
The unprofitable SaaS business model trap - aaronbrethorst
http://blog.asmartbear.com/unprofitable-saas-business-model.html
======
patio11
Companies in this space are also in an arms race where there are very finite
amounts of scalable channels. (Scalable means, in this instance, any way they
can convert money into customers in a predictable fashion.) One would
naturally expect that the channels largely go to whomever is interested in
investing most in acquiring them. However, since many of the participants in
the auction (some channels, like AdWords, are more-or-less literally auctions)
have extra-economic reasons to prefer growing, often the auction's clearing
price will be non-profitable.

Or, to put it another way: the marketing company which has done best from the
investment in marketing companies is Google. (Second best, probably "sales
guys." Successful sales reps at enterprise firms are some of the best
compensated people in software.)

~~~
mijustin
That's what's interesting about this "arms race" to acquire customers: when
startups aren't worried about profits, CAC can be arbitrary ("because we'll
make it back later!").

The bi-product of all this is exactly as you describe: startups are
artificially driving up the cost of AdWords (and maybe other channels, like
salespeople).

~~~
cm2012
Big brands do the same thing. Terms like "Diamond Ring" can't be profitable
online since the big brands are willing to lose money to make sure they keep
brand equity.

------
jmduke
I love Jason's blog but I'm having some trouble understanding this post.

It's okay to spend $X on customer acquisition if $X is less than the lifetime
value of a customer (where X ends up being rather high for enterprise
customers). But if it takes (pulling this number out of the air) two years to
recoup that initial $X, then each customer is unprofitable for the first two
years. And if you're a growth-minded SaaS firm, it's going to feel like a lot
of customers are in those first two years: but once your initial batch of
customers pay off their debts, so to speak, their profit can be invested back
into customer acquisition -- it's not like your profits have to be funneled
outside of the company, or that your growth has to be rampant and unchecked
(with enterprise sales, you're more or less determining your own rate of
expansion by the quality and quantity of your sales fleet). Acquisition begets
acquisition.

Besides the fact that you need a cash reserve (either through your own savings
or outside investment) and patience, I don't see what's particularly wrong
with this strategy.

~~~
lmartel
The tl;dr version is that your company will never get to a size where the
executives will suddenly go "oh, well, we're big enough" so you'll always be
in that customer acquisition phase, and thus you'll never be profitable.

~~~
crazytony
huh?

If the average customer brings in $500 and the cost to acquire the customer is
$200 then you'll be profitable as long as the provisioning* cost is less than
$300.

*everything else associated with a customer

~~~
InclinedPlane
If the cost to acquire a customer is $200 and taken in the first 6 months of
finding a customer lead and the average customer brings in $100/year and stays
for 5 years and starts becoming a paying customer after an initial 6 month
sales period then you will _not_ be profitable easily as long as you continue
growing. It'll take 30 full months to amortize the net cost of acquiring a
customer down to 0. That's a long time.

Also, if your growth accelerates you'll just keep digging deeper and deeper
into a hole.

------
mbesto
I still don't know a single SaaS B2B company - at scale - that is actually
profiting right now.[0] The general assumption is that the cost of sale will
continue to go down (and thus become profitable), but once the market gets
saturation (it is in CRM-SaaS for example), then the cost of sales goes right
back up.

> _The other company has to bust ass for measly 20% /yr maintenance fees._

This is a funny assumption. On-premise maintenance fees for the likes of SAP,
Oracle, etc sit on a nice ~80% gross profit margin.[1] This model is obviously
broken today, but has been a major source of revenue for traditional software.

Here is what I think I will happen to SaaS models (note - it isn't pretty):
[http://www.techdisruptive.com/2012/11/28/how-are-we-going-
to...](http://www.techdisruptive.com/2012/11/28/how-are-we-going-to-make-
enterprise-cloud-profitable/)

Anyone know a large successful Enterprise SaaS that _isn 't_ selling jackets?

[0] -
[http://finance.yahoo.com/q/ks?s=CRM+Key+Statistics](http://finance.yahoo.com/q/ks?s=CRM+Key+Statistics)

[1] -
[http://blogs.forrester.com/duncan_jones/13-02-14-saps_mainte...](http://blogs.forrester.com/duncan_jones/13-02-14-saps_maintenance_price_hike_should_concern_sourcing_professionals_and_their_cios)

