Does the SaaS Sales and Marketing Economic Model Work?

You’ve heard it before. The suggestion by on-premise software vendors and skeptics that the SaaS economic model isn’t profitable.

They argue that SaaS companies’ significant upfront sales and marketing costs and their relatively inexpensive product make for a inherently non profitable economic model. While not many people will argue that the SaaS sales and marketing economic model is not vastly different from other forms of software delivery, the question is: Does it work?

The answer is yes, if the company executes its growth strategy properly and efficiently spends those sales and marketing dollars. Those companies are often on a high growth path, so they’re willing to sacrifice significant upfront sales and marketing costs for the acquisition of long term, recurring streams of revenue from their customers. That revenue is compounded year after year, which can set SaaS companies up for a bright, very profitable future.

I recently read a great analysis of SaaS companies’ sales and marketing spending while doing some benchmark data research on the topic. Bob Warfield at SmoothSpan wrote a blog post titled “Why do SaaS companies lose money hand over fist?” last year that addressed the issue. The title doesn’t exactly sound like a ringing endorsement of the SaaS sales and marketing economic model, but Warfield proved otherwise.

He compared and contrasted three software companies: SuccessFactors, Salesforce.com, and SAP. Two of those — SuccessFactors and Salesforce.com — are pure CRM companies. SAP has a tiny SaaS division that accounts for about 5 percent of its business. In the line-by-line comparison, it expectedly showed that the two SaaS companies spent a lot more on sales and marketing than SAP. There was no clear differentiation, however, between the SaaS companies and SAP on G&A and Research and Development.

The comparison also showed that Salesforce.com and SuccessFactors both have a much higher expected growth rate than SAP. Here is the data that Warfield posted, shown in the amount in sales and marketing each company spent for each dollar in revenue.

  • SuccessFactors spent 56 cents per dollar in revenue last year, but analysts expected a rate of 85 percent growth for the company in 2010.
  • SalesForce.com isn’t far off that number, spending 54 cents per dollar of revenue with a prediction of 44 percent growth in exchange for their investment.
  • SAP — the company that has the smallest SaaS division — spends 29 cents per dollar brought in, but analysts anticipated only 7.5 percent growth in 2010.

So there’s the crux of the SaaS sales and marketing economic model debate. While SAP’s cost efficiency is much better, its potential rate of growth is significantly less. The truth is, SuccessFactors and SalesForce.com, which are both much smaller than SAP, could be wildly profitable if they decreased their sales and marketing spending. But rather than focusing on profitability in the short term, those companies are making an investment now in exchange for significant future growth.

Warfield’s post is more than a year old, but his argument for the SaaS economic model has only grown stronger since he wrote it. Because of the economic downturn, companies that formerly used on-premise vendors are now looking for alternative solutions with a smaller upfront or monthly cost. In that sense, the economic environment has actually increased the SaaS foothold in the market, while reducing the cost of customer acquisition.

According to a ScanSafe survey of 300 IT managers in late 2008, the SaaS model has become significantly more appealing with the onset of tightened budgets and the need for revenue flexibility. ScanSafe’s survey found that:

  • 78 percent of the IT managers surveyed believed that SaaS’s appeal will continue to increase during the economic decline and stagnation.
  • 54 percent of respondents said that they would choose SaaS based strictly on budget.
  • 75 percent said the primary benefit of SaaS was its reduced maintenance cost, while 71 percent agreed that SaaS’s cost predictability was also a significant benefit.

All of these data point to a very healthy demand for SaaS products even in a slow growth economic environment. That surely is yet another proof point that the SaaS economic model can work and will work very well, if the assumptions above hold.

Still, most SaaS companies tend to raise a lot of venture capital funding to support the initial sales and marketing costs that will stimulate that growth. However, it’s essential that those companies make sure they’re spending the capital wisely and strategically improving their sales and marketing economics as they grow. If they can do that, then SaaS companies’ risk profile will look dramatically better and they won’t need to worry about what on-premise vendors say about their potential profitability.

Share Your Thoughts

  • Anon

    Has open view ever used SFDC?

    SFDC, last I checked does not have that 45% profitability that was counted in. Source : their Balance Sheet. I have a natural bias, we are a CRM product firm ourselves.
    We provide “private cloud” based solutions. All our deals are against SFDC and we win 9 times out of 10.

    Having said that, if a user were to google CRM they may engage first with SFDC, 9 times out of 10. Would they buy online? and from curiosity to writing a check how long does it take? Worked for Oracle and SAP I know enough to believe which deals close digitally.

