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.
- 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.
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.