~~~
reubenswartz
37Signals? (Perhaps not a coincidence that they are private.)

~~~
dave_sullivan
When 37signals started coming out with products, they were really early to the
"self-serve saas web app built by cool web devs just like you and me" model.
In many ways, they practically invented the industry. Fast forward 9 years or
so and the market is _very crowded_ with plenty of investor money allowing
businesses that will never turn a dime to stay in business too long (sell lots
of jackets)--on the premise that they can be like 37signals.

For startups from the last 2-3 years (or ones currently entering that
business), given the competitive reality + the massive downward pressure on
saas prices (not to mention upward pressure on user expectations), I don't
think the analogy works as well.

Also, 37S never has published numbers, so who really knows what their
growth/profitability has looked like over the past several years? I wouldn't
be surprised if their growth has slowed significantly due to steeper
competition and an inevitable cooling of their brand's coolness.

------
lifeisstillgood
This kind of feeds into a theory of mine (not well expressed I fear):

The earthquake so far has been Google's effect on Sales and Marketing:

\- each person online is just one click away from every other (person?) web
presence (business sites mostly, but other people increasingly)

\- So if you were the most attractive business on the web you would get all
the customers. The mechanism through which your attraction was discovered was
search / linking.

The person with the most attractive business process will win next - as
businesses make their next step in a chain open to all comers.

So any business process that can be digitised, and can be given defined
interfaces, will find itself eviscerated from internal to a company and placed
in a network of auctionable providers.

So, that's bookkeeping, accountancy, most of HR, calendering, scheduling,
travel, hmmm....

The old idea of outsourcing all your non-core activities is looking like it
really will come true.

Wish I had written that book on ebXML now.

~~~
Maro
For a company that is doing HR/office/mood stuff very well, like the company I
work for (Prezi), these activities could not be outsourced because they are
part of delivering the core values and feeling of the company and are
instrumental in getting the right people on board (HR) and keeping them
(office/mood).

------
lifeisstillgood
Edit: following downvotes.

There is a seemingly sudden rush of SaaS companies at IPO / major growth
levels in the B2B marketplace - how do people track them, or know about them?
Is there a news outlet I am missing?

Add to that, the underlying sell for SaaS companies is either ease of
implementation (which is a non-differentiator) or it is a genuine new activity
(cross enterprise, co-ordinated 3rd party cookie tracking to massively
increase campaign targeting / feedback) - so is there a discussion area on
what these guys are doing underneath?

Basically - what am I missing?

My original for posterity:

I have never even heard of these two companies - where on earth does one find
all these suddenly growing companies?

And frankly, is there a wiki page on what they are really doing under the skin
(marketo / eloqua look like glorified dashboards for third party cookie
tracking)

(Not that there is anything wrong with a glorified dashboard, I just like to
know what people are really doing)

~~~
olegp
Here's a list of SaaS companies sorted by popularity:
[https://starthq.com/apps/](https://starthq.com/apps/)

Popularity is calculated using a combination of the number of likes of the
profile page and Alexa reach, so the first few pages aren't particularly
useful, but once you get to page 15 or so you'll start seeing major SaaS
players in descending order.

Edit: Marketo is on page 32

~~~
ryanbrunner
The majority of these aren't B2B, really, and of those that are, very few of
them are "enterprise" players like Eloqua or Marketo.

~~~
olegp
Having put the list together myself, I'm certain that 99%+ are B2B. It's true
though that there aren't that many "enterprise" players, although Marketo is
there.

