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Posted: October 21, 2013

Software-as-a-Service soars

Keys to driving business operations

Dan King

Software-as-a-Service (SaaS) business models continue to grow exponentially in Colorado. 

Key attractions for SaaS providers are: 1) predictable revenue; 2) customer profitability improvement over time; and 3) automation of multiple customers’ processes on a single version of software. 

Key attractions for customers to use SaaS products are: 1) predictable cash outflows because transactions are typically accounted for as an “operating expense” vs.” capital purchase”; 2) cost optimization (customers often only pay for what they use); and 3) customers can outsource functions to a vendor who can perform a specific task better, and cheaper.

With that, two critical business questions SaaS vendors should address is: 1) what’s my cost to acquire a customer? And; 2) what’s my cost to serve a customer after implementation?

The discussion below outlines these two concepts.  They are simple to understand but very difficult to manage.  The key demarcation between cost to acquire and cost to serve for this discussion is the implementation date:

Cost to Acquire – The cost to acquire/obtain a customer varies.  Common costs include engineering the product to general market specifications, marketing, sales, and implementation.  Indirect costs include Finance to profile deals, and legal, to negotiate contracts. 

A common financial metric for SaaS providers is a cost recovery metric called “cost payback in months” metric.  For example, if a SaaS provider acquires a customer at a cost of $1,200 (also known as Customer Acquisition Costs, or CAC), and the “profit” on the customer is $100 per month, the payback in months = 12 ($1,200 cost / $100 profit = 12 months).  A general rule is the cost to acquire a customer should be recovered within twelve months. 

Cost to Serve – SaaS is also about “services”.  The cost to serve is fundamentally critical to customer retention.  The most common costs to serve include ongoing customer service, operations, engineering the product to customer specifications, and account/relationship management.

A common financial metric for SaaS providers is a customer profitability metric called “customer lifetime value” (also known as CLTV).   For example, if the company acquires a customer for the same $1,200 cost in the example above, the “profit” on the customer is also $100 per month, and the average customer retention period is 48 months, then the customer lifetime value = $3,600 ($100 profit per month * 48 months = $4,800 – less the $1,200 cost to acquire = $3,600).  A fundamental general rule is the cost to serve a customer should, at a minimum, be a positive number. 

From there a vendor can refine financial effectiveness metrics through the CAC  / CLTV ratio, by dividing the customer lifetime value (CLTV = $3,600) into the cost to acquire (CAC = $1,200).  The example above calculates a ratio = 3 ($3,600 / $1,200 = 3).  What is not obvious is whether a ratio of 3 is good or bad.  Check with your investor group to determine your optimized number.

Additional thoughts:

Term – Annual or multi-year subscriptions can lock a customer into using the product for a while, which may command a list price discount in return for a longer commitment.  However, if a SaaS vendor isn’t aware of a customer’s dissatisfaction, the customer will not renew the service resulting in unexpected churn.  

Month over month terms can be favorable to customers and SaaS providers because the customer has flexibility over the term of commitment.  The SaaS provider is motivated to re-earn the business every month by providing a positive experience.  Month over month terms are less susceptible to discounts, but higher churn given the short term nature of the commitment.

Delivery Model – There are two broad delivery methods by SaaS businesses:  1) Fully managed; and 2) Self Service.  Fully managed frequently means the vendor provides access to use the software including a fully or semi-dedicated resource to help operate the platform as a whole.  The vendor cost to deliver this model is expensive and can unfavorably impact gross margins due to the cost of the resources. 

Self-service is just that, the customer has access to the software and is expected to operate the software themselves, while being provided a customer support contact for simple questions.  The vendor cost to deliver the model is less expensive and is usually favorable to gross margins given its lower cost to operate.

I find these concepts universal among all SaaS companies I work with and hope you find this information useful.  The consideration of the cost to acquire and cost to serve in a SaaS model is the beginning of more in depth financial and operating measurement techniques to consider.

Dan King is a financial operations leader with significant experience in venture capital and private equity-backed technology companies in software, SaaS, Cloud and ecommerce business models. He began his career as a CPA with KPMG in the Silicon Valley and is active throughout the Colorado technology and small business community.  Dan can be reached at djk235@hotmail.com

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