Good SaaS Bad SaaS
Its greatest potential is also what makes it so dangerous — and hard for the markets to measure
The events of the last few weeks have made clear that there is a ton of investor uncertainty around the valuation of SaaS companies. Just look at what’s happened to two of the biggest marquis names of subscription software over the last 3 months: Salesforce (CRM) in red, and Marketo (MKTO) in blue:
A mere three months ago, on a relative basis, the markets started valuing Marketo higher than Salesforce. Then — BAM! — a few weeks later Salesforce looks a lot better, and has weathered the recent tech storm incredibly well. Has that much really changed at a fundamental level about these 2 companies in such a short period of time?
The exact reasons for the difference are obviously complex, and the purpose of this short article is not to do a rigorous comparison between the two companies. However, the volatility serves as an example that highlights a fundamental fact of SaaS that average investors are just starting to get their arms around: SaaS liberates customers from the shackles of bad software that they were previously locked into (sometimes for decades), and allows them to make freer choices about where they spend their money. This presents incredible opportunity for the companies that are able to build fanatical customer followings, but puts second- and third-tier companies at much greater risk than in the perpetual license era.
This Revenue Was Made for Walkin’
Let me illustrate. Imagine that you were a salesperson for Mediocre Systems (a fictional but yet all-too-real enterprise software company) in 1995. You sold your customer a state-of-the-art ERP system for $400K with $100K of implementation services on top. 12 months later, your customer had just barely gone live with your product, so they optimistically ponied up their 20% maintenance fee ($80K) for year 2. Going into year 3, they realized they’d made a mistake — there was a newer, better product on the block. But with $580K already invested, and a cost of maintaining their Mediocre investment being only $80K for the next 12 months versus dropping another $500K to switch horses, you had them! They weren’t going anywhere! By year 7, they were finally able to make an ROI-based argument to switch to a better product, but by that time, you’d already collected almost $1M in cold hard cash And what’s more, your risk was very low. Sure, it’s possible they could have fled earlier (or stuck around a bit longer), but the standard deviation on that $1M in revenue was only around $240K (by my rough calculations).
Now, it’s 2015, 20 years later. You’re at Crushlytics, a next-gen SaaS company with an unbelievably great product. Your annual subscription fee is $200K, but you’re expecting an average customer lifetime of 5 years — fairly conservative by some SaaS benchmarks. So that puts your expected lifetime value at $1M. Just like 1995. But wait, it’s not 1995 anymore — it’s the brave new world of SaaS. If you can retain your customer an additional 5 years, you’ll pocket an additional $1M for a total of $2M — almost double what you would have received from the customer over the same time period in the perpetual world. But make your customer unhappy or let your product atrophy, and they could be gone after 12 months.
SaaS is uncertain because lifetime customer value is incredibly dependent on customer satisfaction and the value you’re able to deliver to your buyer. Hit it out of the park, and the rewards are immense. Screw it up, and you will be severely penalized.
For SaaS company builders, this just means the obvious: build an incredible product, inspire tremendous customer loyalty, and then work your tail off to do whatever it takes to keep building on that initial success. Building long-term customer relationships is the single biggest thing that you can do to multiply your company’s ultimate financial outcome. You’re building a snowball.
For investors, whether in the public or private markets, your task is not easy. You need to look “under the hood” far more carefully than in the past. If you can identify truly differentiated products with amazing customer enthusiasm and retention within a given segment of the market, you’ll reap huge rewards.
For everyone, one thing is certain in SaaS: the ultimate winners will absolutely crush the returns of the losers by a wide, wide margin.
