The unprofitable SaaS business model trap

Marketo filed for IPO with impressive 80% year-over-year growth in 2012, with almost $60m in revenue.

Except, they lost $35m.  WTF?

go for broke

It’s not impressive when you spend $1.60 for every $1.00 of revenue, force-feeding sales pipelines with an unprofitable product.

Don’t tell me this is normal for growing enterprise SaaS companies. 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% loss instead of Marketo’s massive 60% 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. 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%/yr maintenance fees.
  3. As a result, enterprise-facing SaaS companies are unprofitable for the first 12-24 months of a given customer’s life.
  4. But, a growing SaaS company will be landing new customers, and in increasing numbers, which means piling up more and more unprofitable operations.
  5. 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.
  6. 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.
  7. 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%/year), you have to replace 25% 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. Use viral growth to offset cancellations.  Few 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.
  3. Drastically reduce the cost of customer acquisition.  An 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.
  4. Drastically improve GPM.  It’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% GPM (e.g. Salesforce.com, Rackspace).  But, companies with extremely low-touch customer service (which doesn’t necessarily mean bad customer service!) can push it way up (Google, Facebook, Freshbooks), unlocking “free money” for profitability.

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.

  • k_ann

    I still love Marketo! ;) But this is a great article. Good data, and interesting points to ponder! Thanks!

  • Mark

    Great post!

    I know this post is mostly about metrics, but I think the story is a bit different from a cash perspective. Are you referring to income statement profitability only? I think it would be good to talk about cash flow mgmt vs just profitability. For instance, you mentioned an old school company that sells a $100k deal and instantly recoups the costs. Couldn’t a SaaS company run the same deal, collecting the cash up front but recognizing the revenue across the 18 month deal term? It seems important to distinguish cash flows vs recognized revenue, especially when thinking about financing.

    I do agree that companies obviously need to get to profitability but cash management is critical to get to scale.

    • http://blog.asmartbear.com Jason Cohen

      I’m not at all referring to cash-flow. Wall street financials (and all companies I’m aware of beyond their Series A) use GAAP, i.e. accrual methods.

      Of course cash-flow can vary greatly due to collection times and of course CAPEX. That *is* important too, but not important in a long-term-profitable sense.

      Put another way, if the *only* problem with a SaaS company is that it’s eating cash through growth, but looking great from GAAP EBITDA, that’s a perfect reason to raise money, and you’ll do so at good valuations. Later stage companies often leverage debt for that instead of investment.

  • Joshua Ellinger

    I like the article (as always) but would like to hear your taken on a company closer to home: BazaarVoice.

    http://www.marketwatch.com/story/bazaarvoice-ipo-opens-up-33-after-pricing-2012-02-24

    I think basically BazaarVoice supports your argument but they are not as much of an outlier as Marketo. Thoughts?

    • http://blog.asmartbear.com Jason Cohen

      BV is an interesting one, and I hear different interpretations from different people. Yes, there’s definitely a general tenor of conversation around whether there’s enough profit and growth, but of course that’s (now) already baked into the stock price.

      The most damning thing I’ve heard is around product versus service, and how much revenue which is in fact service revenue (at associated scale and margin) is / has been reported as recurring revenue, so this lack of distinction could be making the “recurring” part look better than it really is.

      However, I don’t have enough insight or detail to really make a statement with confidence.

    • arustgi

      Looking at the Bazaarvoice share price trend over the last 2 years and its recent guidance as of Sep 5, it appears that the only way investors make money is by passing the shares to the next guy in line, and the last person holding the line is biggest sucker.

      Talk about bad unit economics for a business.

      • http://blog.asmartbear.com Jason Cohen

        Maybe, but you have to take each company on a case-by-case basis. If you used Salesforce.com as an example, you’d see the opposite story.

  • http://www.totango.com Guy Nirpaz

    Very good post and business model analysis.

    Jason – do you see 75% renewal rate as a typical one? Most companies report a much higher number (I always assumed that they are not exactly telling the truth though. ;)

    • Scott

      75% is pretty average. 85% is exemplary. What a lot of companies do is combine their renewal / upsell numbers. So a $100 renewal that upsells to $110 is counted is a 110% renewal.

    • http://blog.asmartbear.com Jason Cohen

      Scott here is correct.

      In general the answer of “what’s good” varies a good bit with the type of company and the other metrics.

      For example, for enterprise company you would expect higher (i.e. 80% is good, 85% is fantastic) whereas with SMB (but still B2B) 75% could be the maximum possible and 70% could be acceptable. A consumer company could be lower still, but even then it depends on whether you’re talking about a high-tech company (higher cancellations) or low-tech consumer (e.g. telco or cable companies are consumer but would die if they have 70% annual cancellation rates).

      By “depends on the other metrics” I mean something like this: Support it costs only $1 to acquire a new customer, because you’re very efficient with word-of-mouth and other things. Then you can sustain very high cancellation rates and (if you’re in a huge market) everything is fine. If it costs $200-$500 to acquire — as is typical with a non-viral SMB business — then you need higher retention rates. If it costs $500 to acquire but only at $10/mo, you’re screwed if *anyone* cancels. But if it costs $500 to acquire but you make $500/mo, cancellation rate can be higher and still profitable.

      So the equation of “profitability” depends on things like rate of acquisition, cost of acquisition, cancellation rate, gross margin on that rate, and so on. It’s not JUST cancellation rate.

