Profitability, one would think, should come quite naturally to a successful, growing SaaS company. But, SaaS startups have consistently struggled to reach profitability. Unprofitable SaaS companies have gone public and remained unprofitable for years after their IPOs, even as they grow revenues into the hundreds of millions of dollars. SaaS companies have eschewed economic convention, with management and investors alike calmly shrugging off the passe’ advice of their obsolete microeconomics professors who cry out in vain from their blackboards that “the role of the firm is to maximize profit.” Many authors have tried to make sense of this morass, two of the more interesting attempts are Bob Warfield’s post entitled Why do SaaS Companies Lose Money Hand Over Fist, and this really cool analysis by Christian Chabot of tech IPOs comparing software companies that were profitable to those that were not profitable at the time of their IPO. And, I’ve certainly made no secret of my own opinion in posts like this one entitled SaaS Failures – The Recurring Revenue Mirage.
This is the third post in a series on SaaS metrics that will unravel the mystery of SaaS profitability (and the lack thereof) from a different angle, a little mathematics. Once and for all we’ll solve the puzzle of why seemingly successful SaaS companies lose money. So, even if you’re not a math junkie like me, please be patient and plough your way through the technical mumbo jumbo. I’ll guarantee some of these results will surprise you!
SaaS profitability is such an important topic that I’m breaking it up into three separate posts (this being the first) that will build on each other by examining three increasingly complex scenarios: 1) stable growth with churn, 2) viral growth, and 3) growth through upselling and upgrades. Along the way, I’ll also introduce a number of new SaaS Metrics Rules-of-Thumb that highlight the impact of customer acquisition costs and recurring cost of service on long term SaaS profitability.
So, let’s get going…
SaaS Metrics Rule-of-Thumb #4
Company Time to Profit Follows Customer Break-Even
This subtle, strikingly simple rule will reverberate through all that comes to follow on SaaS profitability. And, it provides a simple sanity check for predicting when, if ever, your SaaS business will reach profitability. The gist of the rule is that your SaaS recurring revenue over time is nothing more than the sum of its parts. Therefore, the sooner you break even on a single customer, the sooner you will reach profitability as a company.
The chart below visually shows this principle for a SaaS company with a constant rate of customer acquisition eroded by churn which was closely examined in the first post in this SaaS metrics series.
The accumulated recurring contribution of a SaaS company at any time
mirrors the lifetime accumulation of the typical SaaS customer
directly linking company time to profit with customer break-even time.
The average break-even point for an individual customer without churn, “BE0” is given by the following formula:
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.
Now let’s compare this simple individual customer SaaS metric with the more complex SaaS metric of company time to profit. At any given time, the rate at which a SaaS company generates profit is given by the following formula:
Profit = P(t) = [ ARR - ACS ] C (t) – CAC ΔCnew(t)
Where C is the number of customers and ΔCnew is the new customer acquisition rate. Time to profit occurs when this expression changes from a negative loss to a positive profit, or when profit is equal to zero.
P(tprofit) = [ ARR - ACS ] C(tprofit) – CAC ΔCnew(tprofit) = 0
If we consider the simplest case scenario of a constant new customer acquisition rate with no churn, “b”, then after time t, we will have b x t total customers, giving the following equation for time to profit:
P(tprofit) = [ ARR - ACS ] x btprofit – CAC x b = 0
tprofit = CAC ÷ [ ARR - ACS ] = BE0
In this simplest of cases, time to profit not only follows break-even, it equals break-even. This relationship between company time to profit and break-even time for the single average customer is a completely general principle for SaaS (or any recurring revenue subscription business). Unfortunately, the simple case scenario above is also the best case scenario as spelled out in the next SaaS metrics rule-of-thumb.
