Non-Linear Growth

A glimpse around the next corner; mind the curves.

March 23, 2010 • 10:11 am 1

The “Leo the Late Bloomer” of Business Models

My kids love the book “Leo the Late Bloomer”. As the story goes, Leo was a tiger cub who hadn’t quite hit his stride yet.

Leo couldn’t do anything right. He couldn’t read. He couldn’t write. He was a sloppy eater…

Leo’s father, playing the classic fatherly role, was very concerned. He couldn’t figure out what was wrong with Leo. He feared that “Leo would never bloom” and raised his concerns with Leo’s mother. Leo’s mother was not phased, saying to Leo’s father:

Leo is a late bloomer.

Being the dutiful father, Leo’s father continued to watch Leo for “signs of blooming”. Seeing none, he asked Leo’s mother:

Are you sure Leo is a bloomer?

To which Leo’s mother responded succinctly:

Patience.

Leo’s father eventually gave up and stopped watching Leo for signs of blooming.

An Example

Like any child, Leo was on a one-way path toward adulthood and beyond. No going sideways, no turning back; one way. Company building doesn’t work that way, success is not in the future for every early stage business. Some fail, some go on to greatness. But regardless of the outcome, as a category, recurring-revenue businesses are late bloomers. Why? Unfortunately, the recurring-revenue model, with all its advantages, has its drawbacks; the biggest being that early in their development, the income statement profile of these businesses rarely reflects the value that has been created.

Product companies have a distinct advantage in this area; sell something and record it as revenue and profit in the period sold. All the value of the relationship with the customer is reflected on the income statement in the period in which the product is sold. Quite the contrary, in recurring revenue businesses; very little of the value is reflected on the income statement in the period the service is sold. Here is an example.

Suppose you sell storage equipment. You sell a tape back-up system to a small business and charge $1,000 for the equipment. You make a 40% gross profit margin on the product. In the period you sold the back-up system, you record $1,000 of revenue and $400 of gross profit on the income statement. Now suppose you change business models and decide to sell storage as a service. You sell under a three-year contract and charge the customer $50 per month; you make a 50% gross margin on your services. In the first month of billing, you book $50 if revenue and incremental gross profit of $25. In the first year, the storage service provider would book $600 in revenue and $300 in gross margin. Comparing these two business models on the basis of income statement performance only, the recurring revenue service company’s income statement looks less attractive than the product companies  for first 12-18 months.

This issue leads to what I’ve referrred to as the Valley of Death in fundraising for SaaS and other recurring-revenue businesses.

Apples, Oranges and Late Bloomers

The trouble with the example above is that it compares apples and oranges. You really can’t compare the income statement performance of a product company to that of a recurring-revenue services business. We need another measurement that puts these business models on equal footing. I have a strong preference for one metric, the lifetime value of a customer. In the product example above, the lifetime value of the customer is $400, presuming the customer never buys another piece of storage equipment from you. The entire value of the customer relationship is recognized on the income statement in the period in which the product is sold. The lifetime value of the “contract” in the service example is $600, the gross profit the company will earn over the three-year contract term. Contract value is an important measure, but only if the contract can’t be cancelled by the customer. More important is the lifetime value of the customer, which requires a more complicated set of calculations including customer acquisition costs, churn, etc. On this basis, ignoring time value of money considerations, I often find that recurring revenue services businesses capture more value per customer than product companies. The example highlights the point.

Customer lifetime value provides an alternative way to measure value that has been created. It is a concept that barely exists in product businesses. However, it is critical to recurring revenue businesses, precisely because – from an income statement perspective – recurring revenue businesses are late bloomers. If you are a recurring-revenue business operator you must measure customer lifetime value and the aggregate value of the all of the customer you have aggregated. If you don’t, can’t or won’t measure it, you are seriously short-changing the value of your enterprise.

Patience, Patience, Patience

Eventually, as they mature and scale, services business show great income statement profiles. Sticky, profitable, long-term contracts with customers lead to that. But because the economics are back-end loaded, it takes a while, and a great deal of patience. Leo’s mother understood that Leo would eventually bloom; she was patient. As the story goes, one day – somewhat miraculously in the eyes of Leo’s father - Leo bloomed. When he did, he turned into one heck of a tiger.

