SaaS vs Traditional Businesses

As a beginner SaaS investor, I wanted to understand how these businesses differ from traditional ones, so I could better understand what to look at when earnings come out (and why), what these metrics mean in real life, and how they are related, so I could understand how well (or poorly) the companies are doing.
In this post I try to:

  1. Summarize the essence of a SaaS business compared to a traditional one.
  2. Cover the most important metrics and see how they are correlated.

Obviously, the major difference is that SaaS come in a subscription form. This means customers will pay on a per-month basis for their product or service (software in this case). What this means for the companies is that they have better visibility into their revenues as most of these subscriptions are offered through annual (or even multi-year) contracts.

This makes it easier to track, upsell, and hence grow next year’s revenue as the company has already a base to start off. Last year’s customers are not going anywhere so the company only needs to grow from there. So, any growth in new customers will drive revenues up significantly on a YoY basis as existing clients, most of the times, spend more through add-ons offered from the company thus driving their original cost to acquire further down as the times goes by. But you probably already knew this. So, let’s dig a bit deeper.

What’s the difference between SaaS and traditional companies?

Recurring revenue, as explained above, makes SaaS completely different from what we were used to so far. Both as clients and as investors. Here’s how it makes it different for the business owners and the management team.

The revenue of the business comes over an extended period of time (customer lifetime). It is not a one-off thing. “So what?”, you may ask. Well, this turns everything upside down. Because the point now is not to just sell. It’s to onboard as many happy customers as possible (emphasis on happy, more on that in a bit). Words like profitability are not of main concern (at least not during the early innings of the company).

Why? Because every customer you acquire today will be printing money for life — provided he/she is happy. Happy clients will stick around (less churn), buy more products/services from you (more growth), and also recommend your product/service to others within their organization as well as outside (network effect). This makes acquiring SaaS customers not as expensive as it might initially appear. The average payback time for the Customer Acquisition Cost (COC) is around 18-24 months. Less than that is considered excellent, and more than that worrisome.

When you consider that most customers will stick around for years then it makes absolutely no sense to cut costs, but now is the time to increase Sales & Marketing (S&M) to try to capture as many of those clients as possible. Because in about 2 years (or less) you will make it all back and then the customer starts to really contribute to your profitability. This is what is known as a Land & Expand strategy.

What is Land & Expand?

Land and expand is not simply increasing the seats or licenses sold to existing clients. Your sales team will probably help land a client. But then it is up to the customer success team to cultivate a healthy ongoing relationship with your clients in order to find out how they can better serve them, make your offering mission-critical and churn-proof no matter any changes in management and decision makers within the client’s company.

In order to do so successfully, you’ll need to track new user signups, deepen relationship with decision makers, monitor user adoption, and then leverage the relationship built with decision makers to drive adoption through entire organizations.

If executed right, you’ll see increase in Average Revenue per User (ARPU), wider adoption across departments within the client’s organization, higher Dollar Based Net Retention Rate (DBNRR), and higher lifetime value of your clients since you’ll have managed to prove your solution’s importance and criticality within your customer’s organization.

So, our SaaS companies need to 1. Acquire customers, 2. Retain customers, and then finally 3. Monetize customers.

Most investors would not understand the basic economics behind a SaaS company and thus be worried when they see a squeeze in profitability (cash flow positive) even with perfect execution. And the reason behind this is simple, as explained above the first goal is to acquire (fast) as many happy customers as possible. This means that every client onboarded takes money out of your pocket (COC). SaaS companies should accelerate their S&M spending (not the opposite) to boost the customer acquisition pace.

And when, finally, there is a solid base of customers, the contribution will be meaningful to the profitability of the company. However, just because you see customers flowing in you shouldn’t stop investing in your growth just to be profitable. There is plenty of growth to be achieved unless you have penetrated your TAM significantly (which is almost never the case). At that time, it makes perfect sense to accelerate your S&M spending to help scale your growth even further even if it deepens your losses temporarily.

Why would we want to accelerate the spend if everything seems to work out perfectly? Simply because there are usually other players competing for the same market share offering similar products/services. For this, our companies need to get all the growth while they can. Speed matters here. If you are too slow, others will get ahead of you. And since this is a sticky business, you won’t be able to convert them to your service easily (if at all).

This is why valuation is usually higher for higher-growing SaaS companies. And this is why Saul’s method has revenue growth as the no1 thing to look at when trying to identify the best business. Companies growing rapidly means they take market share and are becoming the leader in their space.

Even though some companies select and define the key metrics differently, here are the most common ones:

Annual Recurring Revenue (ARR)

This shows how much a customer is expected to spend within 12 months. So, if for example a customer buys a $20 subscription for 2 years you automatically have a $240 ARR. If you have 10 clients buying that then your ARR is $2400. This tells you in advance how much your clients are expected to spend within 12 months.

