SaaS Economics – Part 2: Scaling the Business

This is the second part of a 2 part series that discusses the cash flow trough that  happens to SaaS, or other subscription/recurring revenue businesses when they decide to scale their business by ramping sales and marketing. These kinds of SaaS businesses face a cash flow problem in the early days, because they have to invest up front in sales and marketing expenses to acquire customers, and only get payments from those customers over a delayed period of time.

The first part of the series can be found here: SaaS Econonics – Part 1:  The SaaS Cash Flow Trough.

The greatest value from this post will come from downloading the model and inputting your own variables. The Excel Spreadsheet and associated PowerPoint file can be downloaded by clicking here. If you store both in the same directory, the PowerPoint graphs can be updated to reflect the data in the spreadsheet by right clicking on each graph, and selecting “Edit data”.

Where is this applicable

  • This model is applicable to any recurring revenue business that uses a sales force.
  • This model does NOT apply to SaaS businesses that don’t use a sales force. I refer to those businesses as having a “touchless conversion”, as there is no sales touch involved. Those businesses usually have a far lower investment in sales and marketing expenses, and become cash flow positive far earlier.

Scaling the Business

From my previous blog post Setting the Startup Accelerator Pedal, you will know that I advocate investing aggressively when you have found a repeatable, scalable sales model.

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The model attached to this blog post will help SaaS entrepreneurs understand the cash flow implications of investing heavily in sales and marketing to ramp growth.

Ramping Sales Hiring

In the first part of this series, we looked at the cash flow implications of hiring a single new sales person. Now lets take a look at what happens when we start hiring 2 new sales people every month:

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The model shows that the worst loss is $190k per month, and that the first profit comes after 21 months.

If we look at the cumulative losses, we see the following picture:

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This tells us that the size of the SaaS cash flow trough is $2.6m, and that the worst cash flow negative point will occur in month 21. The graph also tells us that it will take 32 months to get back the total investment. This is probably the key graph in the entire model.

It is also useful to look at how MRR (Monthly Recurring Revenue) grows in the situation where we are hiring two salespeople every month:

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The graph on the left shows that MRR will have grown to about $1.3m in 24 months. (From the spreadsheet: $2.7m in 36 months).

The graph on the right is a very important metric for a SaaS company to track. This shows how much MRR grew every month. It is effectively the new bookings that happened in that month minus the churn. If you run a SaaS company, this graph will tell you if you are continuing to grow bookings. Since we are continuously adding new sales people and increasing the lead flow, it is not surprising that this graph continues to rise month after month.

What happens if we don’t keep hiring new sales people?

This does raise the question of what would happen if we didn’t invest aggressively and hire any more sales people:

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Here we can see from the left hand chart that MRR does still grow. But the right hand chart tells the important story: the rate at which MRR increases every month starts falling due to churn.

Comparison: hiring one versus two sales people per month

The next question you might want to ask is what happens if we hire only one sales person every month instead of two:

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Not surprisingly, MRR and Growth in MRR are exactly half what they were with two new sales hires per month. Lets now look at the impact this has on the SaaS cash flow trough:

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The left hand chart shows that it takes the same amount of time to breakeven.  Not surprisingly, the right hand chart shows that the size of the cash flow trough is halved, and the profit is halved.  The model is constructed in such a way that you can play with the hiring rate in the second tab. For example, you could change the hiring rate in the second tab from 1 sales person a month, ramping to 2 sales people per month at any time, and then use the graphs on this second tab to compare them to the original hiring rate of two people.

What are the blockers to faster growth?

Now that we have seen the terrific payback from investing in sales and marketing, you might be asking the question: what prevents me from growing even faster?

From what I have seen, the most common problem that determines the limit to how fast you can grow is the rate at which you can grow lead flow. A common phenomenon in marketing is that various different lead sources reach a limit point (see the diagram below).

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This requires that the marketing department be constantly looking for their next source of leads. A great VP of Marketing will be ahead of this problem, and working to create scalable solutions. However even the best VP of Marketing won’t be able to grow faster than a certain rate.

What this tells us is that we need to start by analyzing the rate at which we think we can grow leads, and then set the sales hiring rate appropriately.

Why is it so important to grow as fast as possible?