      Still, cancellation rate remains one of the most important metrics, and in particular getting to zero and then negative net churn is game-changing for *any* SaaS business.

  • Cynthia Typaldos

    And freemium only makes it worse.

    BTW, it’s my understanding that Salesforce is not profitable.

    article:
    Salesforce.com – Sometimes Hype Just Isn’t Enough
    http://seekingalpha.com/article/1285021-salesforce-com-sometimes-hype-just-isnt-enough

    • http://blog.asmartbear.com Jason Cohen

      Thank you, very good point. So even with terrific metrics in other areas, it’s not enough.

    • Nadeem Ahmed

      The lack of profit is due to acquisitions, salesforce.com has the best operating profit in the SaaS industry, they just keep re-investing it into acquisitions…

      • http://blog.asmartbear.com Jason Cohen

        Correct, thank you.

        There are pundits who argue that the M&A is folly and unprofitable, however. For example, they’ve spent over $1b total on the likes of Heroku, Radian6, and BuddyMedia, all of which were unprofitable and purchased at a huge multiple of revenue.

        Therefore, SF will need to more than pay back that outsized outlay in profits, and it’s unclear (as yet!) that these will prove that accretive.

        However, that’s punditry, and you’re correct that in any case their basic model is very profitable, regardless of whether their use of funds is wise.

        • Xgenei

          The article also mentions “growth through huge compensation expenses.” That is my take of the company over the years compared to the viral efforts of (but not the best A:B) ZOHO.

        • Wade Giles

          Saying their model is profitable but their business isn’t sounds like the “separate-buckets blunder” (http://www.bankrate.com/finance/personal-finance/7-psychological-money-traps-and-how-to-avoid-them-3.aspx#5).
          In the Salesforce.com scenario, the core competency bucket is always full and so they buy new buckets. We take from one bucket and pour into these new buckets. Fantastic, but will those buckets ever start filling themselves? Great post and fascinating discussion.

  • George Dolbier

    Excellent article! I have been working with SaaS companies since the late 90s (back when we called ourselves ASPs then xSPs then…. In the early days the focus was on the transition from the licence based biz model, to an “annuity” based business model. I have seen LOTS of failures. Most of the failures for the exact reasons you point out. Also underestimating cost of delivering service, security issues, bad market positioning. A few of things that have been “silent” killers: of SaaS providers

    1) Not aligning sales compensation with customer retention & profit I’ve seen a lot of SaaS companies give great bonuses for signing up new customers, but not giving bonuses based on profitability, contract length, or ongoing customer satisfaction.

    2) Underestimating cost of operations. Especially for SaaS providers that want to sell into industries that have any regulations or service level standards. For example HIPA can have some sneaky hidden costs.

    Enterprise SaaS firms that are delivering a true value to the enterprise can justify an “onboarding” cost. SaaS companies are typically small entities, and it is odd to think of charging a customer an up front fee that will cover pre-sales, marketing, administrative, and technical overhead. Established enterprise vendors, VARs and the like have made this established practice. I often strongly encourage to have enterprise SaaS firms work “onboarding” fees into their contracts.

    Also, SaaS firms have a tremendous amount of knowledge about the service they are delivering, and it’s value to their customers. EVERY Enterprise SaaS firm needs to have a consulting arm, even if it is just the founder. Not only is this a high profit revenue stream, consulting reduces churn, reduces competitive loss, increases value of your service to your client. For Fee, Pre-Sales Consulting assessments, can be an excellent method for Opportunity Qualification that makes the balance sheet look not quite so ugly.

    http://www.linkedin.com/in/georgedolbier/

    • http://blog.asmartbear.com Jason Cohen

      Thank you for your wonderful insights, and I agree.

      The consulting arm is especially salient (for enterprise SaaS), and I don’t think “the founder” is sufficient at all (except of course in very early days when there’s little choice).

      People tend to run away from anything looking like professional services because “it’s not scalable” and “the margins are low.” VCs are equally to blame for this mindset.

      Indeed, if that’s your primary revenue, and the product is a “foot in the door excuse” to sell hours, then they’re right, and that’s a great model for a consulting company, but that’s not a SaaS product company.

      But if it’s in the reverse — as you characterized it — then consulting ensures customer success, which means ensuring multi-year contracts with referencable customers, which is fantastically valuable, and then you throw on top of it all that the division *makes* money, not eats it? Bonus! Who cares what the “margin” is for that department — it’s “free retention,” and more importantly, self-funded customer success.

      • Jeffrey Hartmann

        I think one thing that too many people miss as well is that consulting really helps make a service very sticky. If you system is deeply integrated with the customers systems due to the consulting engagement you have a leg up over any competition. Their systems already are intertwined with yours, and anyone trying to replace you will very likely have to by default get to at least your same level of integration. Also since the company has already paid for this integration, unless giant benefits are going to had by moving they are unlikely to move. Moving would require the same level of consulting costs again or loss of current functionality. Businesses don’t like to pay for the same thing twice, and they certainly don’t like losing current functionality. Those SaaS’s who realize this can use it as a giant lever to really increase profits overall.

        Another thing to point out, if you have a high value product you really should also look at charging for onboarding and bundling it with a consulting package by default. Especially when going after a large customer, charging for onboarding can really help insure success. If the company is paying some portion of their on going charge up front they have more invested in your service. If you just have a simple cost where you are losing money unless the customer stays for a long period, there is little resistance to the customer casting a large net and trying multiple solutions in parallel. Once you have agreement on an upfront fee and begin integration with their systems, you are more certain the customer is a good one. It might not work for all SaaS companies and for all your customers, but it is really worth investigating for your enterprise customers since it is such a giant help to the revenue model and helps make you more sticky.

