Software as a service (SaaS) companies are frequently misunderstood because they are investing for the long-term and don’t generate accounting profits today.
This gives bears the ammunition to argue that these companies won’t ever generate a profit. It wasn’t long ago when quite famous “value investor” hedge fund managers were short Amazon and Netflix because they were perceived as “tech bubble” stocks. (Actually, it was a while ago: the episode I’m referring to dates back to 2014, and it wasn’t the last one.)
The mistake they made was to ignore unit economics.
Walmart spent the first 19 years of its life as a public company—its IPO was in 1970—consuming, rather than generating free cash flow. It produced accounting profits, but the company had to keep raising capital to fund its operations.
A bear, looking at Walmart, would have wagged his finger and said, “One of the principal bullish assumptions supporting many bubble stocks is, ‘the company is growing too fast to be very profitable.’”
But the unit economics are what mattered: Sam Walton was busy expanding his store base. Each store required a certain amount of capital to build, staff, and stock. Profits at the store level flowed over time, providing an attractive return on investment. But that return was masked by investments in new stores. The company appeared to be a money pit, consuming ever-larger amounts of cash.
It wasn’t until 1989 that Walmart turned free cash flow positive. But it was worth the wait. I don’t have return information for the entire period, but from around mid-1972 through the end of 1989, Walmart stock went up 9,139% while the S&P 500 Index increased by just 575%.
Was it smooth sailing? No. It was just as challenging for Walmart then as it is for young companies today.
Walmart’s founder Sam Walton wrote in his 1992 book:
“We've had some tremendous fluctuations of our stock over time. Sometimes it will shoot up because retailing has become a fashionable sector with the investment community. Or it will plunge because somebody writes a report saying that Wal-Mart's strategy is all wrong.
When we bought a chain of stores called Kuhn's Big K in 1981—which took us east of the Mississippi for the first time in a significant way—several reports said we were taking on more than we could handle, and that we would never make it once we got to Atlanta or New Orleans. We've had reports predicting that when we got to St. Louis, or wherever, and met some real competition, we would never be able to stay profitable. Our demise has been predicted ever since we hit the stock market. And whenever one of these big institutional investors reads something like that, and decides he believes it, he unloads a million shares, or 500,000 shares, and in the past that has created some fluctuations in the price of our stock.” (Emphasis added.)
Fast forward to today, and SaaS or software-as-a-service companies, appear to have absolutely nothing in common with Walmart.
Except in many ways, they’re exactly like it. Rather than investing through the cash flow statement and showing accounting profits, though, SaaS companies present a double challenge to analysts: they invest through the income statement and show neither accounting profits nor free cash flows.
Instead of building stores, SaaS companies acquire customers. For enterprise software companies, customers might be large contracts with corporations, or “seats” adopted bottom-up in different company departments. Either way, there is a cost to acquire those customers, which shows up in the sales and marketing line item.
Once the customers are “in,” they pay back the investment through software subscriptions that only flow through the income and cash flow statements over time. Walmart had expenses to build the stores and stock the shelves; SaaS companies have sales and marketing and importantly, software engineers to keep the software running and always updated with new features and functionality.
Example of an LTV/CAC calculation.
Like Walmart, SaaS companies consume large amounts of cash, and appear to lose money the faster they grow. Like Walmart, the unit economics are critical in the evaluation of a SaaS company. What is the return on investment on those acquired customers? What is the payback period on sales and marketing? Does the company have a “leaky bucket” problem, acquiring customers only to see them leave (“churn”)?
These questions all have answers. But it’s not possible to glance at an income statement and answer them. An analyst must do the work, but that work is rewarded.
Even sophisticated investors misunderstand SaaS. In early 2019, I was at a SaaS conference in San Jose, California. I ran into the famous CEO of a software company, who shall remain unnamed.
“My investors urged me to come here,” he told me, “But I think this is a bubble. It’s like the old California gold rush. You see, even after 20 years, Salesforce still isn’t profitable. What hope is there for all these other SaaS companies?”