~~~
lifeisstillgood
I just started scraping that list to do some brief analysis / categorising
myself - if I come back here with the results later will you object?

~~~
olegp
Not at all. Let me know via the feedback form (available via the dropdown in
the upper right when you sign up) what format you need the data in and I'd be
happy to provide it as JSON.

Also, if there's some data missing that you want us to collect, check out our
extractor API: [https://github.com/starthq/extractor#starthq-extractor-
api](https://github.com/starthq/extractor#starthq-extractor-api)

------
programminggeek
It doesn't matter what business you are in, if you aren't turning a profit on
each sale, you won't make it up in volume. In fact, volume will kill you fast.

I remember when Sony was selling the PS3 at like a $200+ loss at launch. I was
surprised that Microsoft didn't take a couple billion dollars and buy PS3's.
It would have cost Sony hundreds of millions of dollars and would have made
the PS3 a money sink hole for even longer. Microsoft had enough money to
probably put Sony out of business doing this.

Obviously, Microsoft could have got in a lot of trouble for attempting such a
strategy, but the point is simple - an unprofitable business model makes you
vulnerable, especially a growing unprofitable business.

If it don't make dollars, it don't make sense.

~~~
dllthomas
You can sell razors at a loss if people buy your razorblades at a substantial
profit.

~~~
crpatino
You are of course right. The problem is that software companies end up doing
the exact opposite more often than one would expect. We do the equivalent of
selling razors at a profit, and to make the deal sweeter throw in the
commitment to provide "as many razors" as the customer can possibly demand,
and replacement razors at heavy discounts... for as long as there's an entity
called McRazors, Inc.

~~~
dllthomas
That's one problem. Another problem is bad estimates of how much the razors
cost and/or how much profit they're actually making on the razor blades.

------
Major_Grooves
Interesting given Get Satisfaction's recent approx. 10x price increase:
[http://blog.getsatisfaction.com/2013/07/16/the-latest-
about-...](http://blog.getsatisfaction.com/2013/07/16/the-latest-about-our-
pricing-and-packaging/)

I just exchanged tweets with them this afternoon saying it would be
interesting to see how this change affects their revenues (maybe if/when they
IPO).

~~~
josephby
This also explains why we're seeing services like KISSmetrics, Dropbox for
Teams, etc. moving to annual, pre-paid pricing rather than monthly with free
versions

~~~
inthewoods
Yes exactly - churn rates too high, free versions not converting to paid, et
al. And for companies like KISSmetrics and Dropbox, those free customers come
with an infrastructure cost that goes up fairly linearly with the number of
customers you add. Tough going if you can't convert from free to paid. And
then you add high monthly churn rates and, ugh, you're in a world of hurt.

------
andrewcamel
I disagree - there exist SaaS companies that have successfully executed and
are on the path to successfully executing the profitable B2B SaaS model. Take
Constant Contact, Responsys, and Blackbaud. While not all of these companies
are highly profitable, they are all proof (and will be increasingly so) that
B2B SaaS companies can reach profitability. The names we all know (e.g.
Salesforce, Workday, etc.) simply need more time to reach that point of
profitability, but they're on their way.

Looking at Jason's example specifically, I have a couple issues:

1) Assuming a fairly strong churn rate (~20%/year), the base of customers for
which CAC has been repaid will make up an increasingly large portion of the
user base as the company grows (in later stages). Forgive me if I'm wrong, but
it seems much of Jason's argument is based around the assumption that
acquiring new customers (S&M) in conjunction with ongoing R&D and G&A will
always outweigh the gross profit generated by the existing customer base.
Maybe if he defines "healthy growth rate" as 50%+, then yes, sure, it will
always be outweighed, but let's be reasonable.

2) If Jason is going with 30% COGS, his LTV metric is off. No startup business
in its right mind would continue operating with a CAC/LTV of 2.53. We're
talking double that in most cases with a bare minimum of 3.