        • Xgenei

          Enjoying this greatly – always wondered about the specifics of consulting versus software (SaP or SaaS). But you failed to mention the key phrase buy-in — so I will.

  • Sam Bayer

    Amen to Bullshit! I prefer tangible profits that I can share with the company than the blah blah blah that fuels the PR machine. http://bit.ly/19g86el

  • Nigel Milne

    Thanks Jason, great insight and very timely–I’m knee-deep in building my SaaS forecast!

  • chirag

    The tendency to loose money at the cost of gaining market domination itself is false. Unless the technology that you are building has the potential of being unique for long period. For instance Google. But, if you are start-up with easy to replicate business model and technology, loosing money is not the option. ask yourself one question…how much time will it take for anyone to replicate your business model?

    Anyways, excellent piece of write-up

  • Richard Garand

    Excellent post Jason. The permanently-unprofitable model might work in some cases if you’re aiming to get acquired or use it to launch another product line but it doesn’t seem like a viable way to build a business that can survive on its own.

    The rush to the SaaS business model may have been overdone. It sounds exciting at first because of the promise of ongoing revenue. But that revenue isn’t forever since customers cancel, it’s not pure profit because of all the expenses you listed, it can be a low-to-medium amount rather than a large amount, and it’s delayed for a long time because you only get a little bit each month. That delay can be enough to completely change the way the business operates.

    On the plus side, all those disadvantages may mean that most SaaS customers are coming out ahead in the deal. So if you subscribe to a few services that’s good news.

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  • Jack Studer

    Net present value with appropriate discount rates solve all these problems. Math FTW

  • Mike Leach

    Eloqua’s stated reason for selling to Oracle was “the enterprise marketing automation space is fully penetrated”.

    Every tech company was using marketing automation, but other industries, less so. They’d reached peak customer acquisition… or so they believed. Good time to sell.

    With every major enterprise player now offering a “Marketing Cloud”, it’ll be interesting to see how this particular space plays out.

    • http://blog.asmartbear.com Jason Cohen

      Agreed that market saturation is a good time to sell. Actually, just before that point, so valuation might still reflect bigger growth opportunity. :-)

      Of course this is just another argument for why SaaS companies need to achieve profitability after reasonable scale, not large scale. Otherwise you can literally run out of market space to grow into, which defeats any claims of defense that “we’ll grow into profit.” If growth slows and/or becomes more expensive, and you still don’t have profits to propel you and to open up new markets, you’re not in a healthy, sustainable spot.

  • Wakjob

    “Stability is more important than growth”
    –Michael Dell

  • WisePops

    Thanks, as founder and CEO of WisePops.com (saas) this is very useful. I love the saas model but I am also interested by a pay what you use model, as I believe this should be the next step. What is your opinion on this, do you believe Saas model has great future ?

    • http://blog.asmartbear.com Jason Cohen

      SaaS models *include* pay-per-use. Amazon AWS is SaaS, for example.

      SaaS literally means “Software as a Service,” which refers to the idea that the physical software itself resides on a server on the Internet, and the customer rents the use of that software, rather than installing the software inside the firewall and paying for it once.

      Thus you always have a recurring component in a SaaS business — the service itself has recurring cost, so you have recurring charges, and the customer accepts this.

      But you can vary the charge by use, you have different tiers, you can have startup/onboarding costs, you might offer hourly professional services, etc etc.. There’s lots of revenue models, and in fact mature SaaS companies will often have multiple types of revenue at the same time.

      So it’s not a “next step,” it’s just part of the umbrella of SaaS business models.

      Indeed, pay per use is an excellent model because it allows people to start using it easily (small barrier to entry, hopefully implying lower sales costs) but has built-in MRR growth assuming customers are successful, which in a healthy company will exceed cancellation rate, and thus mean the company grows on its own power — thus profitably — and only needs to “spend to grow” to accelerate that process.

      • WisePops

        Thanks, fully agree with that. By pay per use I was talking about no subscription : for example WisePops is a tool to create pop-ups for you website. Today customers pay a monthly fee depending on what they need, function of the number of page views of their website. But we could also enable future customers to pay per pop-up displayed, with no monthly fee at all. This would be a 100% pay per use model. For the customer point of view, this is very interesting model too don’t you think?

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  • Brooks

    Great argument, but your SaaS estimations are a bit off. Re-run your numbers with proper estimates and the model doesn’t look nearly as bleak.

    You talked about improving these metrics in the second half of the article, but your starting point was a little low.

    1) Churning 25% on $$ per year….crazy talk. Typically logo churn is 5-10%, but $$ churn is usually less than 5%.

    2) Cost to serve a customer is typically under 15%, not 30% as stated. Often times this is even lower for established firms. There are a lot of efficiencies to be had. Multi-tenant architecture, online video tutorials, certified consultants, etc.

    • http://blog.asmartbear.com Jason Cohen

      I don’t know what SaaS companies you’re looking at, but I think you’re confusing net-churn with cancellation.

      You are factually incorrect to say that typical annual churn by revenue is 5%. I know of zero SaaS businesses with that churn rate. I know of zero public SaaS businesses with that churn rate. And I know a lot of businesses. :-)

      If you mean *net-churn*, then it’s true that large, *successful* SaaS businesses *must* have low or even zero and negative net-churn, otherwise it’s mathematically impossible for them to be big. But it’s very rare for a new (i.e. pre-scale) SaaS company to have negative net churn.

