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Investors have rewarded the entire SaaS industry to pursue growth over profitability for a long time. But TSIA believes those days are waning.
As we enter 2023, the SaaS (software-as-a-service) business model has been with us for over twenty years. Traditional software companies like Adobe, Autodesk, and Microsoft have pivoted to SaaS. But just as everyone is jumping on the SaaS bandwagon, current economic conditions are forcing high-growth (but unprofitable) SaaS startups to tighten their financial belts.
In September of 2022, Salesforce, the poster child for growth over profitability, committed to improving their operating margin by five percentage points—which is massive.1 But keep in mind, this is a company with roughly $30 billion in annual revenues that still struggles to post a positive net operating income.2 Salesforce, just like many other SaaS companies, will be operating in the new normal.
Unfortunately, there is no sign that these three realities will be changing in the coming year. In addition, a significant recession may be a fourth factor that comes into play in 2023. The cost of employees and infrastructure is increasing. Borrowing money to cover costs is becoming more expensive—and you can’t leverage a soaring company valuation.
In this new normal, SaaS companies will have to focus on improving free cash flow and overall profitability.
For over a decade, TSIA has been studying the difference between profitable and unprofitable SaaS business models. There are three main factors that are inhibiting the ability for a majority of SaaS companies to become profitable:
Before we analyze the economic engines of unprofitable SaaS companies, we need to review how enterprise software companies have historically been so profitable. In the world of on-premise, licensed software, there are three critical revenue streams:
The revenue mix for these two profiles is shown in Figure 1.
These two profiles, when well executed, have proven to be highly profitable. Well-managed, publicly-traded, license-based software companies have generated anywhere from 12% to 47% in net operating revenue.
Now, let's turn to the economic engine of SaaS companies and answer the question…
To date, a majority of SaaS providers have gravitated to one economic engine that is dominated by subscription revenues.
SaaS companies will often only have 5% to 10% of revenues coming from any type of additional services. These services are a blend of project and annuity offerings. However, it is very common for SaaS companies to run these services at a financial loss. The revenue mix of a typical SaaS provider is shown in Figure 2.
Overall, this economic engine has not proven to be very profitable.
Publicly-traded SaaS companies tracked in the TSIA Cloud 40 Index are currently generating an average of -10.6% operating income.
Figure 3 provides evidence of how consistently poor the average operating income has been for these companies.
Now, the argument is often made that these SaaS companies are relatively small. When they put on weight, they will become highly profitable like traditional software companies. Sadly, that is not the case. Figure 4 compares SaaS companies with revenues over $500 million to the performance of traditional software companies in the same quarter.
Again, infrastructure costs are not going away. But the practice of simply eating all of the costs of technical support, professional services, and customer success are contributing to lower operating margins and high sales and marketing expenses as documented in Figure 5 below.
As shown, SaaS companies spend the largest portion of their revenue on sales and marketing expenses—twice as much as they do on research and development (R&D). Historically, this was never viewed as problematic because that high investment in demand generation was justified by high growth rates. This thinking is what gave birth to the infamous “Rule of 40.”
The Rule of 40 is designed to reward growth. The rule permits management teams to sacrifice profitability for growth—within reason. According to this rule, a business' combined growth rate and operating margin should be over 40%.
Rule of 40: Annual Growth Rate + Operating Margin >= 40%
However, companies in the TSIA Cloud 40 are spending, on average, 39% of revenue on sales and marketing to grow at 24% and achieve a -13% operating income. In other words, on average, they are “Rule of 11” companies, which is nowhere near the objectives of the Rule of 40.
Companies that spend a high percentage of revenue on sales and marketing but are not growing at a rate to justify that high spend will not be Rule of 40 companies.
One way to assess the efficacy of sales and marketing efforts is to measure customer acquisition costs (CAC). CAC is the cost related to acquiring a new customer.
In other words, CAC refers to the resources and costs incurred to acquire an additional customer. Customer acquisition cost is a key business metric—unfortunately, TSIA knows it is a minority practice for companies to accurately track and trend CAC. But, we can use a simple proxy for CAC which TSIA is defining as revenue acquisition costs (RAC):
In Q3 2022, The average RAC number for companies in the Cloud 40 Index was 2.19. This means that for every 1% of topline growth, these companies spent 2.19% of total revenue.
TSIA would assert that companies paying more for growth than their technology industry peers are inefficient compared to their peers. The lower RAC number a company achieves, the more efficiently the company is growing revenues. Two levers can reduce RAC:
Every quarter, TSIA captures the RAC rating for companies in the T&S 50 and the TSIA Cloud 40. Companies can use this rating to assess how efficiently they are generating revenue compared to relevant industry peers. Figure 6 provides a snapshot of RAC pacesetters for Q3 2022.
Based on the analysis so far, it is clear that unprofitable SaaS companies are facing a dilemma. They are carrying costs for infrastructure and service motions that highly profitable legacy software companies never had to bear. And, the cost of acquiring revenue growth is proving very high.
The intuition of management teams will be to cut costs to achieve improved probability. For SaaS companies that have been enjoying cheap funding and free-flowing spending, there is clearly an opportunity to tighten their belts. However, TSIA does not believe cutting spending in the current SaaS business model will rightsize profitability. Here is why.
Again, the largest expense category for SaaS providers is sales and marketing. So let's start there. The largest expense within sales and marketing are sales reps. Since the growth of most SaaS companies is heavily dependent on direct sales motions, executive teams are highly reluctant to cut here.
So, what else is in this bucket? Perhaps some of the customer success motions are funded here. These CSMs may not be carrying any direct revenue responsibilities, so this seems like a good place to start cutting. But CSMs are there to drive adoption which leads to the expansion and renewal of contracts. The highest margin revenue for any SaaS provider comes from existing customers. Putting that revenue in jeopardy is risky.
The second largest cost category is subscription COGS. The majority of this expense is for the infrastructure required to support the offer. You can look for inefficiencies here but it is unlikely you can make meaningful cuts. The remaining expense is for technical support motions that are included with the subscription.
It will be VERY tempting to reduce funding for support, but this carries the same risk as cutting customer success function. Customers that cannot technically access the solution surely are not adopting and eventually will not renew.
Are there expenses that SaaS companies can trim? Absolutely.
But to become profitable, on average, SaaS companies need to find 11 points of cost savings! You don’t take that number down by trimming across the board and then handicapping key capabilities.
The good news is that TSIA has a perspective on how SaaS companies can escape this profitability conundrum. To be part of this ongoing conversation, join the TSIA community—become a member today.
1 Dan Gallagher, "Salesforce Not Slacking on Margin Focus," Wall Street Journal, Sept. 2022.
2 Salesforce, Inc. (2022). Form 10-Q. U.S. Securities and Exchange Commission.
Want to assess your efficiency and profitability? In this report, learn more about the Rule of 40 and RAC.
Want help navigating the growth versus profitability conundrum? TSIA helps you achieve profitable growth at a fraction of traditional consulting costs. Contact us to learn more.
November 17, 2022
Thomas Lah is
executive director and executive vice president of TSIA. Since 1996, he has used his incisive analysis, strategic thinking,
and creative solutions to help some of the world’s largest technology companies improve the
efficiency of their daily operations. He has authored several books, including, Bridging the Services Chasm (2009), Consumption Economics (2011), B4B
(2013), and Technology-as-a-Service Playbook: How to Grow a Profitable Subscription
Business (2016), and
Digital Hesitation: Why B2B Companies Aren’t Reaching Their Full Digital Potential (2022).
He is also the host of TSIA’s podcast, TECHtonic: Trends in Technology and Services.
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