A client and friend recently refreshed my knowledge by pointing me back at Joel York’s brilliant Software-as-a-Service (SaaS) business financial analysis posts, chaotic-flow.com. Joel comes up with his ten rules for a SaaS business.
Although Joel targets SaaS companies, and in general all subscription-based revenue companies, in truth it applies to all companies dealing with growth that comes from extending revenue streams.
Several years ago, I had a client (I believe they are highlighted in “Success Stories” on atomicinc.com) that, despite torrid growth and profitable customers, continually faced a cash crunch. Every business loves growth, every business loves positive gross margins. So, they asked, if we are growing, our customers love us, and we are profitable on each customer…. how are we continually in cash trouble?
I took a good hard look at their business. Yes, they were beloved by their customers; yes, they were profitable with each customer; yes, they had a torrid growth rate… and yes, they were continually running out of cash.
Their problem, as I identified back then, is exactly the growth problem and its effect on profitability that Joel identifies in Rules #5 and #6. When you grow in a subscription business, or really any business whose contribution margin (i.e. profit from an individual customer) is spread out over time, but whose large customer acquisition cost (CAC) is upfront, then you are putting out lots of money *now* to get a great sum of money (the profit) in the future (the “after now”). There is some natural growth rate – which I determined for the customer – beyond which your profit cash stream from your current customers is simply not enough to pay your high CAC of your new customers, and you will lose money on a period-by-period basis.
In the case of this customer, it was a business with characteristics very similar to lending, which mimics a SaaS business almost exactly. A mortgage loan company (which this was not, but is an example with which everyone is familiar), beyond its usual customer acquisition costs, lends out a lot of money (the principal) right now, and makes it back – plus interest, the profit – over the next, say, 30 years. The mortgage bank would love to lend out to another 1MM safe mortgagees, but it only has so much cash on hand.
In the end, a SaaS business is nothing more, or less, than an efficient (relative to an enterprise software company) mortgage lending company, with CAC the principal, and monthly / annual subscription fees the monthly mortgage payments. You can only grow so fast, before you run out of cash.