Salesforce is the company that effectively created the category of software as a service. It went public in 2004. Since then, the stock is up 7,556 percent compared with only 450 percent for the S&P 500 index. Not bad for an unprofitable company.
Marc Benioff, founder of Salesforce
Except Salesforce is massively profitable: look at the cash flow statement. The company has generated around over 20 percent free cash flow margins since 2017 (margins were also high in 2004, but declined, presumably because the company was investing for growth in the intervening years).
Critics will point out that Salesforce’s free cash flows—indeed, the free cash flows of any meaningful tech company today—adds back stock-based compensation and treats it as if it weren’t a real expense.
The way I think about stock-based compensation is that it’s a very real expense, but the way to account for it is by diluting the share count over time. As a business owner, I’m hiring talent and paying part of their salary in stock. This dilutes my ownership in the business, and hopefully aligns the incentives of the talent I’m hiring, with mine. Adding back SBC gives us a sense of the cash the business is generating. This works because the stock will go higher if value is created: markets are relentless at punishing dilution without value creation.
Real-world evidence seems to back this view. Salesforce’s stock price performance has been exceptional including the fact that shares outstanding increased from 382 million in 2004 to 986 million today. Look at other successful tech companies, and the story is similar.
Value investor Tom Russo always talks about "the capacity to suffer" in his companies: management teams who don't have the principal-agent misaligned incentives problem, and are willing to burden the income statement today, to reap benefits tomorrow.
One canonical example he cites is Nespresso, which cost Nestlé a lot of money to incubate and develop. It burdened the income statement and reported margins for a while, but ultimately flourished and became an excellent business.
This "capacity to suffer" is most evidently expressed by companies without principal-agent misaligned incentives problem: those run by founder/CEOs, especially if they have a controlling stake or super-voting stock.
In SaaS, the "capacity to suffer" is even more necessary as "building the Nespresso factory" is not capex (cash flow statement) but rather "R&D and S&M" (income statement). Whereas Nestlé or Walmart might have been able to burden their income statements only somewhat (since many of the growth investments appear in the cash flow statement), a SaaS company has no choice.
The faster a SaaS company grows, the more money it loses on a GAAP basis. This is why SaaS investors invented the “Rule of 40”: a company growing at 40% should break-even. A company growing at 30% should have 10% profit margins. A company growing 60% can have -20% profit margins.
This highlights the importance of understanding unit economics: the return on investment on acquiring customers (typically expressed in LTV/CAC or CAC Payback Period calculations). When the unit economics are attractive, the optimal strategy is to keep acquiring more customers, even at the expense of short-term losses.
Founder-led SaaS companies are, therefore, like a turbo-charged version of the Walmart or Nespresso story. Founders have the control they need to put pedal to the metal and grow aggressively, income statement be damned. The economics of SaaS make the income statement not very helpful anyway.
Now, let's add another layer to the story: growth investments beyond acquiring users. At this point, the founder/CEO is really testing the market’s patience.
"You're telling me you're not going to generate any accounting profits for a long time while you acquire users in a massive market?... Ok, fine. But now you're also going to invest in all these other initiatives, where we won't see the payoff—if there is any at all—for years?"
This is the narrative playing in many investors’ minds in today’s bear market. Folks who were clamoring for growth despite losses just four months ago are now begging for slower growth and higher profitability. Founder/CEOs with a clear vision of the prize ahead will be able to resist the siren call of “profits now” and go for the long-term win. It’s the ultimate marshmallow test.
In an interview with a16z investor Scott Kupor from 2019, Ron Gill, CFO of SaaS company Netsuite, laid out the economics of SaaS, and explained why these companies are so valuable:
Ron Gill: I think there are some fundamental reasons why dollar SaaS revenue is more valuable than a dollar of non-recurring revenue. I mean, there's the fundamental aspect that it recurs.
That's probably the first thing I would say: the annuity aspect is so valuable. If you look at a company like NetSuite, a high retention, low churn SaaS company, and you do a cohort analysis, you get a year over year increase in value of the entire install base of customers.
