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.