    But thanks to SFDC end users ask far lesser questions before going to other CRM vendors.
    Anyway, the whole point is a poorly engineered product, regardless of pricing or projected pricing could not stay around for long.
    Thanks!

    • http://www.openviewlabs.com Tien Anh

      Thank you for your feedback,

      Perhaps SFDC’s profitability has decreased since Bob Warfield’s article. In fact, I would not be surprised that it had gotten worse.

      At OpenView we use SFDC since inception. Most of our portfolio companies also use SFDC to manage their sales teams. While recognizing SFDC limitations, usability issues and high license cost, we also appreciate that it has a huge customer base, is considered the “standard” web-based CRM, and has very good extensibility through API and its programming language. In fact, I have written quite about SFDC and why we use it at OpenView here:

      http://blog.openviewpartners.com/blog/how-did-it-happen/business-tools-i-am-thankful-for-salesforcecom

      That said, we are always open to looking into other options, especially if you are winning so well against SFDC – there must be something special in there. Perhaps you can send us a link to your product?

      Thanks,

  • http://www.saasmarketingstrategy.com Peter Cohen, SaaS Marketing Strategy Advisors

    Tien Anh,
    I agree with your conclusion that SaaS companies need to spend efficiently on sales and marketing to acquire customers and grow. However, the comparison of Salesforce.com and SuccessFactors’ sales & marketing costs to SAP’s sales & marketing costs are not quite apt.

    SAP’s low ratio of sales & marketing expense to revenues is due to the fact that the company can recognize license revenue immediately. It’s not necessarily an indicator that it’s sales & marketing activities are more efficient.

    By contrast, subscription revenues for Saleforce.com and SuccessFactors are recognized over the life of the subscription, not immediately. In the case of many SaaS companies, it can take 2-3 years’ of subscription revenues to recover the initial sales & marketing costs to acquire the customer.

    Companies operating under the SaaS model – pay for customer acquisition now, and earn revenues over time – need to be especially careful to spend efficiently on sales & marketing. The model also requires deep pockets and patience.

    FYI, I’ve written more about SaaS customer acquisition costs and the trend toward consolidation here: http://bit.ly/9JYhgA

    • http://www.linkedin.com/in/tienanh Tien Anh Nguyen

      Hi Peter,

      Thank you for your comments. What you point out about the effect of revenue recognition is exactly right and is the core consideration for anyone looking to build or invest in a SaaS business. It definitely requires a lot of upfront costs, which requires deep pockets and investor’s patience for sure. However, I am also fascinated by the fact that some companies are doing it much better than other, and I thought compared to most, Sf.com and SuccessFactors are already doing quite a good job, as of the time of the article by Bob Warfield.

      I also agree with your post on the consolidation trend. We are definitely seeing it as investors – some smaller SaaS companies are looking for exit, not because they dont have a good product or good growth, but that they just dont have enough scale to continue the pace of customer acquisition and sustain its upfront costs. We also find that a lot of this cost is due to financial structure and distribution channel architecture. Our strategy at OpenView to deal with this is to help our portfolio companies very quickly figure out a good distribution model that trend towards profitably and work very hard to maintain the same economics even as the company scale up over time, so that they can have a longer runway and always maintain a healthy level of cash so as to keep the options open.

      I look forward to exchange more views and comments with you in this exciting topic,

      Tien anh

  • http://easiadmin.com Dan Katzman

    The real issue is that current GAAP Revenue recognition rules for SaaS companies do not effectively match revenues and expenses. On a cash basis, fast growing SaaS companies are generating much more operating cash than the P&L would indicate.
    There is a large upfront cost to sell, install and educate a customer that will typically eat up most of the first year’s revnue in the first three or four months of a customer’s life. Annual renewals after that have a 70% margin and our customers have a 92% retention rate. The surprsingly slow recognition of this revenue significantly understates our profitability. As an emerging SaaS, we will probably be dividending significant amounts one or two years before we show GAAP profitability.

    • http://www.linkedin.com/in/tienanh Tien Anh Nguyen

      Dan,
      Thank you for your comment. While agree for the most part with your comment on the issue of GAAP recognition, I still think that cash flow is still an issue for SaaS companies. Depending on how a company commissions its sales force for each new account (per annual contract value or per billing invoiced), and how much it collects from the customer upfront (monthly or annually or somewhere in between), its cash balance trajectory can be very positive, or fluctuating wildly between red and black.
      We think the key to success in the SaaS model (which we definitely believe in, as you can see in the number of SaaS companies in our own portfolio), is to capture the growth with minimal cash burn, and to be extremely agile in adjusting and perfecting the economics model as the company grows.

      Look forward to exchanging further with you,

      Tien anh