David Cummings on Startups

Category: SaaS

  • Pricing Options for SaaS Products

    Software-as-a-Service (SaaS) is an amazing way to deliver a product for many reasons, one of which is that there’s almost no marginal cost save for hosting bills and customer service. With high gross margins generally, there’s a fair amount of flexibility in how the service is priced.

    Here are some of the more common pricing options for SaaS products:

    • Per user that uses the system with pricing differentiation based on type of user (e.g. an administrator user would be more expensive than a report viewer user)
    • Per module used (e.g. based on functionality)
    • Per instance of a type of object used (e.g. based on how many of X are used, like projects managed or emails sent)
    • Per transaction (e.g. a percentage of a deal, like how eBay does)

    There’s no right or wrong answer, but in general, pricing should be kept as simple as possible while also representing the value delivered to the customer.

    What else? What are some other pricing options for SaaS products?

  • Balancing Product Expectations with Constituents

    Software-as-a-Service (SaaS) is great from an engineering perspective because of the economies of scale from a low-friction release process (release early and often!) as well as controlling all aspects of the datacenter/cloud servers (more time is spent on the product instead of issues outside of your control found with installed enterprise software). With great power comes great responsibility. One of the biggest challenges is balancing expectations from all the different constituents involved like customers, marketing, sales, prospects, analysts, etc.

    Here are a few tactics for balancing product expectations with constituents:

    • Find the right trade-off between committing to certain features with a timeline and maintaining the flexibility to quickly adjust the priorities
    • Consider using tools like an idea exchange (e.g. UserVoice) so that customers can submit and vote on features they want
    • Develop a customer advisory council and solicit feedback from them in-person or over the phone once per quarter
    • Share a product vision and high-level future features once per year at a user conference

    Balancing product expectations with constituents is difficult. With so many different demands and opinions it’s challenging to make everyone happy. The key isn’t that everyone needs to be happy, but rather that the product has a strong vision in general and everyone understands where things are headed and why it’s headed there. Clarity and direction is key.

    What else? What are some other tactics for balancing product expectations with constituents?

  • The Massive Differences Between Installed Software and Cloud Startups

    Being in the installed enterprise software world for a decade and the cloud/SaaS world for over five years now, there are massive internal differences between these two types of startups. The business models are inherently different, and should be viewed as such, even though both are full scale software companies.

    Here are some of the massive differences between installed software and cloud/SaaS startups:

    • Installed software companies typically provide releases every 3 – 18 months whereas cloud/SaaS startups push releases multiple times per day creating a different dynamic around time-to-market and scope of functionality
    • 10% – 20% of engineering efforts for installed software companies are for debugging issues that are network or environment specific compared to cloud/SaaS companies that control all aspects of the data center hardware
    • Installed software vendors often have more lock-in and higher switching costs compared to cloud/SaaS vendors  due to the heavy customization and internally managed servers
    • Getting the majority of the lifetime value of the customer up-front with installed software makes it easier to cross the desert to profitability, but creates lumpier quarterly revenue and predictability compared to cloud/SaaS startups with recurring revenue

    Installed software and cloud/SaaS startups have massive differences, and startups should think through the pros and cons of each.

    What else? What are some other differences between installed software and cloud/SaaS startups?

  • The NetSuite SaaS Valuation Outlier

    Looking at the last round of Publicly Traded SaaS Company Valuations there’s one outlier that needs more discussion: NetSuite. NetSuite is a strong Software-as-a-Service (SaaS) company with a powerful enterprise resource planning and accounting package along with a host of other tools like CRM. Whereas ExactTarget deserves to be in the 8x revenue club due to growth rate, NetSuite with a market cap of $3.2B (NYSE:N) and a run rate of $280M, is trading at north of 11x revenue, but only has a one-year revenue growth rate of 22% (source: thestreet.com).

    A 22% year-over-year growth rate is solid but a 11x revenue multiple seems like a stretch. What gives? After asking around I found a plausible answer:

    Oracle has to buy NetSuite at some point to be competitive in the cloud and investors have baked that into the valuation.

    Since there’s a suitor with deep pockets in waiting, investors have taken that into account and paid much higher than expected prices, knowing that for Oracle to acquire NetSuite they’ll have to pay a premium on the public valuation, thus there’s still money to be made for investors. The next time an entrepreneur points to the NetSuite valuation as a good example for SaaS multiplies, that outlier needs to be thrown out the window.

