Over and over again, I see exciting headlines for SaaS companies like this…
That when I dig a little deeper, I end up having my bubble burst by a dismal financial statement that looks something like this…
Where is all the money going? Why do so many successful SaaS companies, startup and public alike, have such a difficult time turning a profit?
This is the fourth post in a series on SaaS metrics that will once and for all solve the mystery of why seemingly successful SaaS companies lose money by using a little mathematics. But, before I jump into the technical details, here is the short answer: foolish SaaS companies don’t seriously tackle the problem of reducing Total Cost of Service through automation and economies-of-scale, and they foolheartedly chase after the Recurring Revenue Mirage.
In the last installment in this series, I introduced the following two SaaS metrics rules-of-thumb:
Which in concert make the claim that the time to profit for a growing SaaS company will always be greater than the baseline break-even time for the average SaaS customer.
tprofit ≥ BE0
BE0 = CAC ÷ [ ARR – ACS ]
Where “CAC” is the average acquisition cost per customer, “ARR” is the average recurring revenue per customer, “ACS” is the average recurring cost of service per customer, and the 0 attached to the BE is intended to indicate the absence of churn, i.e., the baseline break-even.
In this post, we’ll zero in on the interplay of growth and profitability with customer acquisition cost and recurring cost of service (collectively total cost of service), starting with…
SaaS Metrics Rule-of-Thumb #6
Growth Creates Pressure to Reduce Total Cost of Service
We know from the earlier SaaS Metrics Rule-of-Thumb #2 – New Customer Acquisition Growth Must Outpace Churn, that successful SaaS companies must strive to grow new customer acquisition at a percentage growth rate, “g”, that exceeds the churn rate. This growth model is quite general. It applies equally well when growth is slow and plodding with a small value of g and when growth is rapid and extremely viral with a high value of g. The only requirement is that our successful SaaS company grow consistently from year to year, which is of course what we all want. In this case, the relationship above between SaaS company profitability and SaaS customer break-even can be made much more exact (see math notes below):
||g x BE0
||means longer time to profit.
||g x BE0 ≥ 1
||the company will never be profitable.
||g = 1/BE0
||is the maximum, profitable rate of growth.
Since no SaaS company in this universe will throttle back on growth, the only acceptable strategy is to reduce the value of BE0 such that g x BE0 is significantly less than 1, otherwise it may be a looooooong time to profit, perhaps well after the company stops growing altogether (gasp!).
This creates pressure to reduce total cost of service by lowering the average customer acquisition cost, CAC, and lowering the recurring cost of service, ACS. Since growth is the culprit, the surest and most effective defense is to fight fire with fire by reducing total cost of service through automation that provides cost-lowering economies-of-scale. (The one other viable solution, increasing ARR without increasing CAC or ACS will be the topic of the next post in the series entitled SaaS Revenue – The Beauty of Upselling and Upgrades) This latest SaaS metric rule-of-thumb is visually depicted in the chart below.
New customer acquisition costs are paid with the recurring contribution of current customers.
If a SaaS company grows rapidly, growing acquisition costs can outpace
the build-up of recurring contribution, such that profitability is impossible.
As outlined in the previous post on SaaS profitability, time to profit occurs when Read more »