      On GPM — cost to serve customer — it depends on the SaaS business. I agree that for business with little-to-no customer service it should be closer to 15%. However with the type of SaaS business I was highlighting in the article — i.e. serving the enterprise, with real customer service — then again you are factually incorrect. CRM is 76% GPM (and it took 6 years for them to get from 70% to 76%, so 70% is more usual). RAX is 71%. BV is 65%. DWRE is 70%. OPEN is 65%.

      So no, my value of 70% for GPM is quite accurate, and I’m unable to find a single public SaaS company at 85% GPM as you suggest.

      • Brooks

        Thanks for your response. Again, I think the article is great.

        My numbers are just what I have seen personally, with my businesses, and what I hear form other industry folks. For example in Bessemers 10 laws of SaaS this year,

        “The top performing cloud companies can enjoy annual Logo Churn rates below 7% and CMRR Churn rates below 5% – with most of the churn due to death (bankruptcies) or marriage (acquisitions) – and CMRR Renewal rates well above 110% due to upsells into this installed base.”

        …and they looked at over 4,000 companies in the past 12 months.

        This is also echoed by Pacific Crest’s annual private SaaS company survey. Where they stated that 75% of companies have less that 5 percent.

        …but they only surveyed 70 companies.

        As far as the GPM goes, that sucks. I’m glad we have a consumerization of enterprise movement on our hands. Personally, I think we need high touch onboarding, but more automated management of active clients.

        You should think about doing a post on public vs private numbers. Looks like there may be some interesting differences. Self selection on their part?

        Keep writing thought provoking stuff. It’s great to have contrarian opinions in the enterprise space.

        • Geoff

          Thanks for this article and for the follow-on comments. As Brooks suggested, I too would like to see some more stats about private numbers.

          For context, my SaaS business is privately held and launched with “Friends & Family” investment. We have revenue in the millions, but not yet tens of millions. We are comfortably profitable, and have been growing at +/-50%/yr for the last several years. We have a 7% revenue churn rate and a 12% customer churn rate. Our gross margins are 81% and we include customer support in our COGS (I believe $CRM et al puts them in SG&A; If we excluded customer support from COGS, our GM would rise to nearly 90%).

          All that is to say that I think Jason’s stats are directionally accurate, and his prescribed “solution” is sound for people who wish to build enduring SaaS businesses with as little outside investment or debt financing as possible.

          Even so, the market is clearly paying for top-line growth without regard to profitability, so if your objective is to sell the business very soon and you have virtually unlimited access to cash, it makes complete sense to push aggressively for more revenue without paying too much attention to your net margins.

          My personal view as an entrepreneur (which was heavily shaped by the recession) is that people who own unprofitable businesses are always working for the bank and/or their investors, and people who own profitable businesses are working for themselves.

          • http://blog.asmartbear.com Jason Cohen

            Thanks, great comments.

            The market rewards growth over profit ONLY WHEN the market also believes there’s a lot more growth ahead of the company AND when the other mechanics in the company are sound, e.g. good GPM and high LTV:CAC. Because then being profitable is in fact hindering growth, and thus hindering taking over the market, which must be the goal of a LARGE company.

            Once the company is large and simple market expansion isn’t how it will grow, they’re betting on the development of stronger business models. This is the current bet on FB, TWTR, and Pinterest. (Are they right? only time will tell.)

            Also note that anyone who takes institutional investment is also not “working for themselves” even when profitable. Profits don’t pay back investors.

            P.S. CRM does include support in GPM — you have to for GAAP. So do we at WP Engine and you should continue to do so as well.

            • Geoff

              “CRM does include support in GPM — you have to for GAAP.” Thanks for clarifying. Good to know for benchmarking purposes.

              “Also note that anyone who takes institutional investment is also not ‘working for themselves’ even when profitable.” Great point.

  • Cloud Hugger

    A great read thanks

    Another strategy is for the saas vendor to totally outsource implementation services to an external provider, avoiding potential accounting treatment of amortising any implementation fees over the same period as the subscription… imagine having to write down $$$ of implementation fees over the 18mths of licensing agreement… eek.

  • B

    Jason, one thing to also consider is the declining cost of email (Eloqua) and additional competition reducing prices on renewals. For example if company X has a 3 year SaaS contract for 100k after three years email prices will have declined therefore if the contract goes into RFP the renewal rate might actually be less or flat, even with additional upsells. This makes it even harder to maintain growth

    • B

      Sorry I meant declining price of email not cost.

  • http://www.Net-Results.com/ Michael Ward

    Weighing in from the other end of the spectrum, I founded what may be the only profitable, bootstrapped marketing automation company in existence. It appears that nearly all of our competitors are playing some version of Marketo’s game of burning VC cash to acquire customers at a loss (to some degree or other).

    We’ve avoided (resisted?) taking any outside money thus far and it’s very much a double-edged sword. We get congratulated for bootstrapping, being profitable, and growing nicely. All that’s good. We say “thank you”. But…

    Operating (purposely) at a loss, spending massively on market awareness and customer acquisition would take our growth rate through the roof. And bump our valuation substantially. After several years of bootstrapping that grass can look pretty green.