If your recurring-revenue business has a strong product in a big market segment and great customer lifetime economics, it too will bloom. But until it does, best to measure the value of the customers you have acquired so that you know you are creating value before your income statement shows it.

Filed under: Economics, SaaS, Uncategorized, Venture Capital

November 10, 2009 • 12:48 am 2

The math of SaaS revenue growth

A conversation with the CEO of a SaaS company today reminded me of the importance of the rule of 78s. What is this “rule”, you ask. If you run a recurring revenue business, it is the most important number you have never heard of.

Back to my conversation with the CEO. We were talking about the use of proceeds for the financing she is trying to raise. In her case, the business is break-even, but has the opportunity to grow into some oncoming market demand. So I asked a classic VC question; “Assuming you close the financing in Q4, 2009, what will your 2010 revenues be?” Simple question right?

Lets say that this company ended 2009 with $3 million in run-rate revenue and that the Company has two sales reps. Each sales rep. has a quota of $10,000 of incremental monthly recurring revenue (“MRR”) bookings per month. Sales reps. historically produce at 75% of quota in this company, so the incremental new bookings per month, per rep is $7,500. At its current level of sales and marketing resource and productivity, this business can expect to generate $1.17 million more in revenue in 2010 than it generated in ’09. To get there, just multiple the $15k per month of incremental revenue the two sales reps. will generate by 78. Why 78? Because 78 is the ”sum of the digits” for revenue producing months in a year. Incremental revenue added in January will produce revenue for 12 months; incremental revenue added in February will produce revenue for 11 months; …; incremental revenue added in December will produce revenue for 1 month. The sum of digits for 12 is: 12 + 11 + 10 + … + 2 + 1 = 78. So the baseline revenue projection for 2010 should be about $4.17 million.

Now lets talk about the enhanced growth opportunity. The Company wants to hire two additional sales reps. who can be expected to produce at the same $7,500 of MRR as the two existing reps. For purposes of the example it will take a quarter to recruit and hire the two new reps and another quarter for them to build a sales pipeline given the sales cycle. Conservatively, these two new reps. won’t begin generating MRR bookings until June. Lets say there is a one-month install cycle so that June bookings convert to revenue in July. So what kind of incremental growth will these reps. generate in 2010? We don’t get to use the rule of 78 this time; no, because these reps. will produce for only six months during 2010, we use the sum of digits of 6, which is 21. That is a lot less than 78; that six month delay between making the decision to hire two new reps and getting them on board and productive really hurts. In 2010, the two new reps. will generate only $315k of incremental revenue. The business can be expected to generate $4.485 million of revenue in 2010; not meaningfully more than the base scenario without additional investment.

While this looks like meager growth, it doesn’t tell the whole story. Remember, this business came into the year with a $3 million run-rate. Without hiring the two new reps, the business should end 2010 with a run-rate of $5.16 million. By hiring the two new reps. that can be increased to $6.24 million, even though the two new reps. are productive for only six months. That incremental run-rate of over $1 million makes a huge difference and sure makes hiring the two new reps. look a whole lot more attractive than the meager incremental revenue they will generate in 2010.

Here are the key takeaways:

1) Get the Base Right: Recurring-revenue businesses are great because they are highly predictable. Applying the rule of 78s and with a little understanding of your sales resources and their productivity, you should be able to estimate your baseline next year revenue with a high degree of confidence.

2) Scaling Takes Time: The most common mistake I see recurring-revenue entrepreneurs make it to underestimate the time it takes for increased sales and marketing resource to impact the top-line. Hiring new sales people today probably won’t move the needle on your next twelve month revenue. More likely, an investment in sales and marketing won’t have meaningful impact until the following fiscal year.

3) Run-Rate Matters: You will see the impact of an investment in sales and marketing in run-rate much faster than in top-line GAAP revenues. If you are asked about what your revenues will be next year, answer the question directly, but also include a description of the difference in the run-rate you expect to end the year with under the no-growth and growth scenarios. The run-rate difference will impress much more than the top-line difference.

By the way, the CEO of the SaaS company I was speaking with got this analysis dead-right. Well done!

