A dollar is a dollar, whether invested in new growth or given back to shareholders as a dividend or share buyback. One approach is not inherently better than the other. As a responsible capital allocator, the key is knowing which one is better for you.