SmoothSpan Blog

For Executives, Entrepreneurs, and other Digerati who need to know about SaaS and Web 2.0.

Why Do SaaS Companies Lose Money Hand Over Fist?

Posted by Bob Warfield on May 19, 2009

This discussion comes up time and time again in the eternal SaaS vs On-Premises debate.  The SaaS guys (yup, that’s me) wax eloquently about all the advantages of SaaS only to have the On-Prem guys shoot us down by proclaiming SaaS companies aren’t real businesses because they can’t make a profit.  The thing is, it just ain’t so.

The latest bout of this I had was amongst my Enterprise Irregulars blogging group, and comes in the aftermath of Sapphire (SAP’s User Conference), which always brings out a lot of discussions like this.  Our discussion got started through Michael Krigsman’s excellent post on SAP’s continued commitment to their SaaS product, Business by Design.  As Michael points out:

The economic differences between delivering software via SaaS and on-premise methods are substantial, with profound implications for how software companies optimize internal operations.

While the group generally agreed that the product had made a lot of progress from the user experience side, it is still extremely hampered from the standpoint of dealing with these economic differences.  In fact, despite having been introduced years ago in February 2006, and despite SAP setting a target goal of 100,000 customers by 2010, the product is nowhere in sight on reaching such goals. 

The continued commitment Michael refers to is a commitment to overcome these problems.  Yet the amount of time that has passed and we still find ourselves at a point where SAP’s CFO has to personally approve any sales of BBD because they lose money on every sale, leads me to believe the challenges must be huge relative to the reality.  In fact I suggested that nothing less than huge architectural issues could delay them so long.  Issues of the kind that often require a complete rewrite of a system to overcome.  I wrote a long time ago that this problem was SAP tacitly quantifying the advantage of SaaS for customers in my post, “SAP Admits that SaaS is Cheaper for You Too.”

It may also be that they aren’t trying hard enough.  Perhaps there are forces inside SAP, as Dennis Howlett hints, that are not enamored of BBD.  As Vinnie Merchandani points out, SAP does not see the SaaS market as very important—perhaps 5%.  Inevitably, all this angst triggered the On-Prem crowd to come forward and argue that it’s a lot of nonsense to pillory SAP for a lack of profitability with BBD when the SaaS companies themselves do no better.

Having looked at the numbers many times, I decided to take a tour once again through these numbers, this time with a comparison versus SAP.  Do SaaS companies really spend money hand over fist to accomplish little?  Are On-prem companies, of which SAP has to be one of the gold standards, run tremendously more efficiently?  To find out, I selected two SaaS companies, SuccessFactors (because it was brought up in the discussion as a well run SaaS company that had a hard time making a buck) and Salesforce.com (because how can you have the discussion without looking over Salesforce?).  We’ll compare the numbers from these companies against SAP.

Given the radically different scales of these organizations, I favor comparing percentages over actual dollars.  How many dollars of Sales and Marketing expense are required for each organization to make a dollar of revenue?  How many dollars of R&D to do the same?  And so on.

Here is what I found, using the most recently reported financial periods:

Sales and Marketing

Let’s start here, because this is really the crux of the argument.  It’s where SaaS companies spend the Lion’s share of their budgets, and where On-prem seemingly doesn’t spend much at all.  Here’s what the numbers look like:

-  SuccessFactors spends a ripping 56 cents for each dollar of revenue they bring in.  Analysts expect about 85% growth in exchange.

-  Salesforce is spending almost as much:  54 cents to bring in a dollar for which the analysts expect 44% growth.

-  SAP has a much more frugal 29 cents per dollar brought in, but the analysts only expect them to grow 17.5% next year.

As a function of pure cost, SFDC and SFSF spend 2x what SAP does for an incremental dollar of revenue, which on the face of it looks highly inefficient.  But, before we write the SaaS guys off, note that by spending so much, they manage to deliver 2.5X to nearly 5X the growth of SAP.  Which one is more efficient?  Not hard to make an argument for the SaaS guys when you look at S&M dollars as payment for growth. 

  1. Either company would be extremely profitable if they wanted to slow down spending, but they’re investing in growth.

SuccessFactors covered this issue in great detail for investors on their IPO road show.  They demonstrated how profitable they could be any time they wanted (you can throttle Sales and Marketing pretty fast) and argued convincingly that they should be allowed to grow.

General and Administrative

This is a category everyone loves to hate.  It’s overhead that delivers no value.  Surely the SaaS companies must be wasting a lot of money here?  Large organizations benefit from economies of scale on G&A, don’t they?

