The best SaaS business model thinking
There is a lot out there about the economics of SaaS business models. Tom Tunguz publishes regular insights about the performance of listed SaaS companies. David Skok offers some excellent analysis. His blog describes the formulas and ratios that drive growth and profitability. SaaStr provides practical tips and advice that are valuable to any entrepreneur. You could build up a list of metrics from these sources that runs to 10 pages or more.
I am not about to try to summarise all this great material in one blog post. This is not a guide to the economics of a SaaS business model. Reading great analysis and working with SaaS startups is a great way to learn. Some key ideas strike me as worth sharing.
CLV is key to unit economics
SaaS is about unit economics. You can calculate a realistic customer lifetime value (CLV) from the available data. I wrote a detailed post on the subject a couple of months ago - find it here. CLV is the building block of long term value. It shows the route to sustainable profit. The formula for CLV includes direct cost and cost per acquisition. Your direct cost should take account of cost to serve. Few SaaS companies can just sign up a customer and watch the money roll in. Those awesome margins need to support a proper service framework. You must keep your users engaged.
Every startup need to get to product/ market fit. At this stage SaaS companies are gaining paying customers with a repeatable process. The results of this process are also predictable. They can estimate the CLV of each customer. But they are not profitable. Now SaaS suffers from an old fashioned challenge. New Business Strain (NBS).
New Business Strain
NBS is an idea from the life insurance industry. In simple terms the cost of acquiring a customer is all incurred upfront. Value is realised over a period of years. Accounting and cash flow follow a more basic model. Growing a business means high short term CPA. This outweighs annual profits from recurring customers. You need more money than you are earning to keep growing. Financing this strain is the purpose of Series A investment and beyond. The alternative is slower growth.
B2B is not viral
Consumer business models can generate hyper growth and profits. This occurs when viral spread reduces CPA to near zero. This kind of viral growth is not open to B2B SaaS. Viral cycle times are much longer. Months not hours. When recommendations do happen they generate warm leads not direct sales. It may be slow and partial but viral still matters. Jason Lemkin wrote a great post about this. Over time, references from your customers will make a difference. Growth will multiply and CPA will come down. When this kicks in, NBS will shrink fast. It just takes time.
Lifetime is a key word in CLV. The number that determines L is churn. The value of your business is sensitive to tiny variations in churn. 2% per month gives a half life of 3 years. That is you will lose 50% of your current customers by the end of three years. Increase this to 3% and the half life reduces to just 2 years. Churn should be a small number. But your margin for error is tight.
Engagement is the great unknown
The biggest gap I see in current SaaS thinking is engagement. Measuring the economics of engagement is hard. We have a crude measure for pre sales engagement. Conversion of leads into paying customers. We have another simple number for post sales engagement. Churn. The process between is more of an art than a science. Finding which steps in the process reduce conversion rates would generate immediate value. Fine tuning service and support to reduce churn will pay long term dividends. Concentrate on measuring behaviour first. If you can attach a numerical value great. Build the model specific to your business from the ground up.
I am leading a workshop for a bunch of Scottish SaaS companies in early March. We will focus on one aspect of engagement. Looking forward to learning some best practice then.
Benchmarks - handle with care
Smart analysis of SaaS performance has led to some well constructed benchmarks. For example Annual Contract Value (ACV) to marketing cost ratio should be around 2:1. This shows a healthy level of NBS. Or Brad Feld's recent suggestion the rule of 40%. The sum of your net margin and your growth rate should be at least 40%. There are many other examples. All are rules of thumb suggested by experienced investors and entrepreneurs. Such benchmarks are due respect. But handle with care. General rules like this are a good indicator of progress but a bad way of setting goals. Think of benchmarks like a thermometer. They give a rough guide to general health. They are not a management tool. You would stay sick for a long time if doctors just focused on reducing your temperature.
I encourage you to read and follow some of the blogs suggested in this post. If you would like help building a SaaS model for your business, get in touch.
Kenny Fraser is the Director of Sunstone Communication and a personal investor in startups.