There are three things to consider when it comes to ARR. First, how much new ARR comes from new clients. Secondly, how much churn there was from existing clients. And finally, how much expansion you had from existing clients expanding their subscription.

Bookings/Revenue/Deferred Revenue/RPO

Bookings is when a contract is signed. For example, a customer just signed a 3-year contract for $3m. Your bookings are $3m and your ARR $1m. Revenues will only start to appear once the customer starts paying (billings recognized) leaving deferred revenue to be realized down the line. For example, once the first year goes by you will still have $1m more in deferred revenue per year and $2m in total Remaining Performance Obligation (RPO).

Customer Lifetime Value (CLV)

This shows how much revenue you will get from a customer minus the cost to acquire (COC). This is important because if your customers are spending less than it costs to acquire over their lifetime then it makes no sense to acquire them in the first place. If that is the case, then the COC needs to be lowered and reconsidered.

Net Revenue Retention (NRR) or NDR or DBNRR

This metric shows how much revenue you keep or grow once the churn is included. By including churn and upsells it gives you a better understanding whether your product is a good fit for the market. For example, you have 10 clients bringing in $100 for year 1. Then the same cohort of clients brings in $120 even though there are now 9 clients because of churn. Even with less clients you managed to bring in more dollars. So, there’s a 120% NRR. Anything above 130% is considered excellent, and less than 110% worrisome.

Even though the scope of a SaaS business is to acquire customers first, in reality what they really do need to do is to focus on customer retention. Because if you keep adding unhappy customers you will lose them too eventually. This is why churn is super critical for a SaaS company. Even a slight twitch to your churn can work wonders.

Net Promoter Score

The NPS shows how many of your clients would recommend your product/service. There are promoters (those who give you a 9-10/10), detractors (those who give you a 0-6/10), and neutrals (those who give you a 7-8/10). This score is an indication to the churn. A high NPS makes your business much stickier and thus easier to grow. A low NPS would make it harder to maintain because of the higher possibility of churn, thus reducing your NRR.

If I could write the essence of a SaaS business in 2 sentences this would be it: To acquire high lifetime value (LTV) customers and keep them happy for as long as possible while offering a never-ending pool of new products/services that meet their needs.

Personally, I think that subscription models are best for everyone. For clients, as they have more control over how much they spend. For companies, as they have better visibility into their revenues and overall performance. For investors, as they have better predictability on what to expect from their investments.

A business owner or an investor?

It makes sense to be able to understand the companies we invest in so that we can assess their progress and stage they are at, to make informed decisions. To do so successfully we should think as business owners first and then as investors. However, one thing to note is that even though we ought to think as business owners there’s an understated difference between the two and there’s a big advantage we have over actual business owners.

A business owner will not be able to jump ship when something is wrong with the organization, they’ll most probably stick around to figure things out. We, as investors though, have no obligation to stay invested until and if the management figures things out. Our advantage is that we can simply exit our position and reenter when things improve while reallocating our funds elsewhere in the meantime to avoid extended losses and — most importantly — the opportunity cost.

Have a lovely weekend everyone,
Pavlos
twitter.com/Pavlos__21

185 Likes

That was a really excellent description of SaaS businesses Pavlos. I’d just add three points.

First, a big advantage of SaaS is that it’s very low capital intensive. No factories, no supply bottlenecks of parts you need, in fact, no parts that you need :grinning:. It’s all done over the internet.

Second, is that having it all done over the internet means lower overhead for the customer company too. If you are a customer company and there is an update to the software, you don’t need someone to go out and install it on all your 7000 computers. It’s done over the internet almost instantly, on all your computers. Instead of quarterly or yearly updates of the software you can get an update whenever it’s needed, even two days in a row if needed. It also means less IT costs for you, and it means you are a happy customer.

Third, for a clearer comparison with a traditional company, let’s say you sell refrigerators, and you sold 50,000 refrigerators this year. Next year you have to find 50,000 NEW CUSTOMERS to buy refrigerators, even to get to the same revenue as you had this year. That gets you to no growth! Having 100% growth would be almost impossible. Your Dollar-Based Net Retention Rate is 00%. That’s zero percent. Last year’s customers pay you nothing this year. Say you sell something recurring, like hair color, or fried chicken, or clothing. Next year you may do as well as this year, you may not, depending what’s in style. But growing 80% for two years in a row (which is routine for a top of the line SaaS company) would mean selling 324% as much hair color, chicken, or coats in two years as you did this year. It just ain’t going to happen.

SaaS companies are a miracle for us investors.

Best,

Saul

110 Likes

May i add a couple of points which may be generalized to other rapidly growing software companies that are innovative.

Low capital requirements plus the very nature of software enables a simpler, more rapid rate of expansion. But not only an accelerated rate of expansion for existing products, but the very nature of software also simplifies innovation and implementation thereof (doesn’t require physical construction). Often, such innovations, especially when sold to existing customers, lead to margin increases.

