Why do SaaS companies, such as Slack, continue to lose money as they grow? Why are investors okay with it and even encourage it?
Money-losing enterprises may remind investors of the dotcom bubble in the late 1990s. Back then, companies were losing money; they were valued on “eyeballs” and prioritized growth at all costs. It all ended with a pop—hence the term “dotcom bubble”—so it makes sense for investors to be wary of making the same mistake twice. However, we need to be careful not to blanket all loss making businesses the same, particularly SaaS businesses.
Back in the days before SaaS, software companies like IBM or Oracle sold software as a one-time perpetual license. They later sold upgrades and consultation for future revenue. In this model, customers pay a large one-time license fee up front and maintenance fees in the later years. The large license fees get recognized as revenue immediately, and so do all of the costs associated with the sale, such as engineering, sales, and marketing. In this model, the revenue and the costs closely reflect the true economics of the business.
On the other hand, in a SaaS business, customers sign up to use software on an ongoing basis, which is called a subscription, sometimes with a contract and sometimes without. There are no license fees and no maintenance costs. With a subscription model, companies can recognize revenue only as the service is delivered, generally on a monthly basis. So even if a customer signs up for a 3-year contract and pays up front, revenue is recognized when the service is delivered. However, costs such as engineering, sales, and marketing are all recognized immediately. The traditional accounting methodology mismatches revenue and costs for SaaS businesses and, therefore, does not reflect the true economics of the business.
As long as the lifetime value of a customer (LTV) is greater than the customer acquisition cost (CAC), it theoretically makes sense to continue to acquire more customers. As a result, SaaS companies will grow fast and lose money faster on the accounting books. They do this because for every dollar they spend to acquire a customer, they generate more profits in the long term, as long as LTV is greater than CAC. Once the business matures and growth slows, the delay in revenue recognition will be shorter, and the company will scale. The company will then generate outsized profits on the accounting books.
Something to watch out for as you read more on LTV and CAC is the so-called rule of thumb saying that a LTV-to-CAC ratio greater than threefold represents a healthy SaaS business. We’d like to caution our readers on rules of thumb in general. The LTV and CAC can be calculated in many different ways and, hence, manipulated. The goal is to make sure that the value of a customer is greater than the cost of acquisition. This means truly understanding the customer and the costs. As in any other case, the devil is in the details.