Anyone spending any time in early stage investment or in the software industry will know that Software as a Service (SaaS) is king.
Customers expect it
SaaS solutions are attractive to enterprise customers, who increasingly prefer cloud-based software over maintaining legacy applications on their own servers. They can do this for the payment of a monthly subscription (thing Canva or Salesforce or Xero), and they get access to set features, typically tiered access depending on their chosen subscription plan, as well as future releases and bug fixes .
An attractive business model in theory
The business model is attractive, offering a repeatable revenue stream (the subscription charged to the customer) from a once-off acquisition cost. Once acquired, customers are typically sticky, sometimes even insanely loyal to the product. The subscription fee charged is called ‘recurring revenue’, and by recurring we are implying it is predictable, and theoretically lasts forever. ‘Recurring revenue’ leads to the acronyms MRR (monthly) and ARR (annual), which you are guaranteed to encounter in any SaaS pitch deck. Typically these companies are valued as a multiple of the ARR. This facilitates comparison between companies, using their recurring revenue as a benchmark.
Variable costs are low, gross margin is high, operating leverage is high - all the KPIs are promising. I’ve built in excess of 30 or 40 financial models for SaaS companies, and of course they all show the proverbial hockey stick of growth 🏑. This is why, as an investor, SaaS is an attractive proposition. You are investing in the acquisition of a fixed income-like revenue stream, and in theory this is lower risk than other early stage ventures, but still with the attractive upside risk.
In practice however…
That’s the theory. In practice, the hockey stick growth projections often aren’t fully realised, for a multitude of reasons.
One common flaw is underestimating the customer acquisition cost. As the business grows and hires more sales talent, there will be variability in their productivity and this impacts the cost to acquire a customer. As the company explores different acquisition channels, the degree of human touch required to convert will vary, and this introduces additional cost.
Tim Brewer is an experienced tech founder, investor and advisor. While he has now returned to Australia, his experience includes working as an advisor to a number of high profile global software companies including Dropbox. Tim acknowledges that the cost of acquisition is all guesswork for most startups starting out. "But the important thing is to be get to a stage as early as possible where you can measure it in a sophisticated way. Until then, you can't optimise the process."
Tim's latest venture is Functionly, a SaaS product aiming to improve the process of designing and managing an organisational chart. The focus has been on building an intuitive, easy to use product. "The easier you make it to access your product, the bigger the footprint of potential customers. Then the challenge becomes acquiring the customers in a scalable way."
Organic acquisition (eg referrals or online search based) is an attractive strategy. "We recently got a 5 star review on G2 [a business software review site], now we’re actively asking customers to review us on there." But organic alone won't deliver the volume required. Tim's spent the last quarter gaining certainty around the cost of acquiring customers through paid advertising. "Our approach is to try one channel a month, by the end of this quarter we should have a view on which channel to focus on."
Performance marketing is a data-driven approach to measuring the performance of your marketing spend, in the relentless optimisation of its RoI.
"Performance marketing is THE skill you need"
"Really, performance marketing is THE skill you need in the founding team of the startup, or failing that as an early hire. There’s a handful of performance marketers here in Perth, but they are hard to find and sought after. I had to acquire mine in the US."
Implementation growing pains
Another common challenge is that the assumption of continued, stable growth comes unstuck. This great piece delves into some of the challenges of the business model, in particular on the implementation side. The reality is that most SaaS solutions are complex and require lots of hands-on support from a customer success or implementation team. This undermines the plan of a perfectly repeatable, plug-and-play solution.
These troubles often stem from clunky, non-scalable processes. Once a SaaS business starts really getting scale, and more likely than not non-organically (ie by acquiring other SaaS businesses), the problems can be compounded. Having worked as an integration lead for multiple SaaS acquisitions, I’ve seen first-hand how jamming different products together, each with their own implementation methodologies and processes, can all too easily lead to an inconsistent customer experience and inefficiencies, which ultimately will hamstring scalability.
For Tim, a product-led experience is the key. "I didn’t think that a year ago. But we’ve learnt so much in the past year with Functionly. I will now not invest in companies that are not product led, because if you do, a product-led competitor will figure out how to compete with you and will beat you in speed of growth.
"Needing an onboarding process is a bug. By the time we speak with the customer for their free onboarding session, they’ve already spent 3-4 hours in the product by themselves – so they're seeing value in the product from the outset and it's easily accessible to them."
"Very good products don’t need a walk-through."
A product-led growth strategy means that you are relying on the strength of your product to acquire customers. It's often associated with the freemium model, where the user gets to try a basic version of the product for free, before upgrading to premium features becomes a no-brainer because the product is so good at solving the customer's problem. It's probably no surprise that Tim previously worked at Dropbox, a frequently quoted example of product-led growth.
"Post-covid you want to be following a product-led growth strategy - eg can I get into you product from your website in less than 60 seconds? Product-led design is about anticipating how users will interact with the product, what their expectations are, how they currently perform processes. The closer you can get the product to work ‘as the user thinks’, the better.
"The best products mirror how the user thinks."
"I never read a product manual for Dropbox. It worked how I expected it to, I just jumped in first time and started using it. Same with Zoom."
Some would argue that while this works for SME-focused software (where cost of acquisition and implementation has to be kept low because average account revenue is lower), it won't for enterprise level software. Tim disagrees.
"There’s a sense that users will be forced to use the product by the organisation they work for, so people become less concerned about user experience, and focus instead on the sales process. But product led growth can be a massive advantage in enterprise as well. It allows a bottom-up approach, where you start with a key user who is hooked on the product."
Ultimately you still need to sell to them on an enterprise level, but the groundwork has been laid by those initial positive experiences.
Recurring revenue: substituting debt for equity
So assuming those growing pains have been successfully resolved: everything is ticking along nicely and the model is repeatable and scalable. How do founders fund the growth?
Investors love SaaS, founders want to grow faster and so raise money at ever increasing valuations and everyone’s happy, it’s a perfect model, right? Well venture capital doesn’t just invest in disruption, it can also be disrupted itself.
Cue a new form of debt-funding for SaaS companies, in the form of Pipe. The startup gives SaaS companies an alternative to dilutive funding (eg giving away equity), by providing them with a cash advance secured against the recurring revenue. A little like debtor-financing, except the loan is secured against the next 12 months' payments due under the subscription, rather than a single sales invoice. So the customer still pays monthly, but the company gets the annual value of the contract up-front, and can use that cash to invest in product development and sales capabilities, without having had to give equity away as it would in the traditional VC model.
Another provider in this space is Founderpath, who talk about "capital as a service" and offer debt funding at 15% interest to SaaS companies with at least US$25k MRR. They obtain the funds from their backers at 12%, pocketing the margin.
Another emerging model is revenue-based financing, with providers like TIMIA Capital offering debt with repayments set as a percentage (1-4%) of future revenue, which continue until the loan plus a multiple is repaid.
A key attraction of these models is that they require no personal guarantee by the founders or directors of the business, and often involve simplified paperwork.
Alex Danco talks about the second-order consequences of the recurring revenue model which are yet to unfold. He likens the SaaS company’s revenue stream to a fixed income yielding asset, and this is important because typically fixed income assets are of interest to a broader range of investors than startup equity is. Danco argues that equity is messy and valuations distract everyone, with debt becoming a valuable alternative to the traditional equity-fuelled ‘capital stack’. He predicts a new financing product in the shape of recurring revenue securitisation: startups essentially shifting a group of recurring revenue yielding contracts off their balance sheet by packaging them up and selling them as a financial product.
We're not quite there yet, but it would be a very interesting evolution of the early stage funding environment and a challenge to the dominance of the current venture capital model.