I seem to have spent most of the last week in various stages of finding suppliers. From formal pitches to writing an initial brief and several points in between. In all cases the companies I was working with were looking for professional services. Or buying in skills and expertise in some similar form.
Finding trusted suppliers is another on the long list of hard choices a startup leader has to make. In the early stages you might use external suppliers for anything. From building your product to traditional services like legal and accounting. The wrong choice can cause extensive damage. Getting it right is about looking beyond price to find the right talent. Someone with the skills you need and the courage to tell you what you don’t want to hear.
Its Never just price
Let’s start with the biggest bugbear. Price is a terrible way to choose a supplier of anything. And for services there is no worse measure of value. At least with commodity style goods you can compare like with like. When a service is delivered by a skilled team, this is impossible.
Even when a service is described as a commodity (basic accounting or legal for example), the comparison is not so simple. Professional advice is like an insurance policy. When everything goes well it doesn’t matter who you choose. But when a problem (or a claim) arises, the pain caused by having the wrong advisor will be terrible.
So price is never the only factor. If you can’t see any other difference between suppliers, you need to look harder.
The Kakocracy Trap
Noun: kakocracy - Rule or government by the worst of the people
The first step in finding the right supplier is making a list that includes the best options. There are two regular ways of doing this:
Both techniques are useful. But someone also needs to do a bit of research. Scan the internet. Think about whether your job is one that needs a local supplier. Don’t be afraid to go global for some things. The test is the skills you need and the quality of communication.
Talk to people you know. Especially those who don’t come forward with recommendations. This is an area where the startup ecosystem adds a lot of value. And silence is not golden but red for danger.
By all means speak to advisors as well. Only remember there is a lot of back scratching in these networks. Advisors and mentors can be helpful but they are also the prime source of the trap.
There is a cost in time to making a good list of suppliers. It will be outweighed by the benefits of making the right choice more often.
The jobs to be done mirror
The absolute foundation for buying any type of service is to be clear about the expertise you are buying. Its the precise reflection of the jobs to be done framework for evaluating a startup idea. Before you spend any money, understand the job you need done and the skills it requires. Choose a supplier based on those critical areas of expertise.
In some ways its like hiring. You want to find the right talent. The big difference is that you only need this talent for the short term. This means you select a supplier for experience and track record. Whereas you should always hire for potential and fit.
However, track record is not the same as finding someone who has done the same project 10 times before. No two projects are the same. When you look at supplier experience focus on the core skills needed for your project. Take up references. And ask about expertise not just the results.
Take market research as an illustration. Don’t bother about someone having researched the same market you want to look at. What matters is the ability to reach the right audience. Skills in asking the right questions and probing for the real answers. And an intelligent evaluation of the responses.
Be clear about the things your advisor does that you cannot. And agree a scope of work that is defined by those key areas of skills.
An outcome not a result
You are buying an outcome but not a result. A good professional supplier gives you and honest and independent assessment. Often this is not the result you wanted. Get over it. And understand this in advance. Choose a supplier who will give you a great outcome. Don’t try to buy confirmation of your own opinion.
The same principle applies to skills outside the traditional professional arena. There is no point in outsourcing software development because you can't code. And then restricting the developer by your own limited knowledge of the subject.
When you are choosing a supplier, the best test of this is how they set expectations. Look for someone who questions your project objectives. Not just blind agreement. And choose a supplier where communication of changes and new ideas is embedded in their approach.
A word about incentives
Once you get people involved, the psychology of incentives is an inevitable part of success or failure. (I sometimes think Alan Turing over complicated matters. The test of true artificial intelligence will be when a machine offers an emotional reaction to an incentive.)
A key area of incentive when choosing suppliers will be the pricing mechanism. There is no right answer but think about these three things:
The Chairman's View
Finding and buying services from suppliers is a bit of monster. Big corporations devote entire departments to getting it right. And still make mistakes every day. Its an important job for a startup leader. Yet its not critical. For me I want to see a CEO who contains the risk. I don’t expect you to get it right every time.
So think about:
I spend a lot of time with startups. Mainly in Scotland. Where we our unique history binds a country on the fringe of the world deep into global innovation. We are proud of our two unicorns. And there are some amazing founders and businesses. Its tough to generalise - I met Alba Orbital who make satellites this week for example. But the most common business model is a subscription SaaS company aimed at SMB customers. That’s why I write about this stuff so often.