    Marketo and their investors knew exactly what they were doing. I’d guess that they don’t (or maybe didn’t until Salesforce went elsewhere. And Adobe) think their model is broken at all. They have built their business from day one for IPO and acquisition. They (obviously) believe that profit is not necessary to win the game they are playing. They’ve created a massive amount of value for their investors (the early ones anyway). Looking at things from their perspective it would appear that, until recently at least, things have been going just fine.

    • http://blog.asmartbear.com Jason Cohen

      A few things:

      1. I don’t know that investors and executives do know what they’re doing WRT to profitability and metrics. Sure they know they are “spending to grow.” But are they honestly tracking whether a profitable business is growing underneath that intentional spend? I’m not so sure.

      2. Whether you should care more about sustainability or valuation depends on your goals. If your goal is to build a real business that throws off cash and makes you happy and at your option can be sold for a reasonable multiple on revenues, then you should stay the course. If you want to “shoot the moon” and roll the dice on a valuation/buy-out/IPO strategy that’s almost completely outside your control, but if you roll well you could put $100m in your pocket, then you can go that route.

      Another option is to find investors who appreciate that you do indeed have a profitable model, and are willing to take a middle road where you goose growth but not in a way that breaks the model, and where an exit at any point along your trajectory is also acceptable to the investor. This is a strategy that cannot work with most VC portfolio theory, but WOULD work with most angel investor theory, if they can invest enough money to make a difference.

  • Guest

    Weighing in from the other end of the spectrum, I founded what may be the only profitable, bootstrapped marketing automation company in existence. It appears that nearly all of our competitors are playing some version of Marketo’s game of burning VC cash to acquire customers at a loss (to some degree or other).

    We’ve avoided (resisted?) taking any outside money thus far and it’s very much a double-edged sword. We get congratulated for bootstrapping, being profitable, and growing nicely. All that’s good. We say “thank you”. But…

    Operating (purposely) at a loss, spending massively on market awareness and customer acquisition would take our growth rate through the roof. And bump our valuation substantially. After several years of bootstrapping that grass can look pretty green.

    Marketo and their investors knew exactly what they were doing. I’d guess that they don’t (or maybe didn’t until Salesforce went elsewhere. And Adobe) think their model is broken at all. They have built their business from day one for IPO and acquisition. They (obviously) believe that profit is not necessary to win the game they are playing. They’ve created a massive amount of value for their investors (the early ones anyway). Looking at things from their perspective it would appear that, until recently at least, things have been going just fine.

  • AndrewCamel

    Jason, a B2B SaaS company would not operate with a CAC/LTV of 2.53, which is what your example indicates. The bare minimum would be 3, with the average at 5+. Changing the LTV metric to a more reasonable assumption significantly improves your results.

    Also, I don’t really think it’s fair to first rip on Eloqua, which sells a product with a long sales cycle that requires a lot of hand-holding, and then pitch your solutions that really only apply to small startups with light-weight products.

    • http://blog.asmartbear.com Jason Cohen

      That’s factually incorrect. They do it all the time, in fact they can have CAC > LTV, and it’s a perennial problem that’s been written about by most pundits exactly because it’s such a widespread problem.

      For example, Hubspot is often held up as a paragon of successful, fast-growing, metrics-driven, intelligent SaaS business model. But for years, LTV/CAC was <2. It was only in Q2 2012 that they broke a ratio of 4. That's great that they figured it out, but for *most of their life* they operated below the example I gave. (Source: http://www.forbes.com/sites/jjcolao/2012/09/13/a-dangerous-seduction-revisited-in-defense-of-the-lifetime-value-ltv-formula/)

      Now of course I 100% agree that a *successful* SaaS business cannot operate like that! That's part of the point.

      But your statement that "the average is 5+" is just not true. Only at the highest-performing level, and my point exactly is that SaaS businesses MUST achieve that, else I don't think they are sustainable.

      Finally, I don't understand your point about Eloqua. Yes it's a long, expensive sales cycle — that's exactly my point. Marketo is not a solution for "small startups" — it's still out of price range even for us at WP Engine, and we spend six figures a month on marketing.

      If you're referring to WP Engine itself being "light weight products for small startups," then that's incorrect as well. The majority of our revenue, in fact, doesn't come from small business. And in any case, I didn't bring up WP Engine as a counter-example (though it is!), but rather I'm pointing out that many highly-valued so-called "successful" SaaS businesses I believe are in fact not sustainable — i.e. not capable of interesting profits — and I'm comparing those to others which are similar in space and size, but which are capable of it.

      • AndrewCamel

        I’m sorry, but that’s really not true for any reasonably sized company. They will not operate with those kind of CAC/LTV margins (at least with any reasonable managers) that don’t show any signs of improvement.

        The only reason I’m fighting for this one is that I disagree you need to be turning a profit at $30M in revenue. All the big names are on their way (Salesforce, Workday, Box, etc.) and they far exceed that revenue number. It’s just a matter of time.

        I look a very, very long look at Hubspot from 2010 to 2012. You’re right that they did operate at an extremely low CAC/LTV and I can guarantee you they took a lot of heat for it in fundraising. However, one of their biggest selling points and the reason they were able to raise is that they could prove they were able to walk up the CAC/LTV to eventually get the ratio to some reasonable level, which they have now done and maintained successfully.

        Sorry, I wasn’t taking a jab at WP Engine; I honestly don’t know the product very well. I’m glad that improving your website features lower CAC, but honestly, those improvements don’t have nearly as much of an impact on companies at larger scales like those you’re criticizing.

