
Understanding SaaS: Why the Pundits Have It Wrong - moritzplassnig
http://a16z.com/2014/05/13/understanding-saas-valuation-primer/
======
mikepmalai
For those interested in getting a good overview of perpetual vs. SaaS business
model I highly recommend Dave Kellog's post on the topic. He discusses both
the operational and valuation impacts and walks through an example of a
hypothetical startup under both models.

kellblog.com/2011/01/26/perpetual-money-vs-perpetual-license-subscription-
saas-and-perpetual-business-models

Summary:

1\. Wall Street "sees through" the differences in models and value perpetual
and SaaS companies roughly equivalently. SaaS companies are worth 1.8x the
revenue multiple of perpetual companies (he walks through the math in the
post)

2\. There are many good reasons for perpetual companies to move to SaaS models
but valuation isn't one of them

3\. You get roughly twice the EV/R multiple as a SaaS model but building the
revenue stream is just about twice as hard. CEOs who have done the transition
from perpetual to SaaS say it takes 3 years to makes the transitions and it
must be a top 3 company goal for that entire period.

4\. SaaS dampens revenue volatility - for better and for worse. Makes it
harder to grow the revenue stream quickly and makes it harder to change once
established. (This has an impact on investor psychology and reactions to a bad
quarter can be very different in a SaaS model vs. perpetual)

5\. Sales compensation is a tricky issue with SaaS model. Sales people still
want dollar compensation similar to a perpetual sale despite ratable revenue
profile of SaaS.

6\. The implicit assumption that an annual subscription to use a service
should cost less than equivalent perpetual license can be invalid when looking
at the product from a customer Total Cost of Ownership viewpoint. (Companies
are also outsourcing the capital intensity of having perpetual software)

~~~
nrao123
I am also curious on founder stakes in SAAS companies Vs larger enterprise
companies. My hunch was that that the customer acquisition cost (before it was
paid back in say ~24 Months) are being financed by VCs instead of customers in
the previous enterprise license worlds.

Since, 1) VCs are more sophisticated than the typical customers, 2) have more
bargaining power - Are founders being diluted more in SAAS companies (Box.net)
vs enterprise companies (e.g. Oracle)?

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melindajb
Great post. Superb introduction to the concepts with helpful illustrations.
Adding a few ideas to the mix...

Typically a mature SaaS business has about 50% of its revenue from new
customers and 50% from renewals. Early on that number is skewed to growth but
if a company doesn't invest in retention early on, the company can go upside
down, fast. Watching cohorts each month as their subscription expires is a
good way to catch this early. Especially if you're in accrual accounting,
because you can't recognize new revenue right away.

The 3x CAC for LTV is a good rule of thumb but does require you think about
what LTV is. In the late 90s companies acquired customers using a 5 year LTV
assumption which led to some really inflated valuations and lopsided
businesses. I am conservative in my own startup right now, no more than 1-2
year LTV assumption for now to preserve cash flow until product market fit and
retention are more consistent. one great reason for taking investment is to
take some risks in acquisition on LTV, Gambling intelligently that you can
improve your retention enough to match.

Early on, the ratio is likely to be even higher until you can drive the
inefficiencies out of the spend. And as cost per click goes up in a given
market you have to think very, very hard about it. If you're in an enterprise
SaaS business, especially in marketing, it's really ugly for top of funnel
terms. I've seen some terms at $11-$12 a click.

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steve_benjamins
They also did a podcast on this subject. Well worth a listen as well:
[https://soundcloud.com/a16z/a16z-podcast-valuing-todays-
fast...](https://soundcloud.com/a16z/a16z-podcast-valuing-todays-fastest-
growing-software-companies)

~~~
cjbarber
For those who prefer to read:

I paid for and posted a transcription of that podcast.

[http://blog.chrisbarber.co/a16z-podcast-valuing-todays-
fast-...](http://blog.chrisbarber.co/a16z-podcast-valuing-todays-fast-growing-
software-companies)

~~~
pdq
Nice. How does the transcription work, and how much does it cost?

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brc
This is a good article and, although many people will know these concepts
separately, it's good to have them all stitched together.

For me the question raises how to get through the dip when your cashburn is
higher than your revenue because you haven't accurately established your LTV.

The second part of that is knowing how to price your service so that your LTV
will exceed your CAC. You can control both parts of the equation (through
efficient customer acuqisition) and by modifying the product price. But they
don't work separately on each other - an adjustment in one will reflect in the
other.

I guess there is no magic answer to that and it depends on your customers,
your competitors and whatever precedents you think may be applicable.

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lifeisstillgood
I heard A8n on a BBC podcast trying to explain that bitcoin was important not
because it was a currency, but that it solved the Byzantium Generals problem,
and so was a break with most other ways of paying people.

This is another we-thought-about-this-for-a-long-time-to-work-it-out article.
Not A8N quality, but close.

Edit: this repeats pretty much the accepted wisdom as MicroConf et al - Get
the customers paying yearly _now_ so you can use that cash to go acquire
another customer. Nice to see Rob Walling / Jason Cohen are ahead of the curve
still :-)

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johnrob
Most SaaS pricing pages give you the impression that pre-payment is prefered
to month-by-month (hence the discount you get for buying 12 months today).
With this in mind, isn't the old enterprise model just the ultimate future
payment, and thus the ideal pricing model? You get all the cash immediately
and there is zero churn risk.

The SaaS model is great for the customer and bad for the business. Maybe _that
's_ why the market doesn't like it so much.

