Profitability Challenges When Introducing SaaS

Biking up Haleakala, Maui - Filip Szymanski

When introducing SaaS at an enterprise software company, there are a number of factors that impact EBITDA (earnings before interest, taxes, depreciation, and amortization) and the profitability challenge only gets bigger when growth accelerates. From my experience, you have to consider the following factors:

Delayed Revenue. SaaS is a subscription business model where revenue is recognized as the service is delivered. So that fantastic $300k License deal the sales rep was going to close is now $150k/yr, and if you close the deal in Q4, that revenue starts the following year. When switching to subscription, you should expect a revenue dip before it starts to recover and all that “deferred revenue” starts to stack up. That is why you need executive buy-in, and if you are a public company, this has to be messaged carefully to investors as there will be an impact to EBITDA in the near term.

Sales Behavior: SaaS or License? If you compensate sales $1 License = $1 SaaS to protect EBITDA, you are not going to get many SaaS deals unless the customer insists on SaaS. Using our previous example, if you compensate sales reps for License + 1yr Support, a $300k License deal + 20% first-year Support is going to retire $360k in quota. And if the comparable SaaS subscription is $150k/yr, that’s all that the sales rep will retire in quota if you pay on ACV (annual contract value). To avoid a lopsided situation, you can introduce an ACV “multiplier” such as 2.5x, so the $150k/yr SaaS deal turns into $150k * 2.5x = $375k in quota retirement. That looks about the same to the sales rep and should promote customer choice, but now you have quota setting dilemma.

Front Loaded Costs. Sales quota is retired when the deal closes to motivate sales reps. Because revenue is recognized as the service is delivered, the sales expense is typically more significant than the revenue during the sales period. Paying commissions will impact your EBITDA and may even create a cash flow crunch when ramping up sales. Bottom line, you should plan for the sales expenses ahead of time, especially if you anticipate a large volume of SaaS deals. That’s why SaaS companies are well funded, and the reason they get a bad reputation for not being profitable. Sales and Marketing expenses are through the roof to acquire customers as quickly as possible (and yes, the theory is that once growth slows down sales and marketing expenses will drop and profitability will increase significantly).

Margins. Multiple factors impact SaaS profitability, including the scale and maturity of business. Don’t be surprised when launching a new SaaS offering that it costs you more to operate it than the revenue you recognize. The faster you achieve scale, the better the margins, though undoubtedly different products have different margin profiles. Compare yourself to the competition - data is publicly available on a variety of SaaS companies. My rule of thumb, you should be 70%+ gross margin when revenue crosses $10m/yr. If you are taking an existing License product and creating SaaS from it, the offering may very well be more of a Managed service vs. Modern SaaS with a lot more hands-on operations which are costly. Regardless of how profitable you make the SaaS service, it's going to dilute License margin and will impact EBITDA.

Discounting Behavior. Unlike License deals where you can get away with a 90% discount and still make money, that is not the case with SaaS. Let’s say for our example the list price of SaaS is $200k/yr at 78% gross margin. The sales rep discounts the deal 25% and arrives at $150k/yr subscription price, now at 70% gross margin. If the customer is used to 50% discount on License, they may insist for the same for SaaS, and it’s not uncommon for the sales rep to discount accordingly ending up at $100k/yr. But unlike a License deal where there is no service operations expense, the SaaS deal quickly turns into a 55% gross margin deal (after all, the $45k service cost stays constant). Ouch, there goes your EBITDA! And of course, the picture gets worse, because you still have ongoing RnD expenses not to mention sales, marketing, and administrative costs. To control discounting behavior, you will need a discount control process based on margins, either by having service delivery organization own the discount approval past a certain threshold (can be set at the level when margins fall below average) or you can add a variable to sales compensation for profitability (harder to implement).

I hope this helps you manage profitability when introducing SaaS at your software company. For a primer, please check out my article: Introducing SaaS at an Enterprise Software Company.

@FilipSzymanski is a Silicon Valley business leader, visionary, technologist and advisor, with two decades of Enterprise Software experience. Most recently, he led a SaaS transformation at HP / HPE creating a $100m+ business to compete with emerging Cloud vendors. He also advises startups in creating compelling business plans, taking new products to market and implementing operations with solid financial discipline. Formerly he held a variety of positions in Strategy, Product Management and Technical Sales that shaped his interest and passion for technology and Software as a Service.