SaaS Companies Losing Money to Grow Recurring Revenue

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When talking about recent IPO filings and SaaS growth rates, there’s often a reaction that because XYZ company lost millions of dollars last year, it isn’t well run. Inherently, people understand having to lose money to get a startup off the ground as there’s a disconnect between expenses and revenue. Only, once the business has scale, say $50 million in revenue, it seems that the company should be profitable going forward. Often, the SaaS company is choosing to invest in sales and marketing to grow faster.

Losses in a single year are one-time while the recurring revenue added continues indefinitely.

Let’s look at a SaaS company with almost all revenue recurring. If, as an example, you could invest $10 million into a business, and then spend that $10 million on additional sales and marketing all at once (assume other costs like support, R&D, administration, etc wouldn’t go up), and that the additional sales and marketing would generate an incremental $5 million in new annual revenue, that’s a great deal. The $5 million in incremental recurring revenue would make the company $25 million more valuable (assume a 5x revenue multiple for a SaaS company with a good growth rate) and it would add $3 – $4 million of gross margin to the business each year (assume 60% – 80% gross margins and a 100% renewal rate).

When reading about heavy losses due to expanded sales and marketing, it’s important to remember that the losses are one-time, sales and marketing can be easily cut back, and that the recurring revenues generated are indefinite.

What else? What are your thoughts on the relationship between losses from heavily investing in sales and marketing vs the recurring revenues that are indefinite?

Comments

8 responses to “SaaS Companies Losing Money to Grow Recurring Revenue”

August 27, 2013

Mike Lewis (@pescatello)

This is a great and valuable point that many people don’t understand. I’m glad you wrote about it. It definitely didn’t make sense to me at first. T

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1. August 27, 2013
  
  akatztf
  
  Spot on post – again DC. My company is dealing with this right now. Wouldn’t it be closer to 6x vs 5x multiple – what’s the ideal formula on rec revenue…
  
  Reply
August 27, 2013

Nick Francis (@nickfrancis)

This is an excellent debate, David. I don’t like the infinite SaaS “lose money, grow faster” strategy. I know it looks awesome in a spreadsheet and the market clearly rewards growth more than returns. But the cycle never ends. There isn’t a CEO in America that doesn’t see “green fields” and abundant opportunity to invest in more growth.

Everyone says “sales and marketing can easily be cut back.” In a financial model, yes. But I’ve yet to see it happen in practice because the stock price would fall through the floor once shareholders see a realistic rate of growth.

We’re left with companies that don’t return money to investors, reward executives with options they don’t account for on the balance sheet and have lackluster products.

The model seems flawed to me because it assumes markets are infinitely scalable and expenses can be cut back like flipping a switch and a business can be profitable whenever they choose. My (angel funded) company will be profitable in a few months and we’ve had to fight like hell for it, there’s no cutting back in SaaS once you are in.

I have a very simple view of business and my role as CEO of a SaaS company. I’m all in on delivering maximum value to the customers that make the company possible. Manufacturing growth with money the company doesn’t have simply doesn’t feel right. It shifts focus from what the business *should* be focused on, which is making customers happy and driving growth that way.

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1. August 28, 2013
  
  ngamblin
  
  Great post and great reply Nick. I agree that it is easier to make cuts in a financial model than in practice, but stock price is not the only concern. Cuts have an impact on people, people that you know and have a relationship with.
  
  Also, I hope that $50 million in revenue is not required by any business to be profitable going forward.
  
  Reply
2. August 28, 2013
  
  Adam Lazzara (@AtlantaSnoop)
  
  Nick, curious if you think the same would apply if the company was not public. Would David’s thoughts be more in line within that environment?
  
  Reply
August 28, 2013

Adam

What are your thoughts on Jason Cohen’s arguments? http://blog.asmartbear.com/unprofitable-saas-business-model.html

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August 29, 2013

totencough

@Adam, I was about to mention something similar. David, you refer to revenue as a constant, but this is especially untrue when talking about SaaS companies, and even less true when their target market is enterprise. Losing accounts is a real thing, whether it’s to a competitor, or because of something you did, or simply because the company can’t or doesn’t want to pay for your service anymore. If you target enterprise, losing any account can be devastating, and the costs of recuperating from that loss means more spent on advertising, sales, marketing, etc. That means you’re almost constantly catching up to the costs.

Now, this isn’t always an issue, and especially if you are targeting the SMB market, losses are minimal and have minimal impact. This is where SaaS is strongest, as this is generally the most stable market to target if you want to reach profitability.

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August 29, 2013

lance (@lance)

Recurring revenues are not indefinite. SaaS customers churn. The more complicated equation is something like this. LTV > (ARPU*ALC)-(CAC+COGS). You are assuming that ALC is infinity and CAC does not matter. Neither of these assumptions are correct.

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