~~~
clarky07
that's too simplistic. there are pros and cons to each. for example, when
running a saas you have a decent idea of how much revenue you'll have next
month. with a one time sale model you start next month at 0 and only make
money if you find new customers. (obviously not taking into account
maintenance contracts, but still the point remains)

~~~
johnrob
How about if after getting a million dollar check, you just pretend that it
represents 100 10k monthly payments with a 0% chance of cancellation. Does
that sound more stable/predictable?

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mbesto
Great article! A few comments:

> _In the perpetual license model, in-house IT staff managed all software
> instances and thus could incur the internal costs to switch vendors if they
> so chose._

This argument is flawed. There are switching costs no matter if it's SaaS or
on-premise. This is why big companies outsource IT - it's easy to get rid of
100x Accenture consultants who specialize in SAP and replace them with 100x
Accenture consultants who specialize in SalesForce. The switching costs are
normally around process change, change management and training.

> _Budgets are much more decentralized now, because departments often adopt
> SaaS technologies and make purchasing decisions independent of the
> centralized IT organization. In the past, the tops-down technology sales
> model made it very easy for a CIO to unilaterally replace application
> vendors._

Which makes them _less_ sticky. Team frustrated using the $150/month PM tool
that they chose? Good, they can get rid of it. LTV goes to zero.

> _This is why many SaaS companies today invest aggressively in sales and
> marketing when adoption is high, even though it puts pressure on current
> profitability._

SAP and Oracle did too at one point. They're milking their ~90% gross margins
on support contracts today. BUT, they _still_ spend a shitload on cost of
sale. I don't see cost of sale going down[1].

> _As a general rule if LTV is 3X or greater than CAC, that’s a good sign that
> the business model is working._

The fundamental problem today with SaaS is that I have yet to see to that a
scalable and sustainable LTV exists (i.e. "winner take all"). As the OP points
out, we can insinuate (not completely prove) a 3x LTV for Workday, but what
exactly are they doing that SalesForce hasn't done in the last 15 years?
Lastly, if this is a winner-take all situation, then shouldn't we stop talking
about SaaS, since "SaaS" = "Workday"? Or perhaps, is this simply pointing out
that if you're a SaaS your sole position should be to spend donkey-loads of
money on marketing/sales, because you'll just end up getting acquired for your
customers anyway?

[1] - [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/)

~~~
melindajb
these are great questions...I suspect they're looking at erp equivalents with
heavy technical integration, not the basic project management app, which have
switching costs, but nowhere near the complex, often heavily regulated, issues
involved in a multi billion dollar company's data integration situation. Not
saying you're wrong, just that in large installs the post is closer to true
than not.

As for spending donkey loads of money on marketing, it's really hard to get
that model funded today. Investors are wise to it. Not to mention, paid search
isn't nearly as cost effective as it was in certain categories. So you're left
to grow on only product, SEO, and content, hoping for a viral loop. investors
only (should) come in when you can prove that $1 in marketing spend yields $3x
in revenue.

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tlogan
Just a note: as far as I know only 20.3% of Oracle's revenue came from the
sale of new software licenses and hardware while four times that much, or
79.7%, is from annual maintenance fees and services (basically some kind of
subscription). It is very dangerous to assume that these big companies are
stupid.

~~~
orky56
You could argue that those stats are a reflection of a mature company with the
license model. When they were in a similar position to many of these SaaS
companies we are discussing, their license fee and customer acquisition cost
were enormous. That automatically self-selected their customers to be large
enterprises, who they were completely dependent on. The initial license fee is
such a large proportion of LTV compared to maintenance fees. With SaaS,
companies are banking on scalability, personalization (multitenancy), and less
sources of friction. Establishing a successful SaaS company allows them to
realistically chase the long-tail of SMB that single-license companies cannot
scale to do effectively.

------
bedhead
Part of the distaste is that many of these SaaS stocks are trading with
valuations as if they're already at the far end of the J-curve. The market,
evidently, agrees with Marc, so I'm not quite sure what he's complaining
about.

------
patrickxb
I've seen these LTV / CAC ratios before, but what about when CAC is zero? That
is often the case for startups that don't spend any money on
sales/marketing...

~~~
melindajb
CAC is never zero from an accrual based accounting standpoint. You have
marketing software, discounts, staff, etc. that technically count against it.

That said, CAC never remains zero in the long run, unless you're Facebook with
huge viral coefficient, and still, it's not zero. If it was zero, you'd be in
a massive arbitrage that's likely to be unsustainable. Certainly not in any
competitive market.

~~~
patrickxb
Ok, so you could do

CAC = (quarterly business expenses [like salaries, rent, health insurance]) /
number of customers acquired in that quarter

?

~~~
pdq
CAC is the cost _directly_ related to the acquisition of the next customer (ie
the variable costs). This is not the fixed costs of running a company (salary,
rent, etc). It includes basically anything you spend before you sign up the
customer, like answering emails to prospects, implementing new features,
fixing bugs found during trials, writing blog posts, etc. Or for high $$ SaaS
companies, advertising, phone calls, meetings, proposals, demos, seminars,
writing letters, lunch & learns, etc.

If CAC is zero, you are basically saying customers are finding you and signing
up on their own, with zero effort from you. This is possible (ie Twitter), but
the LTV (life-time value) for these products is usually very low. Usually, the
company is expecting a few dollars per year of revenue from each customer from
advertising.

~~~
melindajb
did my response below not show up, because that's what I just said.