So more than a hundred percent, even after attrition, after churn, a year later, the install base is worth more than it was the year before. And that means that acquiring a customer is a huge value. You're acquiring better than a perpetual annuity every time you acquire a customer. So that dollar of revenue that's on the P&L (profit and loss statement) this year, this quarter, represents better than a perpetual annuity of that revenue, which is fantastic.
So that's the first reason. The second reason is really because that annuity is not very expensive to maintain, a company like NetSuite has a gross margin on recurring revenue that's 86%. It's a very profitable annuity.
The big biggest portion of SaaS P&L is spent on sales and marketing. But I would argue that that is being spent on acquiring growth, and a small portion of sales and marketing is going to maintaining that annuity. And so what we see is that whenever a SaaS company turns down the growth, we get profitability and cashflow falling out of the model very quickly, very dramatically. For NetSuite it was 2009, the worst recession any of us have ever seen. Revenue growth slowed from the forties to about 16% in 2009. But that was the year we became net income positive.
That was the year we became operating cash flow positive. That was the year SuccessFactors became operating cash flow positive, in the middle of the worst recession any of us have ever experienced.
And it's because nobody in 2009 was planning for 40% growth the following year, where everybody was in a much more conservative place then. And in that environment, all of a sudden you get profitability, all of a sudden you get cash flow.
So I think that's the second reason is that I believe that the SaaS companies really are inherently quite profitable, quite cash flow generating, and that the profit and the cash flow is being used currently to purchase future growth, to purchase more of those better than perpetual annuities, which is certainly worthwhile.
And then the third reason, I think, that the SaaS company valuations are high, that makes sense, is there is a fundamental transformation taking place.
I lived through the mainframe to client server transformation that happened in the nineties. I was at SAP when R3 was coming out and sort of taking over the world then. Nobody survived that transition. It was just an architectural, just a technical transition from a mainframe model to a client server model. There was no business model transformation. It was perpetual license to perpetual license. And yet no vendor survived that transition.
You ended up with all of the three letter acronyms, ERP, CRMs, supply chain management, all of those emerged in the client server market with nobody really making the transition from mainframe to client server. And I think, I believe very much that that's what's happening again. That's what I believed in when I came to NetSuite in the first place. And I really see that happening.
So I think the third reason of the high valuations in SaaS is because there really is a transformation. And I really believe that the SaaS companies really are going to take over a lot of the markets. It's a much harder transition this time. It's not just, I need to build a similar solution on a new architecture. It's, I've got to do that and transform the business model from everything upfront to deferred over time. And that's a very hard transition for companies to make. So I think a lot of the SaaS companies are really going to take over the space that they're entering.
Scott Kupor: Yeah. So that's interesting maybe just to tease out a couple of those things. So, one thing that you mentioned is this idea of the inherent leverage and scale in these businesses. And that sales and marketing expense, which is really kind of a forward-looking measure of where the growth can be, is a lot of what, when people complain about gee, these SaaS businesses are great, but we're not seeing anything drop to the bottom line. It sounds like one of the things that you believe is we could inherently get these businesses profitable tomorrow if we decided we didn't want to grow at 25 or 30 or 40% a year. And so the leverage is there. It's just that the future growth opportunity is so high that the investments in sales and marketing are scaled so that we can actually get to what we think is long term market dominance in these companies.
Ron Gill: Yeah, that's exactly right. And you certainly want to make sure that you're investing in such a way that you're getting the yield. So there's a whole bunch of other metrics that you're going to use to make sure that the money that you're spending in sales and marketing is doing what you're trying to do with it. And it is turning on a bunch of perpetual or better than perpetual annuities. That it is really yielding as it has before, maybe even that yield's increasing. You don't want to be just spending money foolishly.
So you're going to use other metrics to tell that. But fundamentally, if you're looking at the sales and marketing expense on the P&L of a SaaS company, you're comparing that to the revenue this period on the P&L of the SaaS company, you're comparing the wrong thing, right? You're comparing an investment that's being made in future annuity to a revenue that's just today. If you have an extremely successful quarter in SaaS, you may turn on a lot of annuities. You'll see none of that in the P&L, in the quarter that you do that.
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