-  SFSF spends 21 cents on this for every $1 of revenue.

-  CRM spends 16 cents for every $1.

-  SAP spends 17 cents.

 

I could almost expect that economies of scale ought to lower G&A over time and that this is SFSF’s problem versus CRM.  However, that wouldn’t explain why SAP doesn’t get a further reduction in G&A.  These SaaS companies seem reasonably efficient with G&A.

Research and Development

-  SFSF spends 16%

-  CRM spends just 10%

-  SAP spends 21%

Lots of R&D going on in Germany, I would say!  CRM seems to me is starving the innovation side worse than these other 2 as well, which is kind of interesting.  At some point, Salesforce ought to invest more in developing new products.  I will speculate they have the throttle hard over investing in Sales and Marketing, and that long term, they may wish they’d spent more on products.  In any event, we have heard from many sources it is cheaper to develop SaaS software (no need for multiple platforms, no need to support patching for customers who won’t upgrade, etc.) and these figures clearly bear that out.

Cost of Revenue

This is one of my favorites.  Keeping the cost to deliver the service low is essential for SaaS companies.  The fact SAP says they lose money on every sale of BBD is a direct reflection on this number.  SaaS companies use a variety of technologies like multi-tenancy to keep costs lower, and it seems likely SAP has missed these tricks.  We can’t get the numbers for BBD, but we can compare SAP’s cost to deliver software (largely cost to deliver maintenance, which is Tech Support) to the costs of a SaaS company:

 – SFSF spends 24% to deliver their service.

-  CRM spends just 13%

-  SAP spends 22%

It’s fascinating that SAP spends more than Salesforce spends to run the product and deliver support just to deliver Tech Support.  We can also see that SuccessFactors has a ways to go improving their operational efficiencies.  They spend nearly twice what Salesforce spends, which puts them at a disadvantage.

Conclusion

It seems pretty clear these SaaS companies could be just as profitable as SAP if they were prepared to dial back significantly on their growth.  SaaS companies spend money hand over fist because they’re engaged in a land grab.  The big players like SAP are extremely slow getting to SaaS for various reasons.  As long as these companies can grow like this, they should keep investing heavily in it.  The likelihood an on-prem vendor will dig these customers back out again seems very low.  Customers being taken this way are probably lost for good to the SAP’s of the world.

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34 Responses to “Why Do SaaS Companies Lose Money Hand Over Fist?”

  1. [...] (excerpted from Smoothspan blog post) [...]

  2. rglauser said

    As usual, this is another great smoothspan post.

    It took both RightNow and NetSuite about 10 years to be profitable, right? With all of the SaaS vendors in the CRM space, it seems they are racing against each other to take share from the legacy vendors. So it makes sense that they are pouring money into sales and marketing.

    What about SaaS vendors outside CRM? In the HR / financial management SaaS market, it will be interesting to see what Workday does with $75 million burning a hole in its pocket. Did they really need that much cash? While it is nice validation of their business, I’d assume they are under the gun to quickly ramp up cash flow.

    In the IT management space, you could easily replace any mention of SAP in the post above with HP. They are similarly struggling with a ‘SaaS’ offering. Meanwhile, Service-now.com has been in business about four years, cash flow positive for about two years, and we expect to be profitable on $21 million in recurring revenue within the next few months. However, as a percentage of revenue, we spend nowhere near what SFSF and CRM do on sales and marketing. Never mind that our entire business is a rounding error for HP…

    So in the end, I guess it’s a matter of vendor priority. It seems that different verticals have different market dynamics. A couple of themes are consistent: 1. SaaS vendors are and can be profitable. 2. Legacy vendors are choking on SaaS and it is going to be a painful and lengthy process for them to ever get it right and make money on the model.

    Rhett
    Service-now.com

  3. [...] Recent discussions (including a great summary by Bob Warfield) questioned the impact of established enterprise software companies in the software as a service [...]

  4. fscavo said

    I agree with your general conclusions. However, shouldn’t the percentages add up to 100%? SFSF for example adds up to 117%, while SAP’s adds up to 89%.

    Also, the greater percentage of SaaS vendors for Sales and Marketing means that the other percentages will be suppressed accordingly. So, if they throttle back their spending on sales and marketing, you’ll see the percentage for R&D increase, for example.

    Overall, SaaS is simply a much more efficient business model, as there is much less overhead supporting multiple infrastructure configurations, as you point out.