As the CEO of one of my top holdings said recently at an investor field day (a fintech which i won’t name here to avoid distracting from my point), “we are rapidly converting our gateway customers to our end to end processing services. We do that with a flick of a switch, so all the added revenue goes to the bottom line.”

All of the advantages mentioned by Pavlos and Saul for SAAS companies, seem to work as well for PAAS and IAAS companies such as Snowflake as well.

Amazing! It really is different this time. And i plan to continue to follow Bert’s instructive advice and not let the price action of a stock drive my analysis of our businesses.

GL

22 Likes

Pavlos,

What an excellent summary. Wish I could rec it more than once.

I do have one question. You state in the section about NRR
This metric shows how much revenue you keep or grow once the churn is included. By including churn and upsells it gives you a better understanding whether your product is a good fit for the market. For example, you have 10 clients bringing in $100 for year 1. Then the same cohort of clients brings in $120 even though there are now 9 clients because of churn. Even with less clients you managed to bring in more dollars. So, there’s a 120% NRR.

In your example, you earn $1000 in the first year, and, because you lost one customer, you earn $1080 the second.

I thought that the NRR would reflect the customer loss, so the NRR in this example would be 108%. If the NRR is 120%, that seems to me to reflect the increased spending of remaining customers, but to ignore the lost revenue of the missing customer.

I could easily be wrong about this. Can someone please set me straight?

Bruce

3 Likes

Interesting posts, but is there not a concern that apart from the established giants, companies offering SaaS have little/no moat? Not having studied the scope of these companies in depth, it occurs to me that many of the MF recommendations recently are in the tech/fintech universe and must be competing in the same market(s) eg ecommerce or cloud platform solutions. Not to say that they cannot all be profitable, but we should expect winners and losers and we are seeing some apparent losers (does not seem to be reflected in the Stock Advisor picks). I’d be very interested to see a graphical map to show where MF hotpicks (and the rest of the tech firms) are focused, where these companies are well-differentiated and where they are scrapping over the same customer-base.

2 Likes

Nice points addedupon:

Low capital requirements plus the very nature of software enables a simpler, more rapid rate of expansion.

Yes, if you are selling cars or refrigerators or whatnots, if you have enough demand to double your sales, you have to double your factories. That means buying or renting large buildings, or building your own. Also you have to hire the workers to fill the new factories, pay for electricity, heating, air-conditioning, etc, etc. Then buying the raw materials or parts you need, etc etc.

If you are a SaaS company you will probably have to hire more salespeople, but the cost of doubling your product is negligible. It’s a whole different ball game.

The very nature of software also simplifies innovation and implementation thereof (doesn’t require physical construction). Often, such innovations, especially when sold to existing customers, lead to margin increases.

Yes again! If you want to improve your product you just send out an update in the cloud. You don’t need to change all your assembly lines, design and manufacture or buy new parts, etc. And it’s true, the new modules that get added on take much less S&M, so margins rise. Yes again, it’s a whole different ball game.

Thanks,

Saul

35 Likes

Not Pavlos, but to clarify @Bruce’s question:
In your example, you earn $1000 in the first year, and, because you lost one customer, you earn $1080 the second.

I thought that the NRR would reflect the customer loss, so the NRR in this example would be 108%. If the NRR is 120%, that seems to me to reflect the increased spending of remaining customers, but to ignore the lost revenue of the missing customer.

I could easily be wrong about this. Can someone please set me straight?

The answer is…usually.

You have to be careful with how companies are reporting their NRR.

Some will exclude the churn (i.e. the lost customer) and simply calculate that of the 9 remaining customers, their spend went from an average of $100 each to $120 each, thus a 20% increase.

The more acceptable way to report this is to include the churn, which would take the $1080 revenue and divide by all 10 customers that were remaining customers at the end of the prior period and thus arrive at 108% growth as you mention.

This is a very good point and should absolutely be noted by all investors in SaaS companies.

27 Likes

Nice writeup. Here is how I view SaaS in this day and age.

For a business that subscribes to a SaaS service these days, it’s virtually akin to subscribing to a basic utility service like electricity. It’s always there, always on, always abundantly available. You don’t walk into your business in the morning and expect to be in a blackout, you know as soon as you hit the switch, it will be there. You do not schedule maintenance, or back it up, or worry about your IT staff taking vacation, you don’t have to upsize or upgrade your servers or do anything but simply use it. No different than just using common utilities like electricity.

And therein is the drug. It’s so easy, so abundant, so carefree that you simply take more when you want because it is virtually limitless. Just as we regard electricity, if you need another oven, or fan, or widget for. your business, you just buy it and plug it in. You pay the utility company a little more, but you just don’t really think about it. If you need to put up some Christmas lights, you just know the extra power you need is already there, and you just plug them in and enjoy, without ever thinking if the electric company can deliver the extra power.

That’s the kind of carefree usage we expect from electric, water, and from SaaS. That is the reason why SaaS has revolutionized the way we think of information technology in this era.

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