SaaS Economics – Part 2: Scaling the Business

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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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David Skok

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