Filed under: Economics, Lessons Learned, SaaS, Uncategorized, Venture Capital, ,

July 30, 2009 • 10:37 am 3

Financing a Services Business: The Valley of Death

It is a late afternoon ritual for me to read the Meritage Minute, a daily briefing on key news events published by my colleague Heidi Longaberger. If you would like to receive The Minute, email Heidi at: hlongaberger@meritagefunds.com. Yesterday’s briefing included an AlwaysOn piece titled “In Ten Years Will All Apps Be in the Cloud?” I’m not here to debate the merit of the piece; ”all” is a strong word despite the fact that directionally, movement toward the cloud is inevitable. The article lists a series of challenges of moving into the cloud, most of which are the same FUD often touted by those that don’t quite understand. And of course there is the compulsory Twitter data breach mention. Despite that, the last paragraph contains an important nugget of wisdom; a challenge all services businesses (including those in the cloud) face which has nothing to do with technology, scalability, security or compliance. Here it is:

Return on Investment. From a VC standpoint, it takes a long time to run a subscription business past the Valley of Death.  Time to revenue for a cloud business is very long, because revenue comes in a stream, not a lump. Driving sales has to be very swift and very focused.

This is essentially a financing challenge. It is all too often overlooked by entrepreneurs. Services businesses can be capital efficient, but are not necessarily so. To understand this fully, we have to look at both the cost and revenue-sides of the business.

Build it Before They Come

In the services business, you have to build the service before you serve the first customer; not just the product, the entire service. The product analogy is the R&D that goes into hardware/equipment design or into software development in the software business. But in the services business, the stakes are higher, you also have to create a customer service infrastructure, billing and operating support systems, and service delivery infrastructure to wrap around your offering. These costs are ongoing, they are not one-time and sunk. Worse yet, all that infrastructure has to be supported by staff. Early in the businesses’ development, the services operator is by definition operating at well less than minimum efficient scale, so these up-front investments can consume significant amounts of capital and look highly inefficient on paper. Simply “outsourcing” these functions is not the solution. You are still running at sub-scale so whoever you outsource to is going to charge you rates that reflect your scale.

The point is that the services business has a significant minimum cost structure that is required to deliver on a minimum required level of customer support, quality of service, uptime, sla management, etc. Relative to other businesses, the cost structure is high fixed operating cost, low marginal cost per incremental customer. Now lets look at the revenue side of the equation.

Delayed Revenue

One of the appealing elements of the service delivery model for customers is that they get to swap up-front CapEx (think hardware and software purchases) for a delayed, consumption-based payment stream. This is well and good for the customer, but has some significant implications for the services operator. The first and most obvious issue is that the receipt of cash is delayed; that is challenge enough.

But what happens when you miss your bookings of incremental monthly recurring revenue (MRR)?

The Rule of 78s

Those of us who have been around services business have internalized a concept called the rule of 78s. Lets say you project your company will book $50k of new MRR during your first twelve months of revenue generation. The rule of 78s say that the company will generate a total of $3.9 million ($50k * 78) of revenue over that year. [Note: 78 is simply the total of the revenue months during the year; 12+11+10+...+1] But what happens if the company does only $25k of MRR bookings. Now the first year revenue is only $1.95 million. The company just missed its revenue number by$1 million and that miss is probably all incremental burn because of the high fixed cost, low marginal cost of operating the business. I’ve taken a bit of a liberty (albeit a small one) on the cost structure assumptions here, but you get the point.

Run-Rate Matters

Now lets look at where the company stands at the end of that first year of revenue generation. If the business hits the $50k MRR bookings number, the end of year run-rate revenue is $600k. But if the Company does only half of the projection, the end-of-year run-rate revenue also drops by half; to $300k. Again, the difference, in this case $300k per month, is probably all incremental burn, because of the cost structure of the business. So not only has the company burned $1 million more than anticipated in the first year, but the business is also burning $300k per month more than projected at the end of year. If your fixed operating costs are $600k per month, the business is 2 months away from covering fixed operating expenses under the $50k MRR bookings scenario, but 12 months away under the $25k MRR bookings scenario; assuming no churn. This gap between fixed costs and recurring revenues is the Valley of Death referenced by the AlwaysOn author. Further delays in revenue acquisition are going to exacerbate this problem, particularly if your fixed operating costs are higher than $600k. MRR bookings misses don’t just impact the month of the miss, but reverberate though every subsequent month.