And it niggles a bit that a lot of SaaS analysts focus on the challenges of the SMB market. Every other week I read an article somewhere that argues that you must target the enterprise to achieve SaaS growth. Most of these posts are written by people smarter than me. Yet I can’t get away from a sense that they are missing something. That the economics of SaaS for SMB work. In a niche for sure. But also at scale.
I have one fundamental and rational reason for this. SMBs are a huge market. As this Edinburgh Group report shows they contribute 51% of the economy in the developed world and 67% of employment globally . This week I found time to do some digging into the real economics of the businesses that might serve that market opportunity. Here is my thinking on how the unit economics of SMB SaaS could support a great company. Maybe even a few more of those one horned white horses.
What do the base numbers for SMB SaaS look like?
As a starting point we need to pick some numbers to model the unit economics. These are averages or benchmarks. Not because you should aim for them. Just to give a representative idea of how a “typical” SaaS business works. The base levels for the analysis below came from:
I have summarised these assumptions in the table below. Showing the high, medium and low (HML) points for each assumption.
What follows is a whole lot of messing around with these numbers. If you don’t have the time or the appetite to follow this take away just these messages:
Analysis 1: Growth rates
Now let’s start looking at the impact of different trends in some of these basics of unit economics. I will start with the simplest variable which is growth rates. The graph below shows the impact of H (15%), M(10%) and L(8%) growth on monthly recurring revenue (MRR) and free cash flow (FCF). I have used revenue not gross margin. For small SaaS companies storage and processing costs are in effect fixed cost. Not variable with revenue. As you grow you should switch to gross margin for this type of analysis.
FCF is defined as the difference between the cash paid by customers and the CAC spent each month to acquire new customers. In this simple example cash paid and MRR are identical. Because I have assumed all customers pay monthly. We will examine the impact of upfront annual subscriptions later.
The other main assumptions are constant across all the HML variables. Churn is 5% in each case, LTV/ CAC ratio is 3. ARPU at £39.99 and opening customer base of 100 are the same for all graphs.
This tells us two things. No surprise that the higher your growth rate, the faster MRR increases. By the end of just one year you can see that the High growth option is pulling away from the others fast. If you play with the numbers you find that 15% is around the minimum for the start of a hockey stick to occur within a year.
FCF works the other way around. Faster growth needs more cash to keep the users flowing in. This would change if the LTV:CAC ratio was better for higher growth instead of fixed at 3. This is an important lesson. High growth can arise either from a more efficient sales model or spending more money. If you are struggling to match the cash raised by your competition, the only answer is to be smarter. And the LTV:CAC ratio is the key metric to track.
Analysis 2: Churn
What about churn? Lots of analysts think this is a key factor in SaaS success. Lets fix the growth rate at 15% just so we get a little hockey stick at the end. The graph below shows MRR at H (7%), M (5%) and L (3%) churn.
Here we see a spread of outcome which pretty much follows the spread of churn. Losing customers matters pretty much in proportion to the rate of loss. Keep an eye on churn but don’t get it out of proportion.
One important caveat. I have used churn in customer numbers here. In a SaaS company where the range of ARPU is quite narrow this makes no difference. But if your highest paying customers represent a significant portion of your revenue then MRR churn matters more. The bigger your customers the higher the likelihood that this will be the case. This will also have a big impact on your sales model. Upsell to existing customers is much more important with an enterprise customer base.
Before we leave churn let’s take a look at another effect. If we use the same HML for churn and the same 15% growth rate and fix the LTV:CAC ratio at 3, look what happens to FCF.
Wow! That looks totally wrong. Cash flow gets worse the better churn gets? This is where a small understanding of the dynamics of metrics and ratios could save you a lot of money. Churn is used to calculate LTV. The normal formula is just ARPU/ Churn % = LTV. As a result lower churn gives higher LTV. If we fix the LTV:CAC ratio then higher LTV is an automatic translation into higher CAC .
Simple lesson. LTV:CAC ratio matters but so does the absolute value of CAC. If I fixed the value of CAC instead of the ratio we would see the same pattern for FCF as for MRR. Reducing churn is a good thing. But don’t allow your CAC to drift up at the some time by focusing only on the ratio.