In my previous blog post series, Setting the Startup Accelerator Pedal, I addressed this question. To avoid requiring you to navigate away from this page, I have copied that segment below:

“Why is it so important to be that aggressive at this time? Basically, you need to grab as much market share as you possibly can before a competitor enters your space. There’s a clear tipping point when you’re suddenly recognized as the market leader. At that point, you can shut out your competition. In every tech market, the market leader enjoys an unfair advantage. The press, analysts and blogosphere pay far more attention to the market leader, and the early and late majority customers prefer to buy from the market leader. It becomes a powerful, self-reinforcing phenomenon, and the faster you can get there, the better.”

It is important to note that that same blog post emphasizes the importance being sure you have a repeatable, scalable sales model before hitting the accelerator pedal. I also note that if you can show that your model is truly repeatable and scalable, you will have no trouble raising the money.

What’s the worst than can happen?

Since you are likely to feel nervous about making such an aggressive move, it makes sense to ask what is the worst that can happen? I believe that the worst that can happen if you get this wrong is that you will discover that your model is not scaling as hoped. If this happens, you can simply stop hiring sales people, and let the business catch up. So you might have two more sales people hired than perfect. But within a month or two it is likely that the business will have caught up, so the size of the error is not that bad.

What happens if we collect a year’s payment in advance?

Perhaps one of the most important discoveries that you can make from reading this blog post is what happens if you are able to get your customers to pay you a year in advance. Let’s start by looking at how this impacts the cash flow for a single sales person:

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The impact of this cannot be understated:

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Let’s look at the impact on the entire company, when ramping sales hires at two new sales people per month:

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The lesson to be learned from this is pretty simple: look for ways to get your customer’s to pay in advance, including offering substantial discounts. Doing this can avoid the need for additional financing.

Two other key variables: Monthly Quota and Gross Margin%

Since I wanted to use the model to explore all the various variables that would impact the economics of your business, I thought I should mention that there are two other key variables:

  • Quota for salespeople
  • Gross margin %

Changing either of those variables will have a marked effect on the model. I recommend playing with these to see what I mean. Sales quota can be increased by focusing effort on things like good sales management and training. Gross margin % can be affected by looking at your on-boarding costs, and the cost to serve each customer.

What happens if we can lower Churn?

I also thought it would be interesting to take a look at the impact of lowering churn. In the SaaS world, if you halve your churn rate, you will double your customer lifetime and hence also double LTV (Life Time Value of the customer). So it is an extremely important area to focus attention.

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Not surprisingly, if we halve the churn rate, the cumulative net profit is doubled (see the right hand graph). What is a bit more interesting is that it doesn’t make quite such a big impact on the size of the cash flow trough.  The reason for this is that the benefits from lowered churn only appear later in the customer’s lifecycle.

How you can get Negative Churn

Since churn is such a key factor, I thought you might be interested to know how to make your churn as a percentage of revenue actually negative:

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Using seat expansion, upsell, or cross sell, you can increasing the amount of revenue that you get per client. So even if you are losing some clients, you can still increase the overall revenue from the remaining clients to the point where it is greater than the lost revenue.

Conclusions

When you reach the point of having a repeatable, scalable sales model, I strongly recommend that you hit the accelerator pedal and invest aggressively. The value of this model is it allows you to predict in advance how much money you will need to finance your growth at the maximum rate your lead flow will allow. This model will allow you to show your investors and board members why increasing your losses in the short term makes great business sense, and will have a significant payback in the longer term.

The key insights that come from the model are:

  • How long does it take to get to breakeven
  • What is the total amount of investment required (i.e. how big is the bottom of the trough)
  • How long does it take to recover that investment
  • How profitable the business can be over time after coming out of the trough

Another important insight that the model shows us is the value of providing incentives to customers to get them to pay in advance. This is most valuable in the early days while there is a cash flow trough.

I am interested to hear what you learned after putting your own data into the spreadsheet. I would really appreciate it if you would be willing to share any interesting new insights in the comments below.

To read Part 1 of this series, click here.

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  • http://www.firefishsoftware.com Wmcdougall

    Brilliant posting again ! but will now need another few weeks to get my head around it all.
    Thanks for sharing David

  • http://www.cosential.com Dan Cornish

    First of all, this is the best model I have ever seen for a SaaS business. You are an Excel Jedi. You REALLY understand what goes on inside a business like this. Second, your assumptions are mostly spot on! A few things I might suggest to improve this model.