  • http://blog.voicesage.com paulsweeney

    Very many good points raised here and great comments too. While companies absolutely have to run these customer acquisition metrics, getting good benchmarks is the initial key to staying on track. Understanding where you are in the development of your SaaS is also important because how and where you spend varies as you grow.

    Having “taken care of business” in this way, you might then find yourself up against a better funded competitor who is spending money on customer acquisition, feature development, and brand. This other company is planning on gaining the #1 or #2 position, demonstrating 40-50% yr on yr growth, and then being bought by the legacy players that have to enter this new “high growth cloud market”.

    What gets lost is the fundamental business model. What is being delivered more efficiently due to some new constellation of capabilities? What is the addressable market for this new model of delivery (offer), and most importantly are their new “white space” market opportunities? Your point that eventually the market begins to tap out is really, really important. So my takeaway provocation is to ask how your SaaS is opening up new white space opportunity because this gives you avenues of growth and resilience.

    (and yes, this will pull against the need for absolute, jaw dropping, fastidious focus :)

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  • John Receveur

    Great post Jason, thanks!

    What are your thoughts on a saas platform + services (with fees) to develop specific custom applications?

    • http://blog.asmartbear.com Jason Cohen

      I love +fees for customer success and on-boarding, and I dislike +fees for customization unless the price point and gross margin is high.

      The reason for the former is that prof serv on the front-end means the customer is successful with the platform, which helps with long-term retention, which is critical for any SaaS company. It’s also more likely to result in referenceable customers and growth within the customer base. So if on top of all that the customer will pay for it, then it’s awesome, regardless of net-profit that comes from that group (so long as net profit is positive).

      I don’t like it when it comes to heavy customization, because that’s not scalable. That is, at that point you’re really a consulting company with an “in-house platform” that you’re bringing to bear because it helps you execute better/faster/cheaper/etc..

      That’s wonderful for a consulting company, but it’s not a SaaS play.

      I would except that again if it’s very high dollar with high margin on the monthly rate, with prof serv on top of that. If you throw off enough money, anything is a good idea. :-)

      • Xgenei

        Pencil: +10 points on that one.

  • TomC

    In addition to making sure that your customer succeeds with your product/service, professional services should also be a key contributor to the requirements and priorities of your next-gen product releases. Done right, PS folks live the frustrations your product/service engenders, just like your customers, which is the first step to upgrading the product to eliminate those frustrations. That experience and subsequent feedback should be invaluable to the development team.

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  • Phil

    Hi Jason,

    A lot of interesting conversations here – cash flow vs profitability, market analogs, retention vs acquisition….

    I would like to add two more – risk tolerance and variable costs vs fixed costs.

    Risk tolerance was touched upon by some other comments about the board of directors of Marketo and their exec team. While the argument can be made that bad economics should not be weathered, many SaaS companies were born from start-up roots and have a high tolerance for risk. To me it seems like Marketo’s team is simply confident in their long term economics (5+ years) and are willing to accept that their economics are not perfect yet. I think the market agrees as their stock price has weathered the initial “buyers remorse” stock dip and is net up.

    Technology companies that invest in high growth have a lot of early fixed costs. The cost of R&D for example. Over time, more costs shift from fixed to variable costs which contributes to overall long term profitability.

    I am curious to hear your opinions on where you think the unit economics will be 2-3 years from now.

    • http://blog.asmartbear.com Jason Cohen

      Great points, thank you.

      Risk tolerance is one thing, but a fundamentally unprofitable model is another. Of course I agree investors need to have a healthy tolerance for various forms of unprofitability as the company scales. However there’s some point where “more scale” is no longer a valid excuse.

      It becomes no longer about pure business/market/product risk, but rather just a fact that the business model is not working. That’s simply a problem, no longer a risk trade-off.

      Regarding fixed costs, I agree that as a percentage of revenue, fixed costs should decrease until hitting certain limits. For example, a tech company will always need to invest some in R&D, probably 15% but certainly not less than 10%, and minimum overhead also grows with scale, if you think about executive staff, office space, legal services, HR, etc..

      It is highly unusual for a company which has already achieved scale in the $50m/yr+ revenue phase to drastically improve GPM, so I disagree that it can suddenly be better. GPM by definition are costs that scale in direct proportion to revenue, so it’s only through efficiency innovations and perhaps some scale savings that it can improve. That’s hard.

      On the other hand, it *is* common for companies at scale to increase GPM slowly over time. Both RAX and CRM have increased GPM about 1% per year (meaning e.g. 67% -> 68%, not 67% -> 67.67%). I think that’s a good goal for any SaaS business at scale, and of course more is better, but huge jumps in GPM isn’t something you should be betting on.

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  • http://doteduguru.com/ Kyle James

    Jason,
    So obviously you feel that the market has no idea how to evaluate this company and that their market cap is a joke. Why not put your money where your mouth is and short MKTO?

    • http://blog.asmartbear.com Jason Cohen

      That’s not at all what I said.

      I said that I personally don’t like this kind of company-building behavior, and I wish the startup community would aspire to the goal of eventual profitability.

      I am a red-blooded capitalist and I do believe companies are worth what the market will bear. I have no ill-will towards anyone on this, but rather I have a perspective that I think is healthier.

      Finally, I absolutely do not believe Wall Street stock motions are based on insights into companies. Surely the fact that 90% of trades are in and out in under 2 seconds is proof that there’s much more happening in Wall Street than financial fundamentals.

