The ICONIQ Enterprise Five: Evaluating Software Companies
Christine Edmonds and Vivian Guo | October 2, 2020
To date, ICONIQ Growth has been proud to partner with 50+ leading enterprise software companies, with 21 companies being named World’s Best Cloud companies on the Forbes Cloud 100 this year.
Being part of their growth journeys has made us better investors and, more importantly, better partners with a deep understanding of what strength looks like at various stages of growth; especially what it takes to scale to $100M annual recurring revenue, $500M ARR and $1B+ ARR.
While our quantitative evaluation of software businesses is always tailored to the nuances of a company’s industry, product, customer base and sales motion, below are five of the key metrics we consistently use to understand top-line growth and operational efficiency:
We hope this quick summary of the “ICONIQ Enterprise Five” helps illuminate why these metrics are valuable.
METHODOLOGY & TERMINOLOGY
The following is a quick glance into why we look at each of these five metrics (both individually and in concert with one another) and how a subset of our existing portfolio companies¹ stack up against each measure across different stages of maturity (ARR scale).
The graphics included in this study represent both median (“Strong”) and top-quartile performance for each metric (“Best in Class”²) across the following subset of enterprise software companies in our portfolio.
ARR Growth (YoY, %) = EOP ARR / Prior Year EOP ARR
We have consistently seen our top-quartile portfolio companies double ARR in each of the first 2–3 years of growth as they scale from the ~$10M ARR threshold.
The drivers of this growth are also important to understand — both in terms of size and quality of customers, as well as variation by sales motion. As healthy enterprise companies scale, they can increasingly rely on existing logos to generate new ARR opportunities through upsell or expansion.
ANNUALIZED NET $ RETENTION
Net $ Retention (%) = (BOP ARR + (Expansion -Downsells -Churn)) / BOP ARR
Note: there are several different ways to calculate net retention, please see notes for more information³
As discussed in our prior analysis of recent IPO performance, we continue to believe that net retention is arguably the most important gauge of business health for software companies and the efficiency of their revenue generation.
Net dollar retention specifically accounts for expansion, downsell, and churn which renders it a robust measure of both product strength and customer success motions.
While gross and net retention will begin to converge as companies scale and better manage churn, software companies targeting the mid-market to enterprise sector should strive for net retention of ~120%+ in early stage of growth.
RULE OF 40
Rule of 40 (%) = ARR Growth (YoY, %) + FCF Margin (%)⁴
The “Rule of 40” is the principle that a high-performing software company’s combined YoY growth rate and FCF margin should generally meet or exceed 40%. We typically only begin to place real weight against this metric for companies with at least ~$25M in ARR or 60% in YoY ARR growth (largely due to the volatility inherent in the calculation of this metric at earlier stages of revenue generation).
While Rule of 40 is often cited as the darling metric of the investment community, we believe its true value only comes to life when evaluated in concert with other key dimensions, particularly growth and retention, which help unveil drivers and contextualization of performance. It is also worth noting that this metric is more indicative of company valuation than it is of absolute business health or performance.
Top-quartile companies consistently exceed the Rule of 40 regardless of scale, and the spread of companies across these two measures should begin to narrow as scale is achieved.
NET MAGIC NUMBER
Net Magic Number = Current Quarter Net New ARR / Prior Quarter S&M OpEx
The “magic” of this metric lies in its ability to measure revenue generation against sales & marketing spend while accounting for the lag of a typical sales cycle in order to understand the efficiency of sales and marketing spend and teams at a more nuanced level.
While there are four ‘flavors’ of Magic Number (Gross and Net, each with or without a Gross Margin adjustment)⁵, we typically find Net Magic Number to be the cleanest and most comprehensive view.
As companies scale, magic number will generally trend slightly downward, as initial sales are often extremely efficient at early stages and become increasingly challenging with competitive dynamics, shrinking headroom, and complex customers — coupled with the ‘law of large numbers’. Regardless, a net magic number of 1.0x+ is generally a good long-term goal.
It’s worth noting that magic number can be too high which may be an indication that a company is not investing optimally in sales and marketing spend.
ARR PER FTE
ARR per FTE = Total EOP ARR / Total EOP FTEs
ARR per FTE is another important metric through which we can determine a company’s operational efficiency. Simply put, it looks at ARR generated per full-time employee and is an effective gauge of human capital productivity and efficacy.
This metric is even more telling when analyzed against OpEx per FTE. Team productivity and efficiency are not mutually exclusive — we have seen multiple examples of companies that have meaningfully improved FTE productivity (ARR per FTE) while ~maintaining FTE efficiency (OpEx per FTE) as they increasingly create leverage across teams and processes.
A Brief Note on COVID-19 Impact:
Given significant impact from COVID-19 over the course of 2020, we recognize that many of the top quartile ranges across these growth and efficiency metrics are more challenging to attain in the current environment.
While these benchmarks represent data through EOY 2019, we continue to believe they are appropriate and relevant guide-posts for long-term growth goals and strategic planning.
Notes & Disclosures:
 This analysis includes 33 of the 58 enterprise software investments ICONIQ Growth has made to date, based on quarterly data through YE 2019, represented in the set of logos included above.
 Based on a comparative analysis with a broader set of companies included in the 2019 KeyBanc Capital Markets SaaS Survey, in which our portfolio’s metrics consistently outperformed industry-wide average (e.g., Median ARR growth of 87% vs. 40% for ICONIQ Growth vs. all KeyBanc surveyed companies). This is a subjective measure of performance purely used for terminology sake.
 There are a number of different ways to calculate net retention, including annual net retention, annualized quarterly retention, and customer cohort analysis. We typically use annualized-quarterly net retention to better capture quarter-over-quarter changes, which is particularly important when companies are smaller in scale and greater variation in net retention (%) is driven by a smaller denominator. Sometimes, especially when looking at inconsistent periods, we will use the average of BOP and EOP in the denominator.
 While either FCF or EBITDA margin can be used in the Rule of 40 calculation, we typically prefer to use FCF for software companies . Deferred revenue / payment terms are important and usually more positive than EBITDA, especially in software companies. Using EBITDA for a business that is self-hosted would also not be a good fit (since the company has to factor in PPE, financing debt, or lease expenses).
 Gross and Net Magic Number calculations can be multiplied by a company’s gross margin % to take into account the payback required to fully break even.