Finally, while this is a good discussion to have, I think we're all a bit
naive to think that a bunch of small-scale startup entrepreneurs have enough
knowledge, experience, or expertise to questions the decisions of many large,
long-standing investment firms and successful individuals that all have
supported these unprofitable companies with expectations of their eventual
profitability. Having worked at a late-stage investment firm, I looked very
closely at 100+ of the leading, big-name SaaS companies (we're talking 1000+
pages of diligence in aggregate). From experience, I can tell you there is
plenty of work, far more than just a short article and some speculation, that
points to the fact that these companies will reach profitability.

------
dkrich
While the general assessment is correct, I think the core argument confuses
marginal and fixed costs.

 _Say the average customer represents R dollars in annual revenue. That’s:

$4R of revenue over the lifetime of the customer. But: $1.5R is spent to
acquire the customer (the pay-back period). $1.2R is spent in gross margin to
service the customer (4 years times 30% cost). $0.6R spent on R&D (15% over 4
years). $0.6R spent on Admin (15% over 4 years)._

The last two items strike me as decidedly fixed. That is, that until some
critical mass is hit, there is no difference in cost for R&D and things like
HR between supporting one customer, five customers, or fifty customers.
Therefore it isn't appropriate to allocate a set percentage to each customer
as once you've established an R&D department, each incremental customer is not
contributing 15% of its margin to that cost.

Additionally, there is an inherent assumption that no matter what, as long as
the company is growing it will necessarily be unprofitable. This is only true
if you can assume that there is no point that your customer base is large
enough to overcome customer acquisition costs. In reality, the pace of growth
is probably going to level off at some point whereas the churn rate of the
customer base could be low enough to turn a profit.

I know that the assumption was 70% retention but this seems largely
speculative and unfair considering the considerable R&D spend. If new
developments are made, one might assume higher retention is a possibility.

~~~
josephlord
This bit also strikes me as double counting:

"And that is without any growth at all. But you need to grow enough to keep up
with cancellations at minimum, so that consumes the last notion of
profitability."

Growth to keep up with cancellations is covered by the $1.5R acquisition cost.

Although to disagree with you slightly I would say that Admin at least would
be partially proportional to the number of staff (which is likely to be
related to the number of customers) although improving the system so that less
support was required (better documentation, easier to use software) should
have a knock on effect here. Some parts would be fixed costs though.

------
cwilson
An interesting question to ask is why do unprofitable SaaS companies get
bought for very large amounts of money by other enterprise companies? The
answers to that question are going to be my goals when building a B2B tool
(because my ultimate goal is to make myself rich, let's be honest), not
profitability (why would it be, when it's so hard to do and acquirers seem to
not care).

~~~
matlecu
Actually if you push the reasoning in the article a bit it can make sense.

When they buy the company, they buy:

\- the users and the revenue (which may be losing money for growth as
explained)

\- and also a product that should be easier/cheaper for them to sell to their
existing customers. So they can have a very cheap batch of customers that
grows their revenue a lot without increasing their upfront cost too much

-> it's like the up-sells/upgrade in the article: it's much cheaper to acquire but makes the same money

( eg:

\- you have 1M clients

\- you lose money because it costs you 1.5R to acquire a customer and you're
growing

\- the company buys you with 10M clients, and it's only 0.1R for them to sell
it to these clients because it's an up-sells/upgrade

-> they'll make money with your product even if you can't! )

------
txutxu
I was going to launch a SaaS in Spain oriented to the education market, but
when studying my potential customers locally, did make me almost leave
immediately by the expectations.

I did get a nice job offer in other country and finally did stepped out of my
draft/idea.

Still, I've the feeling that there are SaaS to be created and be successful.
But maybe it's just a minor representation of a big no-no.

------
inthewoods
I'm curious about that retention rate - most companies that I know that have
gone with Marketo have made a long term beat - not just the software but in
terms of implementation, training, data, et al. I'd be surprised if Marketo
has a 75% retention rate - I'd expect it to be much higher. Now, they also
sell at both the SMB and the Enterprise level, so his numbers maybe right on
average.