Analysis 3: LTV:CAC Ratio
Let’s take a look at that ratio. The 3:1 target is rough and ready. Anyone I have read recommends it and then add that there is no rationale behind the number. What impact does it have if we start changing the ratio?
This only affects FCF. MRR does not vary with the LTV:CAC ratio. I have stuck with the 15% growth rate for all 3 scenarios because this is cash hungry. Churn is fixed at the median of 5%. I also see no point in modelling a ratio of 1:1. In this case by definition you are never making any money so something has to change.
It turns out that 3:1 is right on the button. Below this level (1.5:1 or 2:1) cash burns fast. At 3:1 you can stay FCF positive - just. For your SMB SaaS ever to get to cash positive, 3:1 is the minimum ratio. Get there and keep improving is critical to a sustainable business.
Analysis 4: Beware the discount factor
One final analysis of dynamics. Everything so far has been based on monthly subscribers paying every month. Most online SaaS offers packages to tempt payment in advance. Usual approach is a discount for paying a whole year upfront. The argument is that this boosts cash flow. How does this work out in practice?
Another sobering picture. I have fixed the other elements as usual but based on 10% growth. The pattern for 15% growth is the same but extends out over 2-3 years - this allows us to see the effect in 12 months.
The discount element is also fixed. I have assumed 10 months for the price of 12. Again a common approach. The most frequent in the sample of companies I looked at.
HML here is about the percentage of new customers paying annual upfront - H (75%), M(50%) and L(25%). The higher percentage gives a big boost upfront. But it narrows fast. MRR shrinks the more you discount. If I laid MRR onto this it would show that MRR in the High scenario was 8% lower than in the Low option.
Discounts are for the short term. They can produce a much needed cash boost. But keep your eyes open. The benefit is short and the bar for revenue gets higher with every giveaway.
How big does SMB SaaS need to be?
The conclusion so far is simple. The unit economics of SaaS for SMB work. You can generate revenue and cash flow provided your CAC is under control. Yet these numbers deal only with free cash flow. You need to build and maintain a product. Proceed customer service and support. Do all the boring admin stuff that you need to run a business. And make a living for the founders. If each customer is small maybe you need a huge number to make a decent business?
The table below shows monthly and annual figures for 100, 500 and 1,000 customers. Using the mid point numbers for all the other operational metrics.
None of these are unicorn numbers. On the other hand in the context of SMB SaaS they are achievable. Even here in Scotland official statistics show that there are 359 thousand SMBs. Scaling further is great. This show that even 500 customers generates enough cash to make a real living.
To make this work you would need to find the funding to get you to 500. And manage your monthly cash burn within these margins. But it is possible.
Working in the real world
These analyses are based on averages. There is no such thing as an average business. Every SaaS will be different. Even the “choice” between SMB and Enterprise is not real. Potential customers occupy a continuum. These rough and ready calculations can help guide you. And provide a bit of fun. They are no substitute for paying attention to the real details of your company.
I have put the assumptions and calculations I used to generate these numbers into a free Google sheet. You can access this and play with the numbers for your business if you like. Remember this is a simple sheet so you can produce strange effects like the one in Analysis 2 above. And even if your numbers look good you still need to make stuff happen.
In the end metrics are just the voice of your business. What they say will depend on the specifics - customers, product, business model. What you do will depend on you listening and acting on what you hear. These figures are only indicators of the possible. Having worked through them I am convinced of three things:
For anyone involved in building SMB SaaS, don’t be distracted or discouraged. The business model works. Its success depends on delighting your customers so stop reading and get on with it.
Happy New Year to everyone. I hope you are ready launch into another SaaS year. I have spent a fair bit of time over the holidays thinking about some of the big topics related to SaaS. You will hear much more about my ideas over the coming months. For this first blog of 2016, I want to concentrate on one specific topic. Cash.
Every SaaS is looking for money
When I look at the SaaS companies I advise and/or invest in, almost all have one common feature. They have either raised funds in the recent past or they are planning to raise in 2016. In some cases both! So I was thinking about why SaaS businesses always seem to need money. And I came across this post from Jason Lemkin - Why Can’t SaaS Just Mint Cash? Here is one of the gurus of SaaS looking at the exact question. How come even successful SaaS needs more and more money to sustain progress?
