The economics of on-demand services

A post by Ben Kepes over at CloudAve got me thinking about the economics of on-demand services, so I thought I’d do a quick blog. On-demand services businesses come in all shapes and sizes. This is particularly true today with the emergence of SaaS, where the vendor diversity is staggering. Despite the diversity of services – ranging from traditional communications services (think voice, video and data) to highly verticalized SaaS applications (think point of sale applications for yoga studios) – the fundamental economic building blocks of these businesses are, for the most part, the same.

You wouldn’t know it though based on the business plans I review and the discussions I have with entrepreneurs. Generally speaking, the CEOs of traditional communications services businesses that I speak with have a much more mature understanding of the core economics of services businesses than most SaaS executives. I attribute this to the fact that most SaaS executives I see come out of the software space, not the “services” space. And in the services business, there are fundamental economic concepts that simply put, don’t exist in the software business. So if you are a SaaS, PaaS or any on-demand executive whose business plan gets far enough down the Meritage Funds pipeline to have a hard-core conversation about the business’ economic characteristics, here are the things I will want to talk about.

Customer Acquisition Costs: It all starts with acquiring a customer. What are the marketing channels you will use, online, direct, traditional, sales channels, etc.? In each of these channels, what is the fully-loaded cost for you to close and implement a new customer? Do you have hard implementation costs; equipment, installation, setup? If the answer is that you expect customers to find you, go back to the drawing board. You will spend money to acquire customers, particularly if you hope to scale in any meaningful way.

ARPU: ARPU (average revenue per unit) tells me a ton about your business; the first thing being what you think the appropriate unit of measure is for your go to market strategy. So what is a unit? In a communications model, it is typically a “subscriber”. In a SaaS model it might be a seat or in an enterprise or smb model it might be the enterprise as a whole or the smb. Point being, it really depends on the level at which you are selling and where the purchasing decision is made at your customer.  ARPU tells me how much revenue you can generate per month out of a customer as you define it.

Price Degradation: With ARPU in mind, I also want to know about how you expect the price of your service to degrade over time. My experience is that prices for services tend to go down, not up, because as a service moves into a mass market phase from an early adopter phase, the value proposition is naturally diluted. The benefits that accrue to the mass market for adopting your service are less than those that accrue to the early adopters. If this were not the case, the mass market would be early adopters. If you believe that the value and therefore the price of your service goes up over time, be prepared to justify it. Some opportunities have natural monopoly characteristics where the addition of each customer adds value for all the prior customers. If this is the case with your business articulate clearly why this is the case.

Up-sell: Offsetting the natural price degradation in services, tell me about other services that you intend to offer in the future that will provide you with some ARPU lift. Service segmentation is critical, because this enables you to optimize the revenue you generate from your customer base. Be sure to not give functionality away in your base service that you may be able to charge a large percentage of your customer base for later.

Variable Costs: I want to know about all of the variable costs of your business on a monthly basis. These typically include commissions, infrastructure and other service delivery costs, customer support costs, billing expenses. The common thread being that each of these scales up with the number of customers you serve.

Churn: When you sign a customer, how long to you expect to keep them? What does the churn pattern look like; does most of your churn take place in months 1-3 or before the customer ever gets fully implemented? Once the customer is past the initial adoption phase, what percentage of your customers do you lose every month?

With these building blocks, I can make some key observations about your business and its potential to generate big profits. First, with ARPU, price degradation, and up-sell on the revenue side and your variable costs, I can determine your customer level contribution margin, the amount of monthly net cash you generate from a customer unit. If your customer level contribution margin is negative, no level of customer volume can save you. Some refer to this as profitless prosperity; you can sign customers, but never make a profit.

The second observation I can make is related, but less obvious; I can determine the lifetime value of your customer. By running the contribution margin through your churn calculations, I can estimate the lifetime contribution margin of a customer. This number must more than offset your customer acquisition costs if your business is to be profitable in the long-term.

From here, the questions all become about scale; how many customers can you sign, over what period of time and how many are required to cover the fixed costs of running your business.

Don’t worry, I won’t push you on these economics in a first meeting, unless your business plan is so clear that we can jump right into the economics. But rest assured, we’ll get into them eventually. If your business can’t prove out on these metrics, I probably won’t invest and you probably won’t want to spend the next five to seven years of your life trying to build a business that can never get to the finish line. Some may argue that these metrics apply only to enterprise, smb and related segments and that they don’t apply to consumer web 2.0. Unfortunately in the end, I think eBay’s experience with Skype and the poor track record of monetizing web 2.0 and social media are on my side of the argument in the long-term.

The economics of on-demand services