    1. Our marketing costs are not so much website related. We have to sponsor industry events, have lunch-and-learns, user conferences, utilize social media, trade magazine advertising, etc.. so a more complex model to calculate cost-per-lead would be helpful.

    2. We experience a more chunky sales funnel. A mix a large and small deals really skews the numbers. So a rep might make a ACV $80,000 deal their first month, and a few smaller deals and then nothing for a few months. This just happened to us. So I guess as long as total annual sales is around 500,000 per rep, I should not worry about how chunky the sales are except for cash flow?

    3. We are also finding our leads to be much more qualified. The trick for us is in conversion rate between opportunity stages. This might also be helpful.

    Overall it seems that the total number of leads possible is the determining factor for ability to scale. I would suggest another spreadsheet to calculate cost per lead. The key metric I see which needs to be explored more is cost-per-lead(cpl) for businesses where leads from website are a small portion. Perhaps another post about lead gen and marketing and another spreadsheet which can be linked to this one?

  • Troy Hatlevig

    David, great post. Quick note, I suspect I found a typo:

    Perhaps one of the most important discoveries that you can make from reading this blog post is what happens if you are able to get your customers to pay you a month in advance.

    I suspect you intended to write “year”.

    Again, truly excellent post.

  • http://www.forentrepreneurs.com David Skok

    Great catch! Thanks. I’ll fix as soon as I get a chance.

    Best, David

  • http://twitter.com/artpapas Art Papas

    Great post. This captures the art of tuning the SaaS growth engine really well. I wish this post had existed back in 2004, it would have saved me and my CFO a lot of headaches!

  • http://www.forentrepreneurs.com David Skok

    Dan,

    Thanks for taking the time to comment. To answer your questions:

    1. I agree that my model for calculating lead costs was over simplistic for a ton of lead sources. I showed a very simplistic SEM lead source model just to try to get people thinking about how to build their own models for this. I like your recommendation at the end of building a more sophisticated model.

    2. Agreed.

    3. I wasn’t quite sure what you were suggesting when you said ” This might also be helpful”.

    I do agree that the rate at which you can grow leads is the likely limiting factor. This is a complex topic, and one which could take up several more blog posts, if not several books! However it’s a great suggestion to spend more time on this.

    Thanks for adding your comments. It is really valuable to hear how this works or doesn’t work in specific situations. I took a look at Cosential’s web site, and was interested to see that you are in the business of selling software to help automate/manage the sales process. That makes you very well qualified to talk about this topic. I would think that your free trial is a great tool for automating much of the buyer education and qualification steps.

    Best, David

  • http://www.forentrepreneurs.com David Skok

    Art, thanks for the kind words. I hear many good things about you from Brian H, and others. I would enjoy meeting sometime. Perhaps in the early part of next year?

  • http://www.forentrepreneurs.com David Skok

    For any Boston area entrepreneurs that are interested, I will be giving a keynote at the Mass TLC SaaS event next Thursday morning, Dec 16th. I will be discussing this post and other SaaS related material.

    The event is at Constant Contact’s offices in Waltham. Register here: http://saasrevenues.eventbrite.com/

    Use the discount code Skok50.

  • http://www.cosential.com Dan Cornish

    Sorry about #3 I somehow erased my brilliant thought before I submitted. As for the free trial, it is both a positive and negative. I am trying to figure out a better way. The initial blank screen problem is important to solve. We are trying to automate the implementation process as much as possible, but for larger customers, they truly need a human touch.

    Because of our industry vertical approach, the Cosential does not need consultants to help build functionality like other horizontal SaaS platforms. This lowers the cost dramatically for our customers. We also bring industry best practices to the table so the customer does not have to re-invent the wheel. The best positive is the free trial shortens the sales cycle for large customers, and can make the decision to proceed a departmental one as opposed to an enterprise decision.

  • http://www.forentrepreneurs.com David Skok

    Dan,

  • Tiago Wright

    Thank you for the excellent post! In your experience, does negotiating for a year pre-payment increase the sales cycle? Won’t that also contribute to a cash flow trough?