  5. [...] Sound familiar?  This is the primary reason that some of today’s most well known SaaS companies have yet to attain profitability.  It has nothing to do with the so-called up front investment costs of building a SaaS business (seriously…do NetSuite, Omniture and Success Factors ever plan to stop posting losses?).  They have given up too much competitive advantage in pursuit of revenue from markets where they are not competitive or from customers that they cannot serve profitably (as evidenced by this nice little financial analysis by Bob Warfield). [...]

  6. [...] Prognosis on SAP’s Business ByDesign – SaaS based ERP solution for the core mid-market Posted on July 31, 2009 by sanjeevaggarwal I came across a good analysis on some aspects of SaaS vs. on-premise vendors and solutions in the smoothspan post Why Do SaaS Companies Lose Money Hand Over Fist? [...]

  7. sanjeevaggarwal said

    Some additional facts to consider are listed in my blog aboce

  8. decidavenceragora said

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  13. [...] also knows that and hence it is not the strategy-of-choice they are pursuing. Add to that the financial dilemma of spending on BBD as Bob Warfield [...]

  14. [...] sense of this morass, two of the more interesting attempts are Bob Warfield’s post entitled Why do SaaS Companies Lose Money Hand Over Fist, and this really cool analysis by Christian Chabot of tech IPOs comparing software companies that [...]

  15. andrewnadeau said

    Another great post on SaaS Bob. SuccessFactors looks like an interesting case study. It appears that its investors are okay with pursuing growth instead of profitability, but when does your focus turn from growth to profitability?

    I was reading David Skok’s guide on SaaS Metrics (http://www.forentrepreneurs.com/saas-metrics/) and he wrote that growth is a critical success factor because once a company establishes itself as a market leader other good things start to happen. For example, people want to buy from the market leader and the market leader gets the most press.

    Is the thinking that you pursue growth until you are an established market leader, and then you focus on profitability and becoming more efficient?

    • smoothspan said

      Pursue growth until you can no longer grow faster than comparable companies, then become more profitable than they are.

      For Venture startups in a decent economy, if you aren’t doubling every year you aren’t growing fast enough. If you can’t fix it, you’ll probably have to fall back on profitability.

      Best,

      BW

  16. cexk said

    Great post, i’ve already subscribed to your feed. thanks
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  17. [...] acquisition costs. SaaS vendors have to spend a lot of money to acquire new customers. Last year, according to industry-watcher Bob Warfield, Salesforce.com Inc. spent 54 cents on sales and marketing for each dollar of revenue it brought [...]

  18. [...] I came across a good analysis on some aspects of SaaS vs. on-premise vendors and solutions in the smoothspan post Why Do SaaS Companies Lose Money Hand Over Fist? [...]

  19. [...] Why Do SaaS Companies Lose Money Hand Over Fist? « SmoothSpan Blog [...]

  20. Very good post
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  21. [...] Why Do SaaS Companies Lose Money Hand Over Fist? by SmoothSpan Blog [...]

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  23. Nice to read your discussion on SaaS companies

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  24. Just wanted to chip in my $0.02 and say thanks for this post. I know it’s older but it’s still valuable. I am curious if anyone has looked at these metrics (and how they change) for first few years of a SaaS company from startup to IPO, acquisition or bankruptcy?

  25. [...] some benchmark data research on the topic. Bob Warfield at SmoothSpan wrote a blog post titled “Why do SaaS companies lose money hand over fist?” last year that addressed the issue. The title doesn’t exactly sound like a ringing endorsement [...]

  26. […] you have any doubts, try tearing apart the financials for Salesforce.com.  They have managed to build the world’s most successful SaaS company with relatively few […]

  27. […] you have any doubts, try tearing apart the financials for Salesforce.com.  They have managed to build the world’s most successful SaaS company with relatively few […]

  28. […] Bob Warfield – “Why Do SaaS Companies Lose Money Hand Over Fist?” http://smoothspan.wordpress.com/2009/05/19/why-do-saas-companies-lose-money-hand-over-fist/ […]

  29. I read on OpenView Ventures blog that in 2011 Salesforce.com was spending 54 cents per dollar of revenue on sales & marketing…I assume that is because of their massive growth and trajectory? Also, because they are a SaaS b2b company?

    For my b2b SaaS start-up http://quotadeck.com (platform for freelance b2b salespeople) we are planning on 15% spend on sales and marketing activities that includes salaries. But it sounds like if we want rapid growth…we may need to boost it past 50%!

    I took that 15% from David Cummings blog post

  30. […] While searching for some benchmarks data on SaaS companies’ sales and marketing spend, I found a great analysis by Bob Warfield in his blog “Smoothspan”: Why do SaaS companies lose money hand over fist. […]

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