Skeptical not Cynical

You can understand why investors are weary of investing in services-delivery model businesses early in their life-cycle. And so far, we’ve only addressed the costs and revenue economics of the business at an income statement level. We haven’t even begun to address the uncertainties around customer profitability, including the lifetime value of a customer, which makes investors really queasy. Profitless prosperity (think Vonage), is a scary concept to investors and without operating history to prove out metrics around customer acquisition costs, ARPU, churn, renewal rates, costs to serve, there is a bunch of guesswork to be done, educated as it may be. I’ll address some of the issues around customer lifetime value in future posts.

Don’t fret, all is not lost. Some of this, particularly on the cost side can be managed. Better yet, there are actually investors who prefer the services model (I happen to be one of them) and understand how to build services businesses. Having uncovered some of the services businesses flaws, I’ll talk about why I prefer it in future posts.

Filed under: Cloud, Economics, SaaS, Venture Capital, , , , , ,

July 20, 2009 • 4:44 pm 8

SaaS and Software: A distinction with a difference

Anyone who knows me reasonably well knows that I tend to be a structured (albeit non-linear) thinker and that I have a penchant for semantics. Words have meaning and are not to be trifled with. Words with different meanings should not be used interchangeably; they have different meanings for a reason.

So when I got a call from a “adviser” to a growth stage business today promoting a “software company in the human capital management space” , I near about turned it down on the spot. You see “software” doesn’t fit in my investment thesis; “SaaS” does. You can imagine me saying:

I’m sorry, I don’t invest in software companies. I don’t like product company economics, including software license economics. I do however invest in SaaS. You see, I like recurring revenue businesses that have a long-term relationship with their customer. I like to sell something once and get paid many times over that long customer relationship. I like businesses with economies of scale, where the “next customer” has a higher contribution margin than all prior customers. I want to invest in businesses that have operating leverage and can be built into meaningful stand-alone businesses.

Thank goodness I’ve learned that all too many people use the terms software and SaaS interchangeably. So I asked the adviser.

How does the company deliver its solution, through software or SaaS?

His response:

SaaS.

Now we’re talking!

Old handles die hard

The adviser who called me isn’t the only person who’s made this mistake with me. Heck, one of my current investments, IP Commerce, once pitched me that they were a “software company”.  I had to turn them around on that notion; “no, you are an on-demand service”. More recently, I had the a conversation with a cloud-services executive who made the same error; “no, you do not deliver a product, you deliver a service”.

I don’t begrudge anyone whose has used the words interchangeably. It is understandable in some ways; it is hard to let go of the past, and software is clearly the past when it comes to SaaS. People are clearly finding it difficult to shed the product-orientation of software for the services-orientation of SaaS. But let go we must! Why?

More than semantics

There are huge distinctions between software and SaaS. This isn’t just semantics. My Partner Doug Holladay would call this a ”distinction with a difference”. Which is to say that software and SaaS are two fundamentally different business models with fundamentally different:

  • underlying economics
  • key success factors
  • operating skill sets
  • capital formation needs

The point is that the differences between software and SaaS are more important than what they have in common. About the only thing that SaaS and software have to do with each other is that SaaS service-delivery infrastructure is software-based. But can you think of an on-demand services business; telecom, CRM, payments, cloud, securities trading, etc, etc. where that is not the case? I can’t (at least not one where I’d invest); its all software on the back-end. You don’t hear telecom companies proclaiming that they are “software based telecom”.

Yes, SaaS and software compete for market share in the vertical markets in which they overlap; which is just about every vertical market. And that is where the distinction really matters. Selling yourself as software when you deliver via SaaS is like pitching a netbook as a mainframe. It is a step backward. In most application verticals, SaaS has such overwhelming advantages against software from just about any perspective you can imagine (customer, operator, or investor), that any SaaS operator who utters the words “we’re a software” company is seriously degrading the value proposition of their solution.

 So don’t do it. Be proud of the merits of on-demand operating model you’ve chosen. Sell against software; not side by side with it. You have a distinction with a difference!

Filed under: SaaS, Themes

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