It also reminded me of an earlier post by another legend, Tom Tunguz. One of his themes is to analyse the published number of listed US SaaS companies. I think he has a basket of 51 that he tracks. This article highlights numbers for that group of SaaS companies. Almost none of these businesses are generating free cash flow or GAAP profits. Only 18 (of 48 at the time of the post) have ever recorded even 1 year with positive net income. The cash position is better but it still takes on average 6 years for SaaS to become cash positive.
Why does SaaS eat cash?
Why should this be? And does the SaaS business model still make sense if the overall economics are so tough? I believe it does because these numbers are a product of growth. Not the result of a fundamental flaw. That does not mean you can relax if your SaaS is swallowing cash. Growth is one factor but it can also highlight areas of the business model that need attention.
The key challenges that create cash burn are:
Is Enterprise the only answer?
One option to work your way out of the cash bind is to go up market. Enterprise sales generate more cash. Big organisations are great for upset. More users. New modules. Extra locations. It all adds up to a strong ongoing revenue stream.
This option is not open to everyone. Selling to the enterprise means a substantial investment in sales and service capability. You will get the cash flow right in time. But only if you can raise more cash up front. $100m plus rounds are common in the US. This type of funding is much harder in other startup ecosystems.
4 SMB SaaS ideas for 2016
And maybe that is not how you want to run your SaaS business. Your product and market may be squarely in the SMB sector. In this case spending heavy to hire sales people and sell to multi nationals would be the wrong strategy.
So we are back to the start. Every SaaS business needs cash. 2016 could be a year when the business environment gets tough. Fundraising may soon be harder than ever. If you are growing an SMB SaaS business, what can you do to mitigate the cash burn?
I have no easy answers. These 4 ideas are worth trying:
Don’t be afraid to invest in what works. When you find a model. Or a channel. Or a person. Back them. One thing for sure. You will never succeed if you don’t spend the money you do have. Find the right solutions and go for it.
Customer Onboarding often determines the success or failure of SaaS companies selling to SMEs. Look at onboarding as a strategic priority. Within your end to end sales and marketing process. Experiment and test to find the right tactics. Keep the need to generate sustainable LTV front of mind.
A Golden Opportunity
Another energetic and intelligent discussion in the SaaS Scotland Group two weeks ago. We focused on Customer Onboarding. The founders had a great selection of ideas and suggestions as you can see by looking at the ideas page. The session reinforced a key point. Customer Onboarding is a critical element of the SaaS end to end revenue process.
At this stage a SaaS company has a golden opportunity to do three things:
Onboarding and SaaS for SME Success
It is rare for companies to achieve this nirvana. Generating leads at low prices is still doable. People sign up for free trials en masse. But then the theory breaks down. Potential customers either don’t convert or don’t even bother using the free product. Those early sign up numbers evaporate before any revenue appears.
Soon the focus turns to onboarding. Startups ask questions like:
Or even, are we signing up the right customers?
The success of startups selling SaaS to SMEs is often determined at this stage of the recurring revenue model. Many entrepreneurs start out with a dream view of the whole process. Generate leads online. Sign people up for a free trial. Build automated onboarding processes. Convert triallists to paying customers at a sensible rate. Add up the numbers and SaaS looks like a great business.
SaaS Is Not That Easy
5 Strategic Priorities
These are valid and important questions. But they are questions of tactics. The answers will vary by company and by product. There is no repeatable formula for success. Remember some core strategic principles when addressing the challenge:
An Opportunity Not A Burden
In the course of my small business consulting I often hear startups that struggle with onboarding. Sometimes it sounds like teams see this as a burden. Onboarding is a great opportunity to engage direct with your customers. Often it will be the best chance you get. Take the wide view of sales & marketing. Treat onboarding as an equal priority with the rest of your sales and marketing process.
A quick look at the numbers
Tom Tunguz is one of the gods of SaaS insight and blogging. This week he published The Innovators Dilemma for SaaS Startups. His basic argument is that all SaaS companies start by targeting the SMB market. In time they feel forced to move up to the Enterprise market. As always the post is well written and supported by some thoughtful data analysis. There is no question that this is a common path for SaaS businesses. But the revenue model doesn’t need to be this way.