  • http://www.forentrepreneurs.com David Skok

    Tiago,

    In many circumstances it is the wrong thing to do, as it can greatly slow down the sales cycle, and also damage the conversion rate. However if you are in that situation, you can entice the customer to do what you want them to do by offering discounts that some will find attractive. That way you don’t slow things down, or put off the customers that don’t want to pay upfront.

    Best, David

  • http://www.cosential.com Dan Cornish

    David,

    Your comment in reply did not post.

  • http://www.forentrepreneurs.com David Skok

    Dan,

    On your blank screen problem, I assume you are talking about the fact that when they download the trial, they don’t have any data in there yet. Have you tried populating the trial with some sample data, and providing a guided step by step tutorial, with a button to erase the trial data at the end?

    Best, David

  • Scottj Howard

    David can’t thank you enough for this insight and resources, being a less than agile power point and excel jockey has made explaining these concepts to colleagues and clients more difficult than it should be, so thanks for the accelerator.

    The earlier comment from Dan highlights great ideas for expansion and customization, for example I have spent much of my time in complex (ie long) sales cycles where sales stage conversion and length are core drivers of the BD budget and cash position of the firm. I found success in quantifying and scoring the level of client engagement (at each stage) as the metrics that create visibility to success factors.

    I am also hungry for more of your insight to the key dependency of lead quantity and quality, as I think this is the essential challenge first for the model and more importantly any business; most if not all are lead starved. Quality leads increase conversion and velocity as well as revenue & profitability (in some cases), they also lower churn, which as you illustrated change the ROI dramatically. Similar to Dan, I have worked in models that require high-touch business development through all phases of the funnel, which means hard to measure, score, and deliver smooth revenue against. Every business development organization experiences some version of this challenge, where is the solution? Waiting for a CRM team to step in with the tools…

    Sales force & process enhancement is a well documented area that has a mountain of solutions, models, and gurus. I think the market is missing the core challenge – LEADS. A sales person worth their expense account can close prospects pre-disposed to buy despite deficiency in the sales process (bad demo, off target proposals, pricing, etc). The real challenge is getting sales people prospects that are ready to enter the buying process. If the organization produces a sufficient volume of quality leads deficiencies will become glaring whether they are sales, finance, product, delivery, etc; quality prospects will expose them. I think this is what it means to be intimate with the client, the client will identify and shape the solutions to the opportunities in your model. That is of course, if they believe you have a solution to their opportunity. This is what the trusted partner selling model is all about.

    Deeply interested to hear more thinking and experience on the demand generation and lead qualification models that are experiencing success out there. Thanks, Scott Howard @HowieSj

  • http://Intronis.com Kplunkett

    One of the best explanations I have seen of the model for an emerging SaaS firm. Very close to real world models. Great job. I would contest one thing. Based on my experience at Salary.com, the cash paid up front model still creates a trough and would for most people. We do love the cash upfront model. In addition, on-cancellable multi-year deals reduced annual churn for a portion of the base and gave us the occasional opportunity to capture budget flush with multi-year prepayments. Go SaaS.

  • http://Intronis.com Kent Plunkett

    It does not typically increase the sales cycle if introduced at the end of the conversation (like the last day) after the contract has been reviewed and the purchase decision has been made. Present it as an “additional value” option and many clients will grab at the discount.

  • http://www.forentrepreneurs.com David Skok

    Kent, thanks for your comments. Best of luck with your new venture.

    Best, David

  • Ken Hedberg

    Very helpful models with key learning points for SaaS entrepreneurs. However, this understates the cash flow problems of growth, in two important ways.

    First, what are the costs of getting new customers up and running, and keeping them happy? The model has an assumption of 80% gross margin, and of course that can be modified. But, the ongoing customer support may (likely) not be included in the cost of production. These costs can make the cash flow breakeven stretch out much farther with a deeper trough.

    Second, the model doesn’t include working capital requirements of growth. First, how much non-sales effort must go into a new customer before the first invoicing event (demo’s, webinars, implementation efforts, etc.)? Second, after invoicing, how long will the customer take to pay their bill? Once again, working capital requirements will assuredly create a deeper trough and longer cash breakeven period.

