SaaS Math: Why “I” love SaaS!
Hey folks, this is the 1st post in the SaaS Math series. Today I’d like to start with I love SaaS. And when I say “I”, I mean investors.
When I entered the startup World, most companies sold software under a perpetual license. Software was downloaded and maintained on the customers’ servers. It was sold by big expensive direct sales forces. You got paid upfront (one time license fee). Then you sold maintenance contracts.
From an investor’s perspective there were several things that sucked about this goto market approach:
- Costs: Outside sales reps are expensive (think $ 120K base + commissions + travel) and many of them don’t work out long term. They exhaust their contact list then move on to the next product. Plus they work from home largely and it’s hard to manage them.
Also on the cost side when you sell client side software you have to build and maintain multiple versions and often need more sales engineering or support resources.
- No visibility: Enterprise sales are lumpy. Customers like to wait till end of quarter and then squeeze you. So, you can have trickles of business for 2 months and 2 weeks, then stress to bring in the end of quarter business. This creates lumpiness and lack of predictability in your sales. It can impact margins, create delivery backlogs and a whole host of other issues. You may see valleys in your cash collection due both to this lumpiness and the fact that you’re now dealing with centralized purchasing and payables departments in big companies who tend to move s-l-o-w-l-y.
SaaS has none of these drawbacks. While you can use sales teams to sell SaaS products (and we will drill specifically into the cost structure and prerequisites for sales teams and SaaS in this series), in many cases it’s not required. And when it is, you can often scale your sales team only as you win new subscriptions. Your costs of sales, delivery and support scale linearly (or, even better, in most cases realize economies of scale). Most importantly from an investor’s perspective, you have great visibility with SaaS.
In some cases, especially with enterprise SaaS, customers sign-up to fixed term contracts. But even without that, once you have been in market for a while, you will know how long an average customer stays with you. So even without a contract you know how much a customer is worth and how much you can afford to pay for that customer.
Certainty Premium
When you look at public company valuations SaaS companies trade at higher price / revenue multiples than companies that sell software licenses. There’s one key reason for this: Certainty. Financial markets pay a premium for increased certainty (and hence decreased risk).
Let’s say I have 1,000 customers paying me $ 50/ month. I lose 5% of my customer base each month and I am growing my customer base 20%/ month. ARPU is steady at $ 50.
In this example, my business generates approximately $200K of revenue in the quarter. But if you break it down $ 143K of that revenue comes from customers I had at the beginning of the quarter! If my revenue target for the quarter was $ 200K then I was 71% towards that target before the quarter had even begun.
This level of predictability is really why investors love SaaS so much. Once you have predictable customer values and you know how to acquire new ones, then as an investor I can generate venture scale returns without taking venture-scale risk.
SaaS businesses need capital
Some folks like David Hauser from Grasshopper might disagree with me on this, but for the most part SaaS businesses need outside capital to grow. Why? Because you pay upfront to acquire a customer and the customer only becomes profitable over time. So, you have a gap in cash flow. Yes, you can grow organically by saving up enough margin from your existing customers to acquire more, but this is slow. If you want to dominate your market, you need outside capital to maximize the pace of growth.
Given that most SaaS businesses have a need for capital and given that this capital can be deployed with decreasing risk to investors this is a great thing from the investor’s perspective.
SaaS is everywhere
Finally, SaaS is just a huge market. Salesforce was one of the early pioneers of SaaS. But SaaS is now prevalent in pretty much every product category. From CRM to e-mail, productivity apps, blogging, hosting, document sharing, you name it – everything is being sold as a service.
When you add all these segments up you have a $ 21B market for SaaS that is growing 21% annually.
Summary
So when you put this all together from an investors’ point of view SaaS is very appealing:
- lower cost of market entry
- Little or no purchase friction: avoid IT and purchasing departments
- Predictable customer value
- Reduced risk vs. other goto market approaches
- Huge, growing market
So for all these reasons, I love SaaS!
Mark great atricle as usual. As a SAAS start up I think that giving the client the best product in the field is the only way to have a win win on both sides. Small companies like ours have to work the model the way it was intended. No upfront costs. Maybe even a free full version trail. Prove that our software is a must have. Once the client has implemented our software into there company then we become hard to replace. Short term pain for long term gain. Collecting several yrs of monthly payments will always be more profitable than one time licenses. Client wins short term with no risk. In the long run he pays you much more as long as you hold on to him .
Thanks Patrick. You're right its all about the product (including the support around it) when you're a small vendor. Delight your customers again and again and they will stay.
Mark- The software delivery method part of SaaS and its payment terms are 2 different elements that don't always go hand in hand. Often SaaS vendors will throw in a bait and switch on you where they display their "monthly" rates, but when you get to it, they want you to pay upfront for the year, and for a minimum # of users. So, what appears as a $30/month product mushrooms into a $3,000 bill.
Reality is that SaaS is a marketing advantage more than a financial model, at least for the B2B side, which I can speak of, from direct experience. We try to get the client to pay upfront with a small financial incentive, and 80% of them do. This works well for cash flow, and the recurring monthly thing grows by acquiring more new clients, the old fashioned way.
Hey William, I think you see that much more with mature product categories and larger vendors. Think CRM, ERP, etc. My audience is primarily startups. And the vast majority of those cannot force these terms on their customers. Across my companies the annual prepay % is a minority of the customers. A growing one, but still the minority.
Yes and No. I think the distinction is one of B2C vs. B2B. Your analysis was probably tilted towards the consumer market space. I'm a startup with a B2B product, and we're not forcing anything on our clients. They are glad to pay upfront for a SaaS product. They are mid to large companies, and most of them don't like paying monthly.
Most of my companies offer business apps but targeted at prosumers, so yes – still an individual pulling out a credit card. You're right that if you sell to the company directly they don't really want to pay monthly
Great article. I think SaaS has so many positive aspects for both the client and the provider. From a client perspective, the customer service level will inherently be higher for an SaaS product. These providers rely on clients renewing their subscriptions, as opposed to the "afterthought" type of customer service I get from purchasing licenses.
Service is a key success factor in SaaS to be sure. But when you compare all-in costs of sales engineers and customer service for software companies vs. customer service for SaaS, the SaaS costs tend to be lower. I think this is because a lot of effort on the SaaS side is made to make the service easy to use.
One comment about investment – I think it's critical to get investment to fund the machine, but at least in enterprise on contracts you can essentially get cash in advance. It's the salesforce.com model – pay 1+ year(s) in advance.
Yep, for sure. Prepay is a big factor for enterprise SaaS. Even SMB SaaS companies can and should offer annual prepays with a discount.
Mark,
Great info – you've distilled years of knowledge into an easy to understand piece. Combines portfolio theory (diversify, NPV), marketing 101 (keep constant contact with your customers, cost of acquisition), treasury mgmt / risk mgmt (predictability of cash flows, financing receivables) and a host of other goodies.
Reminds me of my old wireless models . . .
Cheers,
Vince the CFO.
Thanks Vince. A lot more to come in this series. I love SaaS.
Thank you Mark. The great article comment is a given, but it's not often that people put out more technical blogs. Great education piece, and especially for those of us, not strong in the SAAS market, it's great insight.
Where do you see the risk (if any) in so much reliance on Cloud services? (for example, the Amazon server going down earlier in the year)
Thanks Jay. It is definitely a risk. I think many startups including a few I work with learned a hard lesson about needing a fallback plan with an alternate cloud that they can quickly move over to. Also, for both cost and reliability reasons some of my bigger SaaS companies have moved from cloud services to their own managed hardware at Rackspace. Still have a vulnerability issue, but things are theoretically more under your own control.