How Do SaaS companies make money?

I’ve been spending quite a lot of time trying to work out the right model for my currently employer to make money out of SaaS. This hasn’t been an easy task, and i don’t think the answers going to be good, but what it has exposed me too is some really interesting analysis work done on the SaaS market in general.  Things like the announcement of the NetSuite IPO , and this post by Rod Drury on Software RnD really got me thinking.  How do SaaS companies make any profit?

 
This post points to some of the more alarming things about SaaS companies. This one is relates to Netsuite

 

the provider of on-demand enterprise-resource planning software reports solid revenue growth: from $17.7 million in 2004, to $36.4 million in 2005, and then $67.2 million last year. But up until last year, sales and marketing costs always exceeded revenue: $27 million in 2004, and $39.2 million in 2005. Last year, sales and marketing costs were $43.9 million, or 53% of revenue.”

 

The Sales and marketing costs exceeded revenue.  What about the RnD, infrastructure, support maintenance, datacentre etc etc…

 
According to this by McKinsey this is a little out of wack but you can see why i think there's an issue.

 {mosimage}

Clearly traditional software companies with incumbency are the cash cows. They’ve cut their code (the RnD mountain) and are leveraging their digital asset for all its worth.  From now on in its BAU enhancements, marginal based pricing (every unit sold only increases the cost of sales by the price of a CD) and stay abreast of what is going on in the market.

BUT the other thing i found interesting here is the parallels between the smaller software companies and SaaS companies (none of which are greater than $1.2b in revenue to the best of my knowledge). 

EBITDA  is quite frankly alarming. From this small percentage shareholders get a return. Hardly appealing. It’s worth noting that because of the licensing model (consumption) you can’t force the client to upgrade and pay more fees either. This EBITDA number is critical because also the money that companies use to reinvest in their product, infrastructure and delivery to help themselves grow.

The Marketing and sales spend is staggering. It makes sense that these companies are massively customer acquisition driven but the return is what?  Surely some clever guerrilla marketing or channel model could help out here? Given that each seat only pays a small about pa or per month you don’t see the massive revenue hikes year on year going head to head with traditional software companies isn’t ideal.

But users are very sticky (at present, but history would indicate that this will change. Imagine if you could export your CRM data (just like you do your feed reader file) and import it into the competition). But if you are a pure play vendor like Salesforce.com, your ability to cross and upsell to increase the ARPU is limited? Netsuite might be slightly different due to the breadth of their portfolio.

 The RnD line did surprise me. To me SaaS software is in constant beta, always being enhanced, optimised and revised in real time. Perhaps like all companies, RnD happens at the genesis of the company. The one cracking good idea and everything else is just evolution?

 The COGS line says to me scale problem. In comparison to large companies they haven’t achieved it.  It poses and interesting problem, one that Rod Drury has again mentioned. How do Kiwi organisations go global (or with my interpretation get Scale)?  It’s my view that the NZ market is too small in its own right to provide true scale benefits to a service provider, including SaaS. 

Xero seems to be targeting right from the get go at being a global enterprise. I think that’s important. But will that be enough? Can the loop of small EBITDA, incremental revenue (per user pricing) and borrowing (VC or IPO) continue on?

I’d be really interested to hear about others thoughts on this as it seems to me that if SaaS companies cannot solve this then the market as a whole is in question.

Leave a Reply