  • http://twitter.com/chasedave Dave Chase

    Before diving back into a startup as head of Sales & Marketing, my consulting firm worked with ~30-40 SaaS businesses. Your 2-part series is excellent, however there’s one thing that I find is often a mystery for startup CXOs — how to set quota. We use a multiplier of On-target-earning. E.g., if one has an on-target-earning target of $100k (base + commission) and their annual quota is $600k, that would be a “6x OTE”. Naturally, the earlier in the maturity of the company/product/category, the lower it will be. Generally 6x would be typical of a moderately mature product/category though we think virtually all SaaS businesses should shoot for 8x OTE and that we saw some at 12x OTE when they nailed the lead gen and sales process. My last situation was typical of what we saw. They had a quota of 6x OTE but were actually at 4x in terms of performance. With an improved sales process, they achieved just under 8x in Q4 after 6 months of improvement.

  • http://www.forentrepreneurs.com David Skok

    Dave, Interesting data. The 8x OTE is a great target to aim for. The SaaS businesses that I work with have not reached that level. They are more in the 5x to 6x level. However given the economics of the SaaS model, those are still great businesses.

    Thanks for adding this. If any other readers have data on this topic, it would be great to hear their numbers.

  • Richard Green

    I started out in the media industry as part of the launch team for eBay UK and my first interaction with a SaaS product was 12 months later in the form of an auction and inventory Management system. eBays confidence steered them clear of partnerships but it was obvious that strategically as part of eBay UK’s rapid product growth we could introduce software to sellers in the form of a unofficial partnership with AuctionWorks, renamed to Marketworks and finally sold to Channel Advisor.

    Ten years later and I find myself 7 months in with a young SaaS company working my applied sales director skills to this industry from the inside out. As we have proven product success from a small but motivated sales team the current topics discussed in Part 1 and Part 2 are perfect at our stage of growth.

    I particularly liked the statement ‘lead growth defines sales hiring rate’, as we have been debating both lead generation and sales hires… I like the idea that business success could be defined by

    1. Lead volumes
    2. Lead quality
    3. Sales metrics conversions

    I specifically wanted to consider how we turn this ‘problem’ in to a competitive advantage

    To create a competitive advantage do we
    1. Create endless leads and expand sales team
    2. Create high quality leads and improve success metrics

    Ideally can we create lead pools across products multiple sectors, countries and ensure we quantify quality metrics to deliver conversion results.

    Q. How do we create high quality leads
    – clearly defined vertical, location (strategy approved) and product & marketing materials aligned
    – effective lead pool farming / inbound lead sourcing (marketing function) (quantity & quality)
    – lead cleansing, data improvement, research, further lead pooling based on insights (senior sales support function) 
    – lead grooming (see below)

    What do we know
    1. Quantifiable number of leads available by vertical and location
    2. Qualitative lead data equals higher conversions, Better Ava, faster growth
    3. Confidence in lead quality and lead quantity by vertical / sector creates an opportunity for rapid expansion

    Lead quality
    1. Expertise required to spot good leads pre call
    2. Qualified leads could be further improved to speed up / firm up sales opportunity
    3. Lead grooming:: Media awareness, to connect on Facebook, twitter, linked in groups.  Influnecers: To connect via linkedin to all contacts and stakeholders. Service awareness, to send client introduction email, media pack.
    4. Senior sales support training execution: Sales director leadership, sales teams involved in workshops to extract hunter gatherer skills, senior sales support who develops key skills, work load managed by team of interns (1 intern per 2 reps). Senior, talented, industry aware, well read individual required to manage the lead funnel, primarily sales director leading to handover.

    ASSUMPTIONS
    1. If we increased the information around a client lead once qualified could we convert the lead faster and with higher AVA’s? Could we strategically grow sales reps monthly new business targets? Does this have an effect on churn? We assume a positive outcome on all points.

    Helpful sales data
    – Business description
    – Decision maker details and background (linkedIn)
    – Twitter link
    – Facebook link
    – Alternative contact information such as mobile, emails, Skype, twitter
    – Access to increased contacts within the business (influencers)

    Action point
    – Sales lead grooming to be rationalised, process created and activated as earlier as possible.

    OBSERVATIONS
    1. Marketing departments have excellent systems and process skills but are not fully aware of what qualifies as a strong converting lead. Opportunity fix here could be based around lead qualification which is time consuming or creating sales support role that works the ‘top of funnel’ lead pool pre lead quality improvement and allocation. Marketing to monitor lead source to conversions over time to understand where to invest more resource.

