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SaaS Application Vendors Will Need Substantial Early Investment to Be Successful

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Wednesday, December 3, 2008

SaaS Application Vendors Will Need Substantial Early Investment to Be Successful

During my weekly investigation of what's going on in the SaaS market, I came across an interesting article titled "When to Spend Cash in a SaaS Business" posted by Phil Wainewright on the ZDNet Sofware as Services Blog.

Mr. Wainewright's article is based on a speech given by Josh James, the CEO and co-founder of enterprise web analytics provider Omniture where he revealed to an enthralled crowd at the SIIA On Demand conference the magic formula that helped his company sustain rocketing growth, dwarf its competitors and become the second-largest listed pureplay SaaS provider in the US, with 5,000 customers and annualized revenues approaching $320 million.

Having built and run several SaaS based software companies, the economics are not surprising.  However, it prompted me to remember that although the investments required by the SaaS ventures are substantial, the associated savings by clients that are using SaaS technology is identically substantial.  And therefore, in the current economic climate, SaaS solutions make even more sense for any organizations, in eDiscovery or in the general business market, that no longer have the budgets to invest in new IT infrastructure and at the same time are having to cut back on IT staff.   SaaS is basically the right solution at absolutely the right time.

The full text of Mr. Wainewright's post are as follows:

Josh James, CEO and co-founder of enterprise web analytics provider Omniture, revealed to an enthralled crowd at the SIIA On Demand conference this week the magic formula that helped his company sustain rocketing growth, dwarf its competitors and become the second-largest listed pureplay SaaS provider in the US, with 5,000 customers and annualized revenues approaching $320 million.

Josh James, CEO and co-founder of OmnitureThe key to understanding the formula is to recognize that SaaS companies bleed cash with every new customer they acquire — the complete opposite of what happens when a conventional software company lands a new account and pockets a huge upfront license fee. Especially if, like Omniture, the application requires significant infrastructure investment but the subscription is billed monthly.

“Every time we add an incremental customer, it costs us more money that quarter — it costs us more cash that quarter,” explained James. “When you multiply that by 250 customers in a quarter, that’s a lot of expense for no money.”

Some statistics illuminate the scale of Omniture’s infrastructure: it operates 15,000 servers for its 5,000 customers, and processes almost a trillion transactions per quarter — that’s a hundred times more than’s proudly touted 10 billion. The average transaction rate is 125,000 per second, with spikes up to twice that amount. Those are truly petascale numbers (to use a word I learnt just last week) and every new customer means adding more capacity.

The financial consequences look exceptionally dire when expressed according to the generally accepted accounting principles (GAAP) that the SEC mandates for public company financials. GAAP forces the cost to be expensed upfront but has no way of recognizing that each Omniture customer generally starts returning a profit by the end of the year, and much sooner in the case of smaller customers.

As James explained: “When we were really stepping on the gas in 2004, 2005, we were GAAP unprofitable.” In 2005, he said, Omniture’s negative free cash flow was in excess of $22 million — more than its total annual revenue — and it had spiked higher at some points. “It is a scary moment,” he said — even when management understands the game plan and has the full support of its financial backers, it takes courage to plow ahead regardless. “It is really important to trust the math. The investors were saying, slam on the gas, but you have that gut-check moment there.”

Omniture was relying on a simple calculation that produces a ‘magic number’ telling you when you should hire more sales reps to fuel your growth as a SaaS business. The formula takes the incremental growth in the current quarter, multiplies by four to annualize it, and then divides it by the amount spent on sales and marketing in the prior quarter.

So, for example, let’s say your company increases sales this quarter by $750k over last quarter. That’s $3 million annualized. If you spent less than $4 million last quarter on sales and marketing. then you spent too little. $3 million is OK — a magic number of 1 is “pretty good,” said James. But ideally you should squeeze that ratio down to .75, even as far as .5 — “Go hire some more reps,” Be warned, though, if it falls lower or goes negative — in this example, let’s say you spent the $4 million but it produced less than $500k in extra sales (or worse, your sales went backwards), then you have a problem that needs fixing.

“Any time the magic number’s .75 or more, you should invest in more sales people,” said James. “Less than .5, there’s probably something wrong with your business.”

The model works so long as the following three factors are in place:

- Your customers will be profitable over time: “Once you know for sure that each customer you have is eventually going to pay off, that’s when you slam on the gas,” said James.
- Your retention rate is strong — 95 percent or better — and stays that way.
- The market isn’t saturated (which I guess is unlikely for anyone in the SaaS business for a while yet).

“If investors see a company that’s growing at a healthy rate with a great magic number, it’s a money machine. There’s no doubt,” said James. “If you’ve got more feet on the street you’re not leaving opportunity out there for other people to take … If you can get that number down really fast, then you’re really making hay out there.”

James displayed a chart showing magic number calculations for several public SaaS companies and praised and SuccessFactors for both adopting a similarly aggressive growth strategy. He acknowledged, though, the difficulties of persuading investors to stand by such a strategy in the current economic climate. SaaS entrepreneurs are going to have to pay close attention to their customer profitability and retention rates so that they can demonstrate to investors the merits of funding their upfront cash needs. By the way, although James didn’t explicitly call this out, his formula also underlines the advantages of working with pay-as-you-go infrastructure providers, because that’s a way of spreading the cash requirement instead of having to fund it all out of your own balance sheet.

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