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  • https://twitter.com/streaky81 Streaky

    “Undo the effect of cancellations through up-sells/upgrades”

    Here’s the real mistake all SaaS (and many other-) providers make. Undo the effect of cancellations by having a reliable, useful product that people don’t want to cancel.

    Novel idea right?!

    • http://blog.asmartbear.com Jason Cohen

      Your way is how SaaS companies stop growing.

      It’s true that if cancellation rates are high, that should be your top priority because it means you don’t have a product that customers value.

      But there’s always a logical floor to how low cancellations can go. I’ll write a whole post on this in future, but there’s always things like customers stopping their projects, budgets going away, a customer which changes such that they’re no longer a good fit, mistakes you make which cause cancellations, etc..

      However, a SaaS company cannot get large with net-churn (i.e. cancellations minus upgrades). Too many customers walk out the door each month.

      Therefore, you MUST also create processes which increase revenue in proportion to the number of customers, just as cancellations decrease revenue in proportion to the number of customers. That can mean viral/WoM, that can mean upgrades/upsells/cross-sells/etc., often on a per-use basis.

      Acting like the only component of net-churn is cancellations gets SaaS companies stuck when they’re mid-sized.

      P.S. If you intend to have a small SaaS company, e.g. <10 employees, THEN it is possible to use your method, because you're so small that low cancellations won't affect you much.

      • https://twitter.com/streaky81 Streaky

        Fundamental flaw in the argument is this – if customers want a product, they’re going to stick with the product. *many* SaaS/PaaS companies have high churn precisely because of what I actually meant – that the product doesn’t live up to expectations in some way. It’s either down too much or poorly-performing or the kind of viral stuff that’s supposed to be driving new customers in culminates in some sort of (effective) lie. Obviously you need customers coming in but many actively piss off their current flock so they’re guaranteed to have revolving-door customer retention.

        That’s the *real-world* lesson people should be learning.

        • http://blog.asmartbear.com Jason Cohen

          Again, *if* cancellation rates are high, e.g. >2.5%/mo, then I agree.

          If they’re not, then railing about how “company just don’t understand how to treat customers correctly” is not enough.

          For example, Rand from Moz famously has written about how their large cancellation rate killed investor interest because it meant they couldn’t make a big company.

          And Moz is a shining example of how to treat customers very well, and run a great company.

          Sure some companies are bad, but you’re oversimplifying.

          • https://twitter.com/streaky81 Streaky

            Oh of course, if churn isn’t a huge problem then it isn’t a huge problem – I know of quite a lot of companies that just ignore it like it’s a normal thing is mostly what I’m saying. It’s especially common around S/PaaS – and with these companies precisely why they can’t grow and be profitable – is the reason I mentioned it.

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  • http://www.referralcandy.com/ Visakan @ ReferralCandy

    Great read. Thanks for writing this!

  • Xgenei

    Fabulous. I hope you can comment on a business model vector question that I’ve been cogitating back-burner for several years. It’s time now to seriously weigh a model for the development, and given the government / spying / court-based intrusion reality and tracking the market / industry reaction out to 5 years:

    specifically, what would you think a SaaS / SaaP hybrid model of some kind would look like, that would cure the (I think overwhelming) toxic associations of cloud-trust-dependency — or do you think that is even feasible? Do you see any wave / rush back to Enterprise SaaP? The factors of a hybrid model might / must (imm) include some legal model of protection, physical protection, distribution-localization, and general independence from big-networking.

    My application is enterprise / individual blind, at least by value – and would definitely be a privacy concern – more than casual social media – bordering on personal counseling.

    • http://blog.asmartbear.com Jason Cohen

      I don’t know what SaaP is. If you mean cloud infrastructure where some is behind the firewall and sound is outside, that’s RAX’s current strategy for cloud services. Of course that’s not an application per se, but an application developer could build on OpenStack as a basis for achieving that. Not sure how much traction there is on that compared to SaaS, but clearly it’s interesting.

      • Xgenei

        Saap = software as a product. Here is the detailed executive summary of my current mind map. Please comment on any part & in sum.

        Back in the day we didn’t worry about this whole layer of virtual server infrastructure known as the cloud – that just confuses the issue. We used to think in terms of thin client for “not big networking” networks, and I came up with the concept of a fat client.

        Examples using the model include MicroSoft (with XP?) implemented for license verification.

        The general idea is-was-will be “big network independence.” Taking that model moderately further we have Adobe’s new “creative cloud” that requires a connection every 30 days. You can host your product, backup your data, store it and edit it live if you want to – or not – it’s all ‘a la carte.’ But if your bill is off – your suite power goes down. Very simple and fair.

        Sending your public presence to the cloud is a no-brainer. So there are only two problems to full cloud computing: mandatory data hosting and mandatory app hosting. The data hosting issue it seems to me is simply a separate service – one I would not subscribe to ordinarily unless I was hosting a wide data farm – and for that reason in segmentation.

        And certainly the application hosting to my mind only makes sense when you are having to synchronize “multiple (i.e. fundamentally incompatible) devices.”

        Okay – so we are down to one technical barrier, aren’t we? i.e. that attempts at synchronization is the whole friggen reason behind cloud.

        But I am sure you agree that synchronization as it is implemented is psychotic. It is like a big house where every single room is high security area that won’t let you in – and never works as advertised – and demands re-authentication, change your password, read new terms, what? Is this a new device? We’re sorry you’re having difficulty…. Who wants to live in a house like that? I’m going to stay in my room.