    What qualifies a good lead
    – NEED for the service (time saver / increased opportunity) AND Budgets available

    Wider Business Concerns ___________________________________________________
    As we know software products can be reproduced with ease and as I read the key points seem to be to restrict competitor entry

    1. Proven business model / robust product / customer adoption / reoccurring revenue
    2. Scale the business at speed
    3. Become the market leader at what you do by market either by success in product and or key partnerships (restricting access)

    So this had me thinking about the key points that restrict this happening globally

    We are well versed on how important SEM is as part of a lead generation strategy that generates leads and demos from our websites but generally I see limitations in most marketing strategies based on funds or resource to produce content. A smart solution here would create huge strategic benefits in the short and long term.

    Management Team (urgent)
    Define strategy, size of markets, lead volumes, quality and cleansing process inline with sales team size. Decide if we work sectors based on sales teams or can we take market share initially on a freemium based product to prime new markets / generate lead pipeline pre sales team creation.

    CONCERNS
    1.Failure to enter new verticals and global markets will result in competitors taking first mover advantage. 

    2. Failure to execute efficiently could reduce effectiveness of the company in current markets.

    Q. How do we ensure we avoid time sucks whilst effectively opening up new markets and verticals pre sales team focus

    3. Global markets:: major concerns are around competitors taking first mover advantage outside of our local market, from previous experiences these prove to be the key markets  (Germany always being the one to watch in Europe as they get exceptional traction quickly, massively competitive and raise large funding quickly)

    – UK
    – USA
    – Germany
    – France
    – Italy

    Key question:: How to access new verticals, global markets, create rapid growth, prepare for competitor attention, securing industry insights, product improvement opportunities from a clear qualitative and quantitive lead pool strategy.

  • Greg Kall

     David, this model is fantastic. Great work.

    I work with a number of ISVs working through SaaS transformation. As you know this transition is painful on many fronts, not the least of which is that on the finance front transitioning from immediately recognizeable license revenue to ratable subscription revenue. Are you considering a version of your model that accounts for that transition, as an aid to ISVs for effectively planning the evolution of Sales and Indirect Channel?

    Thank you.

  • http://www.forentrepreneurs.com David Skok

    Thanks Greg. I have thought about that, but realized that it requires me to build something that those companies already have, which is a model of their own business. With that existing model, It should be relatively easy for an existing ISV to model this transition. I believe that all they need to do is enter their best assumptions for how the SaaS model will work into this spreadsheet, and then compare the two, and build a blended model that shows how customers moving from one to the other will impact cashflow, revenue, and EBITDA. I hope that helps.

  • Smaxwell

    David, this is a real classic post, so I thought that I would point to a related post on scaling that I put on my blog recently:  http://blog.openviewpartners.com/is-your-expansion-stage-company-missing-its-reproductive-organs/

    Essentially looking at the issue from the people and process standpoint.

    Scott Maxwell
    OpenView Venture Partners

  • http://moversdirectory.com/ moversdirectory

    in a way where you are always thinking on your life to be in good .. good movers company must have to consider.

  • http://www.movers.net/ angela shean

    how ,? it can be all easy , through move company that can make a shake for you to be good.

  • Jean Villedieu

    Pretty cool post, the relationship between the volume of leads and the size of the salesforce is really interesting. Thank you David.

  • http://twitter.com/djlk Daniel Lizio-Katzen

    A little late to the comment stream, but I have a couple questions regarding payment options:

    1. In your experience have you seen any impact with regards to payment options and churn? I.e. credit card on file tend to have lower churn than customers on invoice.

    2. Regarding the pre-payment vs. monthly decision subscription option – have you seen the drive for a year’s pre-payment affect churn to the downside when a business has to renew? It would seem that a customer on an evergreen month-to-month contract is more likely to continue paying until there is an issue with their payment type of choice.

  • Andy Wilcox

    Hi David,

    great Blog, i’d like to apply this to a new virtual Network operator business taht I am starting, could you send me the spreadsheet template?

    thanks

    Andy awilcox@indigoforward.com

  • http://www.bettersellsolutions.com/ Robert V Hatcher

    I’ve used the 6x – 8x model with many of my clients, but we usually modify it based upon gross profit. So, we think about “payout as a percentage of gross profit” rather than OTE and quotas.