Now that being said, I do think Marketo's business model seems to be upside
down - and I'm a Marketo customer. What I expect to happen: crappy number over
a number of quarter drive the price of the stock down to where they are worth
about $500-600m (vs. about $1b now) - then someone buys them for $800m (about
the same price as Eloqua went to Oracle). $800m would be close to what Eloqua
went for (multiple-wise).

~~~
patio11
I would have guessed closer to Jason's number, but they quote a retention rate
close to 100% in SEC filings.

[http://investors.marketo.com/secfiling.cfm?filingID=1047469-...](http://investors.marketo.com/secfiling.cfm?filingID=1047469-13-6257&CIK=1490660)

 _Subscription Dollar Retention Rate. We believe that our subscription dollar
retention rate provides insight into our ability to retain and grow revenue
from our customers, as well as their potential long-term value to us.
Accordingly, we compare the aggregate monthly subscription revenue of our
customer base in the last month of the prior year fiscal quarter, which we
refer to as Retention Base Revenue, to aggregate monthly subscription revenue
generated from the same group in the last month of the current quarter, which
we refer to as Retained Subscription Revenue. Our Subscription Dollar
Retention Rate is calculated on an annual basis by first dividing Retained
Subscription Revenue by Retention Base Revenue, and then using the weighted
average Subscription Dollar Retention Rate of the four fiscal quarters within
the year. Our Subscription Dollar Retention Rate was approximately 100% for
each of 2011 and 2012._

Or, if you're wondering how that accounting maps to operationas, "Marketo's
upsells to customers in year N+1 almost exactly cancel churn in yearly
subscriptions since year N, when aggregated."

[Edit: Whoops, now that I think about it, they're sort of juicing that metric
by construction. In a growing company with 1 to 3 year payment terms, quarter-
to-quarter churn could be very close to zero even without churn being near-
zero.]

~~~
hncommenter13
As a public market investor, this sort of thing drives me batty. Many
companies won't release an actual churn rate, but only a "dollar retention
rate," as above. Yelp is one of them.

While the dollar retention rate is certainly nice to know, knowing the actual
customer (logo) churn is critical to evaluating the cost of acquisition and
overall profitability.

As Jason points out, if it costs too much up-front to acquire each customer,
you can still go broke even with a nice-looking dollar retention rate--you
still have to pay to acquire the customers you lose.

------
monkeyspaw
Some food for thought in here. But I'm not sure it's necessarily a problem
with SaaS businesses. His conclusions depend on the arbitrary numbers in the
example analysis.

It seems to me that his criticism is with the pricing rather than the actual
model. If you could have charged $100k up front plus 20% maintenance fees, and
are only charging $5k per month, your pricing probably has issues.

You could also charge setup fees for customers who need high touch
introduction / initial setup to help recoup those costs.

And the sliding pricing scale (eg Salesforce, where you pay more as you have
more success with their software) can help you grow customer revenue per
customer, over time.

Still, some good points to think about. I just don't think it dooms the SaaS
space to crash. It just depends on the value you offer, and how you structure
your pricing.

------
smalter
This reminds me a lot of the example that Bezos used in his April 2005 Amazon
shareholder letter ([http://www.scribd.com/doc/111244354/Amazon-Shareholder-
Lette...](http://www.scribd.com/doc/111244354/Amazon-Shareholder-
Letters-1997-2011), page 27).

I'd love to hear from people who know finance better whether the comparison is
apt.

The analogy seems to be that when you have upfront expenditures that get paid
back over time, you may not have positive free cash flow if you're continually
paying up front for later pay back, and you end up with a business that
paradoxically generates higher cash flow with slower growth.

------
jusben1369
Marketo was founded in 2006. Eloqua was founded in 1999. They're now only $10
million in revenue apart. If you were asked to it wouldn't be too hard to put
together an argument supporting that Eloqua was too conservative and allowed
Marketo to overtake them by being overly aggressive.

