SaaS economics Part 1: it's not looking promising

As we start to think about winding up 2014, I have been poring over some quantitative research by David Skok who, in collaboration with investment banker Pacific Crest Securities and Open View, an expansion stage VC firm. The research, which covers 306 SaaS companies, mostly in the Bay Area, provides a wealth of data on SaaS economics.

The research comes in two parts:

• Part 1 deals with growth and go to market.
• Part 2 deals with the underlying operational economics of running a SaaS business.

Most of the companies in the research are 'early stage.' However, they provide useful data points for those of us who run sanity checks on service providers when someone asks if there is any adult supervision. Hint: often there's not, or very little. Please bear that in mind when reading my analysis. Why does this matter?

Due diligence on the vendor should be a priority once you've got your short list in place. This is never easy but it helps to have a solid understanding of the business model so that you can assess vendor viability. This is especially true in immature and fast moving markets.

Second, 2014 has been an odd year. Not too many alarms among the software vendors, everyone seems to be doing 'ok' but there are signs that 2015 could be 'interesting.' In my view it will only take one shock among the bellweather vendors for the markets to panic and then all hell breaks loose. That's because the sky high valuations placed on many of the so-called hot vendors is way out of whack with conventional thinking about how a stock should be valued and when anything untoward happens, market makers switch their thinking in little more than the blink of an eye.

In turn, just about every SaaS vendor is using their stock price to pay significant amounts of what are otherwise considered salaries through stock options. These impact GAAP earnings but are almost always sugar coated in reports by stressing the non-cash impact of these awards. But... stock options are only any good if the stock price is going up or if the award is made at low cost to the employee. If the stock price tanks then the options are useless. Ergo employee dissatisfaction and a heading for pastures new.

Hence the feeling among some analysts that SaaS companies are over engineered financially, leading to a dangerous situation for investors. Add in the jittery nature of market makers who blow hot and cold on a whim and you have the cocktail makings of something less appealing than a Slow Comfortable Screw.

The growth and GTM numbers

As might be expected of relatively small companies, expected revenue growth was well into double figures:

Excluding companies with <$2.5MM in revenue, we found a more traditional bell curve distribution, with median 2013 growth at 29% and projected growth for 2014 at 33%. These rates were still below last year’s survey results of 32% and 36% for 2012 historical growth and 2013 estimated growth.

But it is what to took to get there that caught my attention. The strongest growth rates came from those companies that were booking annual contract value (ACV) in the $25-100,000 range (33%). Those are large numbers for small companies but reflect the kinds of deal we'd expect to see among enterprises looking to buy SaaS services from any provider.

However, it's go to market and the cost of acquiring those customers where things get interesting.  Check the graphic below.

 

I was surprised at the level of field sales people involved, even in the very smallest of companies. I had always had it in mind that inside sales would be the primary driver or that companies would use telesales operations. I presume therefore that in a highly competitive marketplace, getting in front of customers remains the best strategy for achieving high growth. Thinking further and recognizing that this research covers a concentrated segment of the market, I realized that culturally, buyers in the US prefer face to face sales.

Even so, the research clearly points to the fact that no amount of high profile coverage in media nor immediate friends and family or internet presence gets you very far. When it comes to landing those all important larger deals, the research shows clear bias to field sales:

But what does all this mean for cost?

Respondents, excluding the smallest companies, spent a median of $1.07 to acquire each dollar of new ACV from a new customer. This drops to $0.90 if we include the companies <$2.5MM in revenues. This result excluding the smallest companies is noticeably higher than the $0.92 and $0.90 we derived in the 2013 and 2012 surveys respectively. (With pressure on growth rates, it’s possible that companies are spending more to stay competitive. In the cost section to come later we see higher sales and marketing spend, particularly for the larger companies whose growth increased.)

There's plenty more detail about upsetting and how that works alongside cost details around commissions and so on but I couldn't help wondering how these companies expect to break out and turn a profit. The market has clearly voted with reward for growth but this is proving a costly exercise and not every company can win,

One astute commenter noted:

I notice that my most successful client start with a brand new "centralized internet sales team" at HQ. Companies that "repurpose" their existing field sales force into an "distributed online sales team" appear less successful.

This makes complete sense given the sales values being achieved and the need to rapidly ramp volumes. From the outside and as a buyer, how do you pick the winners from the losers?

One simple way is to determine whether the vendor is offering you a no cost entry (freemium) level version - which may fit your needs - or a 'try before you buy' version where you get to see what's on offer for a limited period. The research says that those which are growing strongest operate on the 'try before you buy' principle. See graphic:

Cost structure

One of the great benefits of running a SaaS business is that the cost of operation is relatively low. That's because you are not normally paying for infrastructure in advance of making sales. In fact it is quite common - as the researcher clearly shows - for companies to use third parties like Amazon Web Services of Force.com. However, the cost of using those services is surprisingly high. Even so, the early stage benefits of NOT running data centers and the like are plain to see. The research says that companies building their own infrastructure are growing at median rate of 27% while those using third parties enjoy growth of 56%. That's a HUGE difference. Things change as the company becomes bigger and the economies of scale from operating own data centers kicks in.

I was surprised at the variety of cost. Amazon is often held up to be the gold standard for providing best value and so it proves, coming in at 6% of revenue. The surprise was the cost of Force.com operations at a whopping 15% and well above anything else. (See graphic below.)

Elsewhere, I have heard some rumblings about Force.com costs so this number should not surprise.

Overall, the picture would appear healthy. Plenty of growth across the board and sure, costs are running as you'd likely expect for an early stage SaaS business. But that isn't the whole story. When we start to  apply what we are seeing in this analysis to the larger enterprise vendor market you would think that economies of scale would have a dramatic impact on profitability.

They do - up to a point - but it is the drive for growth that is keeping SaaS vendors of all stripes in the red. The question comes: can it continue and if not then what happens? I will be offering some thoughts on that in Part 2.

Image credits: graphs via David Skok, featured image © Warakorn - Fotolia.com