SaaS Failures – The Recurring Revenue Mirage
There is an argument that has been passed around the SaaS community that software-as-a-service requires a long runway to profitability due to high up-front infrastructure and customer acquisition costs coupled with the long payback period of a subscription-based revenue model. While this seems reasonable, my personal belief is that it is complete nonsense that usually just provides an excuse for poor management. Here is why.
1) Infrastructure investment is really not that much.
While infrastructure can be significant for a single customer, the cost per customer drops dramatically once you have reached a few hundred accounts. Most SaaS companies don’t spend more than 10% of revenue on infrastructure. This is the whole point of SaaS, lower TCO. While infrastructure cost may be significant, it is not enough to justify the huge losses that are typical of many SaaS vendors (including some prominent, ostensibly successful public companies). The vast majority of costs of any software company is labor. This is still the case for SaaS. And usually, most of that labor is in sales and marketing.
2) Acquisition labor costs are fixed, but not easily avoided.
The common misconception that SaaS companies can and should recoup acquisition costs over several years of recurring revenue comes from a textbook investment model where a fixed up-front investment is paid for over time by a variable income stream. Like buying an expensive machine that produces lots of inexpensive widgets. Or more similarly, spending heavily on direct marketing to sell high margin magazine subscriptions.
Under this theory, as SaaS vendor can justify high acquisition costs compared to an annual subscription price, because these costs will be recouped over the full lifetime of the customer…right? Wrong. The fallacy is that these are short term analogies applied to a long term problem. So, they distract us with fixed and variable costs, when our eyes should follow the avoidable costs. As the short term turns into the long term, each new fixed investment cost is avoidable. If it does not meet ROI requirements, the companies in the examples above simply have to avoid buying another machine or stop sending out direct mail respectively.
But, most of the acquisition costs in a SaaS or software company are labor-related, i.e., avoiding acquisition investment implies firing sales and marketing staff. Not likely. What is more likely to happen in an innovative, growing software company is that these resources will be reinvested ad infinitum, whether or not the new investments match up to earlier ROI. Or, they will be redeployed into account management and support roles as the company matures. Either way, any historical plan to recover early acquisition costs will be long forgotten. At least until a layoff forces the repressed memory back to the surface.
Enterprise and Web infrastructure software companies grew very rapidly throughout the 90’s, because they were expanding into a supply-constrained technology vacuum with deal values that justified high acquisition costs resulting from an outbound sales model. Most SaaS companies are expanding into demand-constrained markets like hard-to-get-to SMB segments, new unproven application sectors and competitive replacement markets…all of which can be tough going and are better addressed by an inbound sales model. Over investing in customer acquisition is like pushing on a string. A better strategy for the vast majority of SaaS companies is to establish a stable, profitable cost structure as early as possible, then grow profitably by accurately matching acquisition capacity to the market demand they can capture or create. And, build a company culture grounded on technology innovation and a lean, efficient operational approach.
The goal of this blog is to share knowledge and opinions that will help executives at Internet software companies that create and deliver B2B, B2C and B2B2C software-as-a-service ( SaaS ) applications critically analyze real-world, go-to-market strategies and tactics by applying sound business principles
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Joel – Thanks for this article! It is a point I’ve been wanting to approach for a long time.
On infrastructure – add to your arguement the point that if the infrastructure is cloud-based (which it certainly should be in my opinion) it is flexible in both directions. It can expand to meet demand growth and retract to meet slowing transactions.
On customer acquistion – if the marketing group is smart, they are investing in ways to leverage social media and the network the application rides on – the Internet! I see so many leave this on the table for a competitor to grab it is just plain unbelivable.
Joel – I agree with what you are saying. I owned a SaaS oriented business from 2002-2008, raised over a million dollars in private equity on an a weak sales forecast, then invested too heavily in infrastructure and personnel, assumed the profits came over the lifetime value of the customer, fought for every sale, had much higher support costs than expected and ultimately ran out of funding.
The net result was my loss of the company to the investor and my dismissal. A bitter lesson, but one that supports EXACTLY what you are saying about mismanagement. In the end, I like to call it “the perfect failure” because of the lessons learned. I was fortunate enough to gain incredible insight/experience into the space and am contemplating going back for more, hopefully more successfully and definitely wiser…
For those reading this who are in the SaaS space, what he is saying is absolutely true.
Thanks for these insights, Joel. I agree that the cost of acquiring customers, while important with on-premise applications, is doubly important in the software-as-a-service model. There are, indeed, some prominent SaaS companies who are making a big bet that their customer base and revenue stream will grow fast enough to cover their sales & marketing spending.
For some, with deep enough pockets, this may work out. Unfortunately, others may end up like WIle E. Coyote in the cartoon. The too-clever predator runs off the cliff, keep his feet moving, and stays airborne… until he finally looks down at which point the floor of the canyon quickly comes up to meet him.
Hi Joel. I found this view quite interesting. We are a Company that is helping IT Companies to set up and manage their channels in EMEA and in the US (we are just starting there) and we have noticed that many SaaS Companies have lost time and money in trying to approach traditional IT resellers/VARs to resell their solutions. Obviously the channel value proposition did not match and this has caused many disappointments.
As you somehow suggest, I think SaaS requires a new go-to-market with a much more flexible operational approach and new categories of partners.
Should you be interested we could elaborate on this.