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.

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