Spend, spend, spend for SaaS success

I've long suspected that leading SaaS vendors were doing the right thing by plowing money into sales and marketing rather than reporting net profits at this stage in their growth cycle. As I wrote in February, commenting on Salesforce.com's financials:

"Cutting back now would be like a star forward taking his hockey stick and snapping it two instead of running forward to score the decisive goal in a big match."

A couple of blog postings last week have contributed some valuable financial analysis to back up my contention. First of all, fellow Enterprise Irregulars blogger Charles Zedlewski posted an insightful analysis of financials from the recent crop of SaaS IPO filings.

Zedlewski begins by highlighting the disparity between the supposed lower cost of selling software via the Web — often described as the 'pull model' of selling — and the "ton of money ... (between 65% and 100% of revenues)" spent by NetSuite, SuccessFactors and Constant Contact on sales and marketing. He links to a Sandhill.com article that begins with a 1998 quote from SAP's then CEO Hasso Plattner:

"Why do software companies need a sales force? If customers just looked things up on the Web and talked to some of our people over the phone, they would figure out that we had what they needed and that would be that."

Ah, how typically naive of a software CEO to believe that, if only customers had perfect information about his product, then of course they would buy without hesitation. The real world is more textured than that, and the more complex the software, the more difficult (and push-oriented) the sell becomes — as many SaaS vendors are discovering as they journey up-market.

Zedlewski goes on to discount the argument recently advanced in an article by McKinsey consultants that it's all down to scale — that SaaS companies have higher costs simply because they are not big enough yet. Not true, says Zedlewski:

"The true factor driving SG&A for these SaaS companies is growth, not scale. SG&A spent in the prior year (cost to acquire customers) correlates very well to growth in the subsequent year (returns from customers acquired). So, as long as you believe there's growth left in your market, keep spending to capture that growth."

Here's how Zedlewski arrived at his magic formula (perhaps we should call it the 'Zed' ratio, someone suggested):

"I created a simple ratio I called 'growth efficiency'. This ratio is growth rate in a given year divided by the SG&A % from the prior year. Essentially this evaluates how much growth is generated by a point of margin spent on SG&A in the prior year."

The ratios provide a lot of food for thought. Here's what Zedlewski has calculated for several leading players and IPO prospects:

"Salesforce had reached a fairly stable equilibrium where a point of margin spent on SG&A returns a point of growth the following year. However this has been deteriorating over the past 2 years. If the high end of Salesforce’s 2008 guidance holds, they will be down to a .69 ratio ...

"Successfactors’ ratio is all over the map due to their experimentation, but in 2005/2006 a point of margin spent on SG&A returned a point of growth ...

"Netsuite has been a consistently less efficient business. A point of margin spent on SG&A currently returns only 2/3 of a point of growth the following year ...

"Constant Contact has the best business of the four. A point of margin spent on SG&A gets you 1.4 points of growth. This with a product whose average selling price is just $34/month ..."

Zedlewski concludes that, "The pull model is as elusive as ever, but Constant Contact seems to give us a few hints as to how it's supposed to work." Certainly, it makes sense that a product with a lower price point and a simpler return on investment should be easier to sell. But perhaps also this tells us that scale counts, too. It implies that products that lend themselves to more of a pull model reach scale more quickly, whereas products that need more push to gain traction require more scale before they produce returns.

Certainly that's the conclusion suggested by another blogger's analysis. Bob Warfield has pulled together data on several listed SaaS companies and put the results in a graph:

"Let's start out with a look at public SaaS companies and what it costs them to acquire $1 of revenue ... The curve fits pretty nicely, and we can see that there is a pronounced knee. Somewhere in the $20-$50M range, these companies reach critical mass and they start acquiring revenue more cheaply than Sales and Marketing Costs."

Unfortunately, Warfield's data isn't as transparent as Zedlewski. He goes on to compare his selected SaaS companies against a number of unnamed conventional software companies and comes to the conclusion that, "it costs those companies more to acquire revenue than it costs a SaaS company." Without seeing the data, it's not possible to validate that conclusion, but Warfield draws a similar conclusion about why SaaS companies aren't reporting profits to the one implied by Zedlewski's analysis:

"One could throttle Sales and Marketing back to a more profitable stance based on the analysis above, but why do it if you can log growth over 50% or so a year? Growth in the software world is ephemeral but on the flipside software companies seem to shrink very slowly. The moral is to strike while the iron is hot and lock in as much growth as possible."