Let's take a quick look at the numbers in the post. The benefits of moving up to enterprise rest on two broad assumptions about the startup financial model.
1. Inbound “sales” reps selling to SMBs generate less ARR per $ of revenue than outbound sales reps.
2. Churn for SMBs is double the rate for Enterprises using the same product.
Low churn is about pain not loyalty
I have two big problems with this basis of argument. Take churn. The “stickiness” of traditional enterprise software is not based on loyalty. It has everything to do with the pain and cost of implementing big systems. Everyone hates to change because it is a horrible experience. The business benefits are never realised. SaaS changes this by definition. If your software is a genuine service it will not be hard to install. It will be configured not customised. You will not have a long contract commitment. And your balance sheet will not be heavy with intangible “assets”. Remove the costs of switching and the churn numbers will even out.
The old sales model is dead
The enterprise sales model is rooted in old ways of doing business. And it is people heavy. The inbound (or inside) model is changing the way business buys products. From software to homewares, customers have different expectations. The twentieth century world gaves us sales reps, account executives, quotas and bonuses. It was no fun for the customer. Most big enterprises created an expensive defensive wall (called procurement) to deal with it.
Migrating to new ways of buying software will change all this. The fundamental unit of sales growth will no longer be sales people. User engagement will drive value for both new and existing customers. The dynamics of the cost to win and serve markets will change. There is no reason why this should favour the enterprise.
Disrupting the value chain
The value chain for business software will be disrupted. At root this is a form of disintermediation. The current relationship between big software and big business has many layers. At the outset there is a sales/ procurement layer. Once in operation various parts of corporate IT interact with the software vendor. Account teams, support groups and even development touch the customer. In each part of the relationship, consultants, advisors, resellers and specialists proliferate. This creates enormous distance. A gulf between the people who build enterprise software and the front line users.
Cloud, APIs and the sharing approach to software development will change all this.
SMBs are the future SaaS Revenue Model
This is great for the software business and great for customers. It means great software becomes all about delivering value to the user. Much less about how its sold. It creates the opportunity for products users love to succeed.
I love small business consulting because it gives me the chance to work with great startups. I prefer the more holistic view of the SaaS opportunity articulated by Christophe Janz. There are at least 8 ways to build a $100bn SaaS business from Whales down to Microbes. All are valid they just need different revenue models to succeed.
SMBs can be the rule not the exception
At the end of his post Tom Tunguz highlights a couple of exceptions - Xero and Intuit. These are great companies. I believe they are the start of a trend not exceptions to the rule. Successful SaaS businesses are making beautiful software more affordable for SMBs. It is my business to help SaaS startups take advantage of this SMB opportunity. If you would like to know more, get in touch or subscribe for updates.
What the experts say
I read a great post from AdEspresso recently. Its about churn in SaaS startups that are selling to SMEs. In simple terms, high churn in the first 3 months of use is just part of the sales funnel. 5% churn or higher will not kill the business. Once through this early period, users will stick around. I work with a lot of SaaS companies and most of them target the SME market. This got me thinking about the economics of these businesses.
I started to look again at the best SaaS sources. Tom Tunguz, Jason Lemkin, David Skok and others have written a great body of work on SaaS metrics. But it is all about selling to the enterprise. They talk about CLV or annual revenues in the 10’s even 100’s of thousands of dollars. The main element of customer acquisition strategy is people. Marketing, sales and customer success teams. Look at this post on the fundamental unit of growth for example. This is not the same world that many startups live in.
This took me back to what has helped SaaS companies succeed in the SME world. The first thing I noticed is that the basic framework of SaaS metrics remains the same. Customer Acquisition Cost (CAC), Growth, Monthly Recurring Revenue (MRR), Customer Lifetime Value (CLV) and Churn. It is only when you dig into these numbers that the differences emerge.
Customer Acquisition Strategy is the first difference
Start with CAC. Accepted wisdom is that sales efficiency (CLV/CAC) runs around 0.8. Anything over 1.0 is considered good and 2.0 is best in class. Coupled with high churn, this level of cost makes selling to SMEs look very unattractive. But this is not the reality. SME SaaS can achieve sales efficiency ratios of 5 or even 10. It just costs less to get a new revenue dollar.
