The unprofitable SaaS (Software As A Service) business model trap

With the hyper growth of accounting software being acquired as "Software As A Service", (on line via the cloud) we're always interested in where this business model can lead.  Mindful of that we read Jason Cohen, the founder of WP Engine & Smart Bear Software.  He writes for Venture Beat: Marketo filed for IPO with impressive 80 percent year-over-year growth in 2012, with almost $60m in revenue.   Except, they lost $35m. WTF?

Don’t tell me this is normal for growing enterprise SaaS companies.It’s not impressive when you spend $1.60 for every $1.00 of revenue, force-feeding sales pipelines with an unprofitable product.

I know the argument: The pay-back period on sales, marketing, and up-start costs is long, but there’s a profitable result at the end of the tunnel.  Just wait!

Bullshit. Eloqua was also a SaaS company, also selling to enterprise, selling the same product in exactly the same space, also tightly integrated with Salesforce.com, and IPO’ed with a $5m loss on $71m in revenue — a 7 percent loss instead of Marketo’s massive 60 percent loss.

So no, this upside-down business model isn’t what a SaaS business should construct.  I wish the modern startup community would understand the mindset that gets a company to this point, and resist it. 

The mindset works like this:

1. It costs a lot of money to land an enterprise customer.  Marketing, sales, legal, account management, on-boarding, technical guidance, training.  And: how many times do you run through that process and still lose the customer?  So these costs are amortized over the customers you do land.
2. 
   
3. SaaS companies earn their revenue over time.  Whereas a normal software company might charge $100,000 for an Enterprise deal, and thus immediately earn back those “customer startup” costs plus profit, the same SaaS deal might be $5000/mo, and it might take 18 months to get that same amount of revenue.  The good news is, after that 18 months, the SaaS company still charges $5000/mo.  The other company has to bust ass for measly 20 percent/year maintenance fees.
4. 
   
5. As a result, enterprise-facing SaaS companies are unprofitable for the first 12-24 months of a given customer’s life.
6. 
   
7. But, a growing SaaS company will be landing new customers, and in increasing numbers, which means piling up more and more unprofitable operations.
8. So much so, that even when an older customer individually crosses into profitability, there are so many more unprofitable customers, the company remains permanently unprofitable so long as it maintains healthy growth.
9. 
   
10. Plus, there’s all the other costs — R&D to build the stuff, office space, executive salaries, billing, legal, finance, HR, tech support, account managers. To actually be profitable, you need to cover those costs too. So it takes even longer to be bottom-line-profitable.
11. Therefore, it is healthy and reasonable for SaaS companies to be unprofitable as long as they’re growing even a little bit.

Early in a company’s life, this line of reasoning is correct.  But at Marketo’s size, this argument falls apart.

Why, exactly?

There’s a tacit assumption that if only we just stopped spending to grow, we’d be profitable.  Thus, this “really is” a profitable company, and the only reason it’s not is growth, which means market domination, which is a Good Thing.

The fallacy is: That time never comes.  No company stops trying to grow!  The mythical time when growth rates are small so the company reaps the rewards of having a huge stable of profitable customers never arrives.  When do you “show me the money?”

It’s worse. Growth becomes harder and harder for SaaS companies because of cancellations.  Even with a great retention rate (e.g. 75 percent/year), you have to replace 25 percent of your revenue with new — which means unprofitable – customers just to break even in top-line revenue!  More losses, more unprofitability.

Even with very broad numbers, you can see how this model doesn’t work.  Here’s typical numbers for an enterprise SaaS company at scale:

• 1.5 year pay-back period. (i.e. time to earn back the revenue to cover all your customer acquisition expenses)
• 75% annual retention.  (Which also means you turn over the entire customer base every 4 years.  On average of course — some stay longer, many shorter.)
• 30% cost to serve the customer.  (Can also be stated at 70% Gross Profit Margin, meaning for every $1.00 of revenue, $0.30 disappears in direct costs to service that customer, like servers, licenses, tech support, and account management.  Many public SaaS companies, even the titans like Salesforce.com, are about 70% GPM.)
• 15% revenue == cost for R&D department.
• 15% revenue == cost for Admin department. (office space, finance, HR, execs)

Say the average customer represents R dollars in annual revenue.  That’s:

• $4R of revenue over the lifetime of the customer.  But:
• $1.5R is spent to acquire the customer (the pay-back period).
• $1.2R is spent in gross margin to service the customer (4 years times 30% cost).
• $0.6R spent on R&D (15% over 4 years).
• $0.6R spent on Admin (15% over 4 years).

So out of the original $4R, we’re left with $0.1R in profit.  That’s 1/40th of the revenue making its way to actual bottom-line profitability, and even that takes 4 years to achieve.

And that is without any growth at all.  But you need to grow enough to keep up with cancellations at minimum, so that consumes the last notion of profitability.

What’s the solution?

Successful, profitable SaaS companies at scale (certainly by $30m/yr revenue, but should to be paying attention to this stuff by $5m/yr), do several things to make the math work:

1. Undo the effect of cancellations through up-sells/upgrades
   Salesforce.com and ZenDesk charge more for every person you add, and more per person when you increase the features in your plan.  Their customers grow (on average).  Thus, their revenue over four years is not 4R, but rather it might be R on the first year, 1.5R on the second, 2R on the third, etc., so perhaps 7R in four years.  That drastically changes the equation, because cost to “acquire” the customer doesn’t go up, and in general R&D and Admin don’t either. Taking “rate of cancellations” minus “rate of upgrades” is called “net churn.”  Getting to zero net-churn is a big step in getting profitable; the most successful SaaS companies have negative net churn.  It’s not just pure software companies that achieve this — hardware/server SaaS company Rackspace also has negative net churn, which enables them to grow revenues 30% year-over-year with $1.5 billion in revenue and $300m in profit.
2. 
   
3. Use viral growth to offset cancellationsFew B2B companies can truly claim “viral growth” characteristics.  But for the few who do, they can maintain growth rates of X%/yr where X is much larger than cancellation, and do so with very little acquisition costs.  In this case, cancellation never “catches up,” and you win
4. .
5. Drastically reduce the cost of customer acquisitionAn 18-month pay-back period is a killer.  If customers can be found with paid advertising, if they can sign up without talking to a sales person, if they can learn the product through in-product tutorials, great documentation, and how-to videos, if they can import their data without assistance, if they can demonstrate value to the purse-string-holders without a sales person writing the presentation for them, then the cost of cancellation-replacement and proper growth becomes small enough that it’s no longer a barrier to profitability, even under conditions of growth.
6. 
   
7. Drastically improve GPMIt’s hard for a service-oriented enterprise-sales company to not have real costs around tech support, account management, and extensive IT infrastructure, which is why even the most cost-efficient (and profitable!) enterprise-facing SaaS companies often can’t push much past 70 percent GPM (e.g. Salesforce.com, Rackspace).  But, companies with extremely low-touch customer service (which doesn’t necessarily meanbad customer service!) can push it way up (Google, Facebook, Freshbooks), unlocking “free money” for profitability.
8. 
   

Another way to think about these solutions is that a SaaS business cannot have static fundamental metrics.  The metrics themselves need to improve — lowering cancellation rates, lowering net churn, increasing GPM, reducing cost to acquire customers.  Leaving the metrics alone, and trying to “grow until profitable” doesn’t work.

It’s like the old Jackie Mason joke — A man is selling jackets at cost.  The customer asks “how can you sell at cost, how do you make any money?”  Answer: “I sell a lot of jackets!”

Marketo is selling a lot of jackets.