    What else? What are some other reasons NetSuite is a valuation outlier for SaaS companies?

  • SaaS Recurring Profit Margin Metric

    The CEO of Zuora has a nice slide deck online titled The Only 3 SaaS Metrics that Matter where he talks about the subscription economy, gives the three metrics, and provides benchmarks from publicly traded companies. The three metrics are straightforward and make sense:

    • Retention Rate – How much of your Annual Recurring Revenue (ARR) you keep each year
    • Recurring Profit Margin – ARR less churn less non-growth spend (growth spend is money spent on sales and marketing)
    • Growth Efficiency – How much does it cost to acquire $1 of annual contract value?

    Retention rate is a common one as is growth efficiency in the form of the SaaS Magic Number, although I like that growth efficiency is much easier to understand than the ratio of sales and marketing spend from one quarter compared to recurring revenue growth in the next quarter.

    The middle metric, recurring profit margin, is a great idea and not mentioned enough. One of the reasons successful SaaS companies have such great valuations relative to other companies with similar revenues and profits is that many SaaS companies could be much more profitable and still retain their revenues if they cut back on sales and marketing — recurring profit margin represents this number.

    Here’s a quick SaaS startup example for recurring profit margin:

    • $1 million in annual recurring revenue
    • 85% renewal rate
    • $50,000 profits (so, $950,000 in annual expense)
    • $300,000 spent annually on sales and marketing
    • Recurring profit margin: 1,000,000 times .85 minus the difference between total expenses and sales and marketing expense (950,000 – 300,000) = $200,000 or 20%

    Another way to calculate recurring profit margin is by taking away the sales and marketing expense (e.g. $300k), subtracting out the annual recurring revenue amount from customers that leave based on the churn rate (e.g. $150k), and adding in existing profits (e.g. $50k). Startups that spend an unusually large amount on sales and marketing, have high renewal rates, and still break even, will have excellent recurring profit margin metrics.

    What else? What are your thoughts on SaaS recurring profit margin metric?

  • Scaling a B2B SaaS Startup is Expensive

    Software-as-a-Service (SaaS) is an amazing model with great recurring revenue, high gross margins, and strong industry growth. That said, scaling a SaaS startup is expensive. Very expensive.

    Once you’ve crossed the desert and reached profitability, you can control you own destiny, especially if profitable, however modest, is true profitability paying market wages, and not just ramen profitable. Now, break-even or slightly profitable is great, but scaling the business and staying ahead of the market requires significantly more investment. The real challenge is when the law of large numbers kicks in based on the size of the customer base and the renewal rate. In order to grow, the number of new customers signed monthly has to keep growing because the number of customers leaving keeps growing.

    Scaling a SaaS business is expensive because the primary expense of the business is people, and people need to be hired and trained in advance of customer acquisition. With the SaaS model, customers don’t pay a large sum of money up-front, rather they pay monthly or quarterly, often with an annual contract. The lifetime value of the customer is great but payment is spread out over years, with a decent chunk of the first year’s revenue going towards sales and marketing costs for customer acquisition, leaving little left over to staff up engineering, support, services, and back-office functions.

    To recap: first year customer revenue almost all goes to sales and marketing, payments are spread out over years, and people are the largest expense, which need to be hired and trained in advance of delivering value. To scale a SaaS startup, sales has to get out in front of churn, which is always growing on an absolute basis assuming the the churn percentage stays constant and the business is growing. Along with significant investment in sales and marketing, all other core aspects of the business need investment in advance of customer growth.

    What else? What are some other reasons scaling a B2B SaaS startup is expensive?

  • Look Out for Harvest Mode SaaS Startups

    Software-as-a-Service (SaaS) startups should have great revenue growth with companies buying more cloud-based tools, the layering of recurring revenue on top of recurring revenue, and the strong investor appetite to fund money-losing businesses. Unfortunately, things aren’t always so rosy. In fact, when a SaaS company’s growth stalls, and has outside investors with a timeline on the business, there’s a serious chance the company will be sold to a non-strategic buyer and put into harvest mode.

    What is harvest mode you ask? Good question. Harvest mode is when a significant percentage of staff is cut, typically 30-80%+, for the purposes of maximizing profitability and milking the recurring revenue.