    Dave, in your example of $600k quota, 80% gross profit and OTE of $110, the payout is 4.36. Doing it this way allows the sales leader to say “for every dollar we spend on our sales guys we get $4.36 of profit returned to the company” (of course, given the caveat about lead gen, etc).

    I usually encourage clients to do it this way so they can turn the conversation with the CEO from sales being an expense (i.e. “what’s your sales expense”) to sales being the engine that drives the company forward (i.e. “for every dollar we spend on sales we get n dollars in return)

  • http://www.forentrepreneurs.com David Skok

    I like the idea of using the gross profit a lot in situations where the GM% is lower. Thanks!

  • Elliot

    Hi David

    I’ve been building out our forecasts based on your data and there’s something I can’t quite get a handle on regarding marketing costs.

    Your model accounts for the cost of paid website visitors but does not assign a cost for organic visitors. Assuming these visitors came from inbound marketing (content creation, PR) and other marketing activities (events, sponsorship, media partnerships etc) there would be an associated costs for marketing staff resource in the case of the former and marketing budget in the case of the latter.

    Would these costs contribute to CAC i.e. do they contribute to the cost per lead so that they grow proportionately inline with the number of sales hires? This seems problematic because a single marketing exec could in theory manage adwords activity whether the budget is £1000 or £10000. Similarly, the budget for event sponsorship couldn’t increase exponentially because there are only so many events to sponsor.

    Or are they a fixed cost that merely increases gradually over time? If so, how do you establish a reasonable budget?

    Interested to hear your thoughts on this.

    Many thanks!

  • http://www.forentrepreneurs.com David Skok

    Hi Elliot, you are very much asking the right question here. The way these costs are taken into consideration is that CAC should take all your sales and marketing headcount costs into the calculation. However I do make the point that in the early days, some of these costs (such as a VP’s Salary) need to be pro-rated, as you will not need to hire a new VP as you scale up the business. Here I recommend using your common sense as to what the costs will be at steady state in a more highly scaled model.
    I hope that answers your question, but if not, please let me know.

  • Elliot Jacobs

    Thanks for the quick reply David. It does make perfect sense for marketing spend and resource to grow in order to feed a growing sales team. I guess the gap in my knowledge is establishing a realistic marketing:sales ratio so that CAC isn’t too low, throwing other key metrics out. I’m sure that ratio will differ wildly from company to company but I’ll need to do more work to establish a realistic range (i.e. does a Saas company with 50 sales execs have a marketing team of 2 or 20?).

    Thanks again!

  • http://www.forentrepreneurs.com David Skok

    It does vary a fair amount. But if you want a rough guess to start with, for 50 sales reps, I would guess at around 8 – 10 marketing folks. I hope that helps.

  • Elliot Jacobs

    Awesome. Thanks again.

  • http://www.copylab.co.uk Copylab

    David, what’s your view on compensating sales people for year 2 revenues? We are a marketing services business with a short sales cycle, and long-term recurring revenues over several years. We have been paying a flat 20% sales commission to our sales agent, but we reckon we should be tapering it after year one – to incentivise the sales agent and improve the company’s profitability. What’s your view?

  • http://www.forentrepreneurs.com David Skok

    My thinking would depend a lot on how likely it is that customers would renew after one year if they didn’t have a two year contract. If the answer is very likely, then I wouldn’t reward the sales person too heavily for that additional year’s contract. But if the answer is that it is quite difficult to get renewals at the end of the first year, then I’d pay more for them booking a two year contract over a one year contract. I hope that gives you the guidance you need. But if not, reply to this again.

  • http://www.copylab.co.uk Copylab

    Hi David, thanks for that. That makes sense. We’re fortunate in that once the client signs up, the contracts tend to be open-ended in nature – and just need some gentle client relationship management (rather than selling) to keep them going. Sometimes they last for many years. Sounds like we could reward for year one and taper for year 2 and zero from then on.

  • http://www.forentrepreneurs.com David Skok

    Yes. You may possibly want to also consider adding a customer success team who have the combined job of making sure that the customers are happy, and also signing the renewals. In a situation like yours where there is not much renewal selling to do, the variable comp for getting higher renewals need not be very high.