The myth of "pull" economics vis-a-vis SaaS?

Charles Zedlewski is one of a handful of bloggers I selfishly wished blogged more often (before the jokes start, yes I realize I firmly deserving of that label too, of late). Every time he puts fingers to keyboard, I know I'm in for thought-provoking analysis.

With the recent rash of SaaS filings, Charles decided to look at the costs associated with the SaaS model and whether or not the "pull" aspect was in fact playing itself out.

What struck me with all three companies was the losses. The first order explanation is quite simple: all the companies spend a ton of money on sales & marketing (between 65% and 100% of revenues). Most of these businesses are the farthest thing from the oft discussed but seldom witnessed “pull model” that’s supposed to lead to superior profits.

The root cause for the losses is a little more subtle. In a recent article, McKinsey consultants asserted that the primary cause is scale. In fact they go so far as to say that these scale economies are nearly identical to those of on-premise software companies.

It's hard to argue with Charles' conclusion, which is that, at least to date, SaaS vendors have foregone margin as a trade-off for growth.

I also wholeheartedly agree with him that it's a question of scale and, Salesforce.com is approaching a point where they will need to make good on the promise of margin delivery. As long as the incremental spend translated one-for-one to the top line, one could make a logical case to continue, but now that the marginal utility of each additional SG&A dollar is driving less than a dollar in revenues, show me the profits.

Note: This is not a recommendation to buy or sell any publicly-traded security nor is it a recommendation to participate (or not to participate) in upcoming IPO offerings of Constant Contact, SuccessFactors, NetSuite or any other company. This discussion is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, maintained a long equity position in CRM and, through a passive investment in a venture capital firm, have exposure to SuccessFactors (privately held). We may, or may not, have interest in participating in the IPOs of these companies or other securities listings. At times, we may maintain derivative options as a hedge on underlying positions.

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Comments

[Bob Warfield]

Is "myth" too strong a word to use for SaaS? It does make a good headline, I'll admit.

I think of pull as relative. Relative to perpetual license software companies, SaaS has pull. See my blog post for some numbers on that:

http://smoothspan.wordpress.com/2007/07/17/its-cheaper-for-saas-companies-to-acquire-customers/

I think you can convince yourself pretty quickly, as I have, that SaaS companies can acquire customers more cheaply, hence they have more "pull". Relative to a Web 2.0 play like Facebook, perhaps their pull is relatively poor. OTOH, they seem to monetize better. This is why I like analyzing the ration of Sales and Marketing spend versus Revenue. If I spend less than $1 of S&M to achieve $1 of revenue, I have to call that pull. Many perpetual license companies find that extremely hard to achieve unless they slow down their S&M to target only the absolute cream, and hence radically slow their growth.

MacKenzie is right that there are scale effects at work, but I think the scale factors are radically different for perpetual vs SaaS. The knee on the curves for SaaS companies are pretty cheap--less than $100M in revenue. On perpetual companies the knees is at almost $1B in revenue before sales and marketing per dollar of revenue go down significantly. This is one factor fueling the M&A frenzy as folks like Silver Lake will tell you.

I think the real rocket fuel comes when SaaS companies figure out how to really leverage the principles of Web 2.0, and make their offerings truly collaborative and viral. We're not there yet, but it will come.