SaaS Metrics Rule-of-Thumb #5
Best Case Time to Profit is Simple Break-Even
SaaS Metrics Rule-of-Thumb #2 – New Customer Acquisition Growth Must Outpace Churn states that if you want to break free of the churn limit, then you must increase new customer acquisition to compensate. Unfortunately, this mandate places you neatly between a rock and a hard place with respect to profitability. On the one hand, your customer acquisition costs increase each year, while on the other hand churn is eating away at your ability to break-even on every new customer you bring the door. The net result is that both churn and growth push SaaS profitability out beyond the single customer break-even point in direct relation to their intensity. The higher your churn, the longer it takes to reach profitability. The higher your growth rate, the longer it takes to reach profitability. And, if either your percentage churn rate or growth rate are too high given your customer acquisition cost and recurring contribution, your SaaS business will never reach profitability. The chart below shows this general principle for the simple case of a constant new acquisition rate subject to churn.
For a growing SaaS company subject to churn,
the best case time to profit is the average break-even time for a single customer.
If churn is too high, profitability becomes impossible to achieve.
In the next installment in this series entitled Growing Up Poor – How Foolish SaaS Companies Lose Money, I plan to zero in on the root causes that lead seemingly successful SaaS companies to lose money. And, then move on to the solutions to this obstinate problem. Some of the concepts presented in this post as well as earlier SaaS Metrics Rules-of-Thumb were developed in previous installments in this SaaS Metrics series:
SaaS Metrics Math Notes
SaaS Metrics Rule-of-Thumb #5 – Best Case Time to Profit is Simple Break-Even can be shown using a little math trick. After I show it, I’ll try to explain in plain English to provide a little more insight into its cause (hint: if you don’t like the math, skip to the end). Taking the formula above for time to profit:
P(tprofit) = [ ARR - ACS ] C(tprofit) – CAC ΔCnew(tprofit) = 0
and rewriting it in terms of the baseline break-even time, BE0 = CAC ÷ [ ARR - ACS ], gives the following:
C(tprofit) = BE0 x ΔCnew(tprofit)
Because we are following SaaS Metrics Rule-of-Thumb #2 – New Customer Acquisition Growth Must Outpace Churn, the new customer acquisition rate, ΔCnew, is always increasing. Since C is just the sum of all the customers acquired at the lower acquisition rates from earlier times, then had we acquired customers at the current acquisition rate the whole time, we would clearly have acquired more customers.
t x ΔCnew(t) ≥ C(t)
Substituting this little trick formula into the above gives the following:
tprofit x ΔCnew(tprofit) ≥ C(tprofit) = BE0 x ΔCnew(tprofit)
tprofit ≥ BE0
What does it mean? In a subscription business, you reach profitability when the contribution from current customers covers the acquisition cost of new customers. This is the essence of SaaS Metric Rule #4 – Company Time to Profit Follows Customer Break-Even. In the base case, everything is constant and customer break-even = company time to profit. But, if you lose customers to churn on the revenue side, while you acquire new customers at a faster rate each year on the cost side, then it takes more current customers to cover your new customers, so the faster you grow, the longer it takes to stack up enough customers to cover your new ones. If you grow too fast, you can never catch up, and you’ll never be profitable…unless you stop growing! Or, you take action to reduce costs. This is the topic of the next installment in the series: Growing Up Poor – How Foolish SaaS Companies Lose Money.
Check out the rest of the SaaS Metrics Rules-of-Thumb
- SaaS Metrics Rule-of-Thumb #1 – SaaS Churn Kills SaaS Company Growth
- SaaS Metrics Rule-of-Thumb #2 – New Customer Acquisition Growth Must Outpace Churn
- SaaS Metrics Rule-of-Thumb #3 – Viral Growth Trumps SaaS Churn
- SaaS Metrics Rule-of-Thumb #4 – Company Time to Profit Follows Customer Break-Even
- SaaS Metrics Rule-of-Thumb #5 – Best Case Time to Profit is Simple Break-Even
- SaaS Metrics Rule-of-Thumb #6 – Growth Creates Pressure to Reduce Total Cost of Service
- SaaS Metrics Rule-of-Thumb #7 – Churn Creates Pressure to Reduce Total Cost of Service
- SaaS Metrics Rule-of-Thumb #8 – Upselling and Upgrades Accelerate SaaS Profitability
- SaaS Metrics Rule-of-Thumb #9 – Joel’s SaaS Magic Number
- SaaS Metrics Rule-of-Thumb #10 – SaaS Customer Lifetime Value Drives SaaS Company Value