    Here’s a simple example harvest mode scenario:

    • SaaS company is break-even on $10M in revenue and 70 employees
    • Growth stalls and investors, controlling the company, decide to sell to highest bidder
    • Company is bought for $30M and 50% of the 70 employees are immediately laid off
    • Employee costs represent 80% of the expenses, so a 50% staff reduction results in $4M in annual profits
    • Company continues to improve the product and sign up new customers, while revenues and profits slowly shrink
    • The financial buyer of the company is able to fund the acquisition with the $4M/year profits

    This is a hypothetical example of a harvest mode SaaS startup. I’ve personally seen it happen a few times and it’s important to look out for them, especially if you’re a potential customer thinking about choosing a vendor.

    What else? What other thoughts do you have on harvest mode SaaS startups?

  • Gathering User Feedback For An Established Product

    User feedback is critical for building a successful software product. As the product matures and becomes established, user feedback is easier to get, but can also become overwhelming with requests from so many different constituents. Here are some ideas for gathering user feedback for an established product:

    • Quarterly check-in calls by a client advocate or account manager to find out how things are going
    • Idea exchange with single sign-on so that customers can post ideas and vote on other ideas
    • In-app net promoter score where you ask once per quarter how likely they are to recommend the product
    • Regional user groups with a company team member facilitating
    • Annual users conference with significant customer interaction
    • Customer advisory board that does a quarterly conference call with the VP of Product Management

    Gathering user feedback with these methods is the easy part. The real challenge is organizing the information and combining it with your own vision and opinion for the product. Then, clearly communicating the direction and future functionality with the key stakeholders.

    What else? What are some other ways to gather user feedback for an established product?

  • Notes from SaaS Growth and the Cost of Capital

    SaaS Capital has some great resources for Software-as-a-Service (SaaS) companies with one of them being a white paper titled SaaS Growth and the Cost of Capital. ExactTarget in the 8x revenue club is a great example of the SaaS business model, which is one of my favorites. Here are some notes from SaaS Growth and the Cost of Capital:

    • 13 public SaaS companies tracked by Pacific Crest Securities have increased 40% in value from the beginning of 2008 to the beginning of 2011
    • Best valuations come from SaaS companies growing more than 25% annually in a large market
    • Main driver for valuations comes from revenue growth rate (not profit growth)
    • Three of the four fastest growing SaaS companies are spending more than 40% of revenue on sales and marketing
    • When today’s market leading SaaS companies were in expansion stage before going public they spent 60 – 70% of revenue of sales and marketing and took on outside investment
    • Cloud technologies are contributing to higher incremental gross margin for SaaS companies (along with Moore’s Law)
    • High-growth SaaS businesses are worth three to five times more than slow growth ones

    The author of the white paper really drives home the point that growth for SaaS companies results in a huge premium and should be seriously pursued.

    What else? What are your thoughts on SaaS growth and thd cost of capital?

  • Large Customers as Edge Cases with SaaS Products

    Software-as-a-Service (SaaS) is an extremely efficient model for product development since the delivery components and upgrade cycles are controlled by the vendor (an inordinate amount of time is spent supporting configuration environments with installed applications). There’s one edge case with SaaS product that isn’t talked about much: unusually large customers.

    In the installed software world, unusually large customers typically require more expensive or exotic hardware and the problem is somewhat solved. With SaaS it isn’t as easy because SaaS applications are often sharded whereby clusters of customers are grouped on the same database, but individually delineated. As the customer base of the product grows, the SaaS company adds more and more shards. This breaks down with an unusually large customer when the customer is so large as to not fit in an isolated shard or with the standardized hardware used to power the other shards is not powerful enough.

    Modern technologies like Cassandra and HBase provide amazing scalability across a cluster of machines and solve the scale problem. Unfortunately, the tools to develop against them aren’t as simple and powerful as tools for standard databases like MySQL and PostgreSQL, but they are rapidly improving.

    Some ideas to deal with the unusually large customer edge cases with SaaS products include the following:

    • Data size allotments with fees for additional storage
    • Setting upper-bound limits for certain categories of data and not allowing overages
    • Isolating the account to a dedicated shard

    My recommendation is to think through scalability limits early on and address them in advance of customers reaching them.

    What else? What thoughts do you have on large customers as edge cases with SaaS products?