There is a simple reason for this difference. Enterprise SaaS requires sales teams. Tom Tunguz post above lists Sales Development Reps, Account Executives, Customer Success Managers and Upsell Reps. SMEs need none of this apparatus. In fact they hate it. Small business owners are far too busy to spend time talking to reps. Once they have a a product they just want it to work. They don’t expect or want regular account calls. The recurring revenue model does not depend on direct sales.
This doesn’t mean marketing, sales and support don’t matter. It does mean that the product and onboarding process needs to be friction free. Most of your customer acquisition will be online. So you need to learn what works. How you reach the right online audience and how you convert with minimal intervention. Partnerships or integration with parallel products can also be part of the mix. Keeping CAC low and Sales Efficiency high is an art form.
CLV is linked to the recurring revenue model
CLV is another major difference. For an SME this number will be much lower than for an enterprise. The revenue models are different. At its most basic this means you need more customers to make a viable business. With SMEs there will also be much less opportunity for upsell. Service revenues from installation will tend to be nil. Growing CLV means you need to keep customers loyal. You need to embed your SaaS product in the life of their business. Be too good for anyone to risk a change.
...and finally churn
That brings us back to the final element as pointed out by AdEspresso. Churn rates can look high. The idea is that this is part of the sales funnel. It should be combined with conversion rates. The success of early months for an SME customer also depends on the onboarding process. Remember this is unlikely to generate much if any revenue. Yet managing your customers through this process is critical. Building a frictionless product is half the battle. Investing in people to help your customers will also pay dividends. Far more than a sales force.
Onboarding is the secret of success
What is the secret of a a great on boarding process? Des Traynor from Intercom wrote recently about the evolution of onboarding. In today’s world there is one key - change. You want the small business owner to adopt your product. He or she needs to change something. It can be a change in business process. A change in time allocation. Even a change in lifestyle. Your on boarding process needs to help your customer change. It also need to link that change to success for their business. To find out more about SaaS metrics and to receive a free copy of my SaaS Revenue model tool, subscribe below.
Late last year I started digging into the startup financial model. My whole career has been about how a business works. I don’t do blue sky strategy. I am not a system and process ops guy. I design, analyse and improve business models. This is the systematic view that works in my curious brain. I find myself poking around in a lot of different ideas. When I can see what works, I can help fix most things.
SaaS is the leading business model
In the startup world most things come back to software as a service (SaaS). Most of the businesses I am trying to help are SaaS based business models. The best startup ideas I see are SaaS based. The mechanics of the SaaS business model make sense. SaaS Metrics and the startup financial model hang together well.
I have learned a whole lot about SaaS by working with some great companies. I read and follow a bunch of great people who share interesting stuff. (You can go here for my quick guide to the best SaaS reading).
Revenue Models don't add up
Over time though I have realised that there are some things which don’t quite add up. For example the sales model, some aspects of the economics, typical customer revenues. The experts view doesn't fit with my experience of real startups. I couldn’t make sense of this. Then it struck me when I was reading a post from AdEspresso. All the great stuff I read online is about SaaS companies that sell to the enterprise. But the companies I talk to are aiming at SME customers.
How are SMEs different?
So I started to think about why selling SaaS products to SMEs might be different. If so, what would that mean? This feels like it might be a long journey but here is what I have found so far:
SMEs want to take advantage of new digital technologies. There is a great small business market out there for SaaS companies.
Helping small business change
At the heart of any successful business software is change. Adopting any software product requires business change. In a big organisation there will be managers and consultants to drive this. For an SME change is much harder. It takes time and focus. It risks the precious business that the owner has spent so long building up. You need to take away the pain as far as possible. You need to provide the encouragement and show the benefits.
I would love to learn
I want to help great SaaS companies serve the SME market. I love consulting for startups. Helping find the right growth tools. I am fascinated by SaaS customer acquisition strategy. I understand the revenue models. How can those SaaS metrics work better when selling to SMEs? What kind of small business consulting and advice do startups need?
I would love to hear from startups, entrepreneurs, growth hackers or customers. What are your ideas about how best to tackle SaaS for SMEs. Let me know your thoughts in the comments below. Or subscribe to my newsletter and receive my SaaS Revenue Model absolutely free.
Kenny Fraser is the Director of Sunstone Communication and a personal investor in startups.