Let’s get fiscal! Is SaaS a Profitable Business Model?

As followers of the SaaS market, we regularly hear of exciting new start-ups developing innovative solutions to customer problems and delivering them in slick, easy-to-use web and mobile...

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As followers of the SaaS market, we regularly hear of exciting new start-ups developing innovative solutions to customer problems and delivering them in slick, easy-to-use web and mobile interfaces – ticking all the boxes for a SaaS start-up. They secure investment at an early stage and invest in refining their product, expanding their team, and in doing whatever it takes to increase usage and grow their customer base. It would appear that exponential growth is the order of the day from many investors, but at what cost?

Customer Acquisition Cost (CAC) has become a feared term amongst SaaS founders and a key metric for any start-up worth its salt. Fundamentally, a great product with a great market opportunity to match may not be enough to guarantee success, and some serious thought needs to be put in to the bottom line. Start-ups can often fall in to the trap of deciding on a pricing model for their product at an early stage, thus locking in the revenue side of the equation when the cost side of the equation remains unclear. In many cases they simply land on a price point that is too low in an attempt to make their offering more compelling to the market and to boost growth. It is often only when a good level of revenue growth is achieved and maintained for a year or more that the spotlight begins to shine in to the dark corners of one’s cost of sale and the questions are asked – why are we still not profitable? And when do we plan to get there?

Cartoon of disgruntled business boss and chart of declining profits, business man says, It's important to note we really are trying hard.

The first point to note is that traditional monthly or quarterly income statement view of revenues versus cost of sale tends to look particularly bleak for a growing SaaS company due to the way in which its revenues are realised. In the traditional software model, where a perpetual licence sold and paid for up front accounts for the lion’s share of revenue earnings, it is easy to match that revenue against your CAC and to see straight away if your margins are healthy. In the SaaS model, the same CAC is incurred for in the marketing and sales effort to get that customer on board, but the SaaS start-up’s balance sheet can only recognise the revenue in line with the monthly subscription payments that start to come in once that customer is in life – an issue that is compounded by the relatively common practice of offering 30-day free trials. Revenues in the SaaS model, therefore, are rarely going to allow for a profit to be shown in month one, quarter one, or even year one – so the more appropriate metric to compare your CAC to becomes the lifetime value of the customer or LTV.

This is a relatively simple concept to grasp and for SaaS founders to explain to investors (if it needs to be explained) but it also ready-made excuse for lack of profitability extending in to years two, three, and beyond. Apart from the obvious cash flow implications that must be managed when revenue and cost of sale don’t align, higher than expected CAC and an overly aggressive pricing structure can often lead start-ups to exaggerate the LTV of their customers in order to show profitability but, to drag up the most overused of clichés, a bird in the hand is worth two in the bush, and LTV may not always stack up to our expectations. So, other than re-adjusting the pricing model that your customer base have signed up to and risking dissatisfaction and possibly churn, what can a growing SaaS start-up do to improve their prospects of profitability?

Executives are discussing the need for change and businesswoman suggests not changing 'and something magical just happens'.

Well, at the risk of over-simplifying the issue, it becomes a matter of minimising CAC while maximising LTV. For a mathematical approach to what kind of LTV/CAC ratio is healthy for a SaaS company, check out Andreessen Horowitz’s excellent analysis of the key metrics to look at in the valuation of SaaS shares. However, as a general rule, SaaS start-ups should aim to get to a point where they are recovering their CAC in the first 12 months and their LTV is at least three times their CAC. Achieving can often appear like a delicate balancing act between creating such an excellent customer experience that your customer is unlikely to churn and willing to grow their spend with you, while also keeping the sales process as low touch as possible in order to keep a lid on costs. In order to improve LTV, the key objectives must be high levels of customer satisfaction and low levels of churn – the advice here is to let your product become your key marketing tool and make it such a fantastic experience that word of mouth and viral effects do the selling for you. Easier said than done, I know, but all the sales and marketing spend in the world won’t make up for a poor user experience. Following in that vein, further ways to improve LTV are regular product enhancements and expanding your product set as multi-product customers tend to be stickier customers.

On the CAC side of the coin, the first measure to be taken is to limit your use of relatively expensive sales mechanisms like outbound ATL marketing and field sales unless you are in the enviable position of enjoying the kinds of high margins that allow for this expense. It is better to focus on low touch inside sales where possible and to take a good look at your inbound marketing options. Also, avoiding the temptation to “chase elephants” and focus a huge amount of time and effort in acquiring large customers who require significant customisation of your product and end up wielding a lot of bargaining power is a good way to keep your CAC in check. It is far preferable as a growth strategy to focus on a homogenous, out of the box offering with mass market appeal supported by a single instance, multi-tenanted environment than to bend to the will of large customers and watch your CAC soar. Finally, methods such as touchless online conversion, freemium offerings, and perhaps further down the line a look at channel sales models are all potential CAC busters. In general though, it is important to consider both sides of the profit and loss account from day one in your start-up business and to remember that growth comes at a cost.

by Michael Cullen @michaelcullen87

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  1. Is SaaS a Profitable Business Model ? | Agile Payments

    […] Get the answers in the full post on Saascribe from Michael Cullen @michaelcullen87 […]

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