 _Your_ job, if you're running these companies, is to make your shareholders
happy and create a large return. i) Did this happen for the VC's involved? ii)
Is this now happening in the public markets? Those are the (only) questions
that matter.

------
s_q_b
Businesses that don't make money will always fail. For some reason, the tech
industry finds new and interesting ways to delude ourselves (and investors!)
into thinking this law doesn't apply. But sooner or later, like gravity, it
exerts its pull.

Make something people want. Sure. But more importantly, make something that
costs less to make than people will pay.

~~~
kposehn
Instagram.

There are businesses that can succeed at it, but they rely on not making money
until acquisition, where the acquirer bets that they will add other value down
the line.

That said, it is not an avenue I necessarily want to follow.

~~~
Maro
But Instagram didn't make money as a company for itself, Instagram itself was
sold and made money for the founders/investors. The two are not the same.

~~~
kposehn
I'm not making that argument necessarily. If you only define success as making
money in general revenue, it doesn't fit the bill.

But to me, selling for $1bn (at the outset), is definitely a success.

~~~
s_q_b
For the founder and the seed investors and the VCs, certainly it was a great
success. From my perspective, that's a type of success is exceedingly rare,
akin to winning the lottery.

That mindset doesn't fit with my own personal goal of building a business that
returns consistent profits, preferably as soon as possible after launch.

------
callmeed
I'm curious if Yammer fell into this trap or if they were able to reach
profitability with any of these techniques. Seems like they had a bit of viral
growth but some initial searching implies they hadn't turned a profit yet.

Also, the press seems to only want to talk about their revenue growth.

~~~
davidu
Yammer was not even close to a profitable business at the time of acquisition,
not was that ever a goal.

------
mp99e99
I found this pretty accurate. He might have overstated churn retention is
closer to 85% but I think the author is pretty much "on" with this post.

------
bedhead
Until the public markets start valuing these companies on earnings and cash
flow instead of sales, expect more of the same.

------
Mister_Snuggles
This is a real world example of the Sustainable Growth Rate, which is a
financial concept that applies to any business.

[http://en.wikipedia.org/wiki/Sustainable_growth_rate](http://en.wikipedia.org/wiki/Sustainable_growth_rate)

------
bachback
A seriously bad article. I don't know the company in question, but there are
always companies in industries that either a) are very profitable, b) not
profitable yet, because they invest in growth (profit = sales - (marketing) -
R&D) or c) are unprofitable. Many software businesses don't earn money or low
rates of ROEs - so what? It would be much more interesting to look at some
cross-sectional data than to speculate based on sample size of n=1 ?! Btw,
looking at the website of MKTO I'm not surprised, although the public market
puts a tag of 900M$ on this company, which in 2012 made 60M$ in revenue while
having netincome of -35M$. this has nothing to do with the SaaS model in
general IMO (working for a quite successful one myself). Constant market-fit,
zero-cost deploys, world-wide customer-base - what more do you want? Compare
that to 5 -10 years ago, or making your living with custom software.

------
mathattack
If your core business isn't profitable, SaaS won't get you there, but it is a
great model if you can get big. If done right, the value from not having to
re-implement at each customer site is huge.

------
jacques_chester
This doesn't seem so much about profitability as _cashflow_.

Cash is, as they say, king.

You can be unprofitable for a long time _if_ your cash position can bear it.

If your cash position is bad, then no amount of projected profits will save
you.

------
rgrieselhuber
Great post but the 75% retention thing was odd. All of the SaaS companies we
know would flip their shit if annual retention dipped below 98%. Even 98%
would be very painful.

~~~
usaar333
98%? Can I ask who your SaaS companies are selling to? If you are reaching a
diverse business audience, I would think > 2% of your customers each year
would implicitly cancel by going bust.

~~~
rgrieselhuber
That would be surprising. If more than 2% of my customers every year were
going out of business, I'd come to the conclusion that I was selling to the
wrong audience.

------
TeeWEE
At a certain point customers will find your product without the SaaS company
having to put money into it. This is where you become profitable.