        Throwing out synchronization is why I think we need to focus on FAT CLIENTS that are essentially ultrabooks or better, that can effectively be run remotely by the *individual user* who needs to connect via something in his pocket or bag or car – Android or whatever – that he doesn’t mind losing. This isn’t synchronization. Everything goes into a local hole, remotely operated, which then outputs to anything you wish in a fairly controlled manner. Chaos is quelled!

        So I see the future in FAT CLIENT STRATEGY – and to develop cross platform for just the main OS Trinity – in other words the samo-samo that existed right before there was iPhone and cloud. I think cloud for anything enterprise is a misdirection – and the Big Brother (actually I think Big SYster is the one you have to worry about) revelations is just the first time people are seeing her naked with the light on.

        And so we have anything that will run in an Apache server stack – starting with Javascript, maybe Adobe AIR, and Java and java-tricks.

        (Add.break.anything at all)

        • Xgenei

          More evidence for a post-Google world space.

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  • Newbie

    Great points made. But I missed the key one – caring about customers! Talking to them, finding their problems, understanding why they cancel etc. Solution 3 is very important but it is actually part of exactly this.

    I see so many companies making products for themselves. The customer wants to be shown results with no time wasted on reading how great the product is. Why is it so hard to start using product right away?

    And why is it so hard to send feedback? I am a customer who want to help them with my free feedback ready to take my time to write it – then why do they make me jump through so many hoops? Hard to find the link. A long silly form to fill. Long sing-up process! Any surprise why no feedback arrives?

    A young startup with small user base has one great advantage that none of their big competitors can dream of – it can approach each customer personally! Get it right and nobody will cancel! Suddenly the problem is solved.

    Finally some free feedback for this site :)
    On my iPad I see an icon with red “i” at the low left corner, covering the text. I find it distracting, especially the red. Then when I click and it expands to several icons, worse thing happens – it dims the text (makes it hard to read). When I click on search icon, a tiny search window appears on top of screen, but the main text remains hard to read. So basically large space on my screen is wasted! And when I click search, it does not search the actual text but goes into Google search! Why not take more space that is wasted anyway and explain what the search will do? This is again all about customer care!

    One more thing – for some reason I could not send any comment on my iPad. Every time keyboard became non-reactive! Then I’ve found the error console full of errors! Whoever is a designer or developer of this site – please check the error console!

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  • http://www.neteffects.com.au/ Cloud Computing

    If companies become to comfortable with the SaaS set up they might end up with this scenario. When you decide to venture into SaaS you have to be prepared with everything, the changes and circumstances it has to bring.

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  • http://www.mycigaretteshop.net/ Virginia

    Great discussion about “viral growth” characteristics and cancellations.

    http://www.mycigaretteshop.net/

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  • Alex

    Regarding fixed costs, I agree that as a percentage of revenue, fixed
    costs should decrease until hitting certain limits. For example, a tech
    company will always need to invest some in R&D, probably 15% but
    certainly not less than 10%, and minimum overhead also grows with scale,
    if you think about executive staff, office space, legal services, HR,
    etc.. http://www.cigs4us.biz/

  • Shane Hopkins

    Great discussion here, I knew that there were intelligent folks on the internet somewhere…finally found a bunch – excellent string of comments by all.

    Jason’s points seem to me to be well thought out, and backed by good data most have agreed is accurate. so…

    My question is this: what keeps (has prevented) the SaaS model from naturally evolving into exactly what Jason and others here have described? Why has this flawed model not already fixed itself? The first ASPs came into play long ago, I was there. Many of the points made here today, were being debated back then before most of you were born for cripes sake.

    I smell:
    human nature
    greed
    focus on short-term satisfaction
    Poor values
    Weak cowards afraid to stir the pot with new fees for on-boarding cuz they might loose their Saturday tee time with a 15 year client.
    Leadership with no confidence in their services because they do not truly understand them – or because their services can’t justify another fee.

    Many value their yearly bonus, quarterly reports, and looking good in the board room over pride and the betterment of mankind.
    “Yeah, our current business model will crash and burn eventually, but maybe i can be out of here with my share before we reach that point” – this is easier than fostering the adoption of more sensible methodologies you all mention here.
    I have gone into that board room and tried to communicate that there was a better way, and with great caution tried to introduce the idea that change was needed, and that it would be hard, but we need to do it now, sharing the evidence (data) of seemingly slow but sure sinking ship. I never pointed fingers but always presented the data as it was spit out with no spinning. Always the same result, 2 or 3 of us would be on board, they would pull me aside in private and say “makes perfect sense, we gotta change direction” – 12 others would never speak to me again – they were all praying that they would be retired before I could get any changes implemented. Some would visit me before quarterly meetings to make sure I would not be presenting any data that shed light money spent poorly when they were driving….leave me a fruit basket and a note…seriously – weak frigging’ cowards. That’s why you younger folks run the show now, old schoolers of the 90s would follow a nope train to fuckthatville if they thought they could get a $100Grand out of it – leave it for the next guy to fix and never loose an hour of sleep over it. Operating at a loss with no light at the end of any tunnel is an acceptable state for some… period. Is anyone that commented here also in a leadership position with a SaaS co. besides Jason? (I assume Jason is) If so, what’s your deal? All seems so obvious to me….why follow the flawed model and think it will be different (this time) for you?

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