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The unprofitable SaaS business model trap Shutterstock July 24, 2013 7:51 AM Jason Cohen Jason Cohen is the founder of WP Engine & Smart Bear Software. M arketo filed for IPO with impressive 80 percent year-over-year growth in 2012, with almost $60m in revenue. Except, they lost $35m. WTF? Jason Cohen It's not impressive when you spend $1.60 for every $1.00 of revenue, force-feeding sales pipelines with an unprofitable product. Don't tell me this is normal for growing enterprise S aaS companies. I know the argument: The pay -back period on sales, marketing, and up -start costs is long, but there's a profitable result at the end of the tunnel. Just wait! Bullshit. Eloqua was also a SaaS company, also selling to enterprise, selling the same product in exactly the same space, als o tightly integrated with Salesforce.com, and IPO'ed with a $5m loss on $71m in revenue a 7 percent loss instead of M arketo's massive 60 percent loss. So no, this upside-down business model isn't what a SaaS business should construct. I wish the modern startup community would understand the mindset that gets a company to this point, and resist it. The mindset works like this: 1. It costs a lot of money to land an enterprise customer. M arketing, sales, legal, account management, on-boarding, technical guidance, training. And: how many times do you run through that process and still lose the customer? So these costs are amortized over the customers you do land. 2. SaaS companies earn their revenue over time. Whereas a normal software company might charge $100,000 for an Enterprise deal, and thus immediately earn back those \"customer startup\" costs plus profit, the same SaaS deal might be $5000/mo, and it might take 18 months to get that same amount of revenue. The good news is, after that 18 months, the SaaS company still charges $5000/mo. The other company has to bust ass for measly 20 percent/year maintenance fees. 3. As a result, enterprise-facing SaaS companies are unprofitable for the first 12-24 months of a given customer's life. 4. But, a growing SaaS company will be landing new customers, and in increasing numbers, which means piling up more and more unprofitable operations. 5. So much so, that even when an older customer individually crosses into profitability, there are so many more unprofitable customers, the company remains permanently unprofitable so long as it maintains healthy growth. 6. Plus, there's all the other costs R&D to build the stuff, office space, executive salaries, billing, legal, finance, HR, tech support, account managers. To actually be profitable, you need to cover those costs too. So it takes even longer to be bottom-lineprofitable. 7. Therefore, it is healthy and reasonable for S aaS companies to be unprofitable as long as they're growing even a little bit. Early in a company's life, this line of reasoning is correct. But at M arketo's size, this argument falls apart. Why, exactly? There's a tacit assumption that if only we just stopped spending to grow, we'd be profitable. Thus, this \"really is\" a profitable company, and the only reason it's not is growth, which means market domination, which is a Good Thing. The fallacy is: That time never comes. No company stops trying to grow! The mythical time when growth rates are small so the company reaps the rewards of having a huge stable of profitable customers never arrives. When do you \"show me the money?\" It's worse. Growth becomes harder and harder for SaaS companies because of cancellations. Even with a great retention rate (e.g. 75 percent/year), you have to replace 25 percent of your revenue with new which means unprofitable - customers just to break even in top-line revenue! M ore losses, more unprofitability. Even with very broad numbers, you can see how this model doesn't work. Here's typical numbers for an enterprise SaaS company at scale: 1.5 year pay-back period. (i.e. time to earn back the revenue to cover all your customer acquisition expenses) 75% annual retention. (Which also means you turn over the entire customer base every 4 years. On average of course some stay longer, many shorter.) 30% cost to serve the customer. (Can also be stated at 70% Gross Profit M argin, meaning for every $1.00 of revenue, $0.30 disappears in direct costs to service that customer, like servers, licenses, tech support, and account management. M any public SaaS companies, even the titans like Salesforce.com, are about 70% GPM .) 15% revenue == cost for R&D department. 15% revenue == cost for Admin department. (office space, finance, HR, execs) Say the average customer represents R dollars in annual revenue. That's: $4R of revenue over the lifetime of the customer. But: $1.5R is spent to acquire the customer (the pay -back period). $1.2R is spent in gross margin to service the customer (4 years times 30% cost). $0.6R spent on R&D (15% over 4 years). $0.6R spent on Admin (15% over 4 years). So out of the original $4R, we're left with $0.1R in profit. That's 1/40th of the revenue making its way to actual bottom-line profitability, and even that takes 4 years to achieve. And that is without any growth at all. But you need to grow enough to keep up with cancellations at minimum, so that consumes the last notion of profitability