Saturday, February 20, 2016

That’s a nice little $1-2M SaaS company you have here. Call me to discuss if it will scale!

About two years ago, Josh Hannah of Matrix Partners wrote an excellent article titled “That's a nice little $40M eCommerce company you have there. Call me when it scales.” In it he argues that an eCommerce business with $10 to $20 million in revenues is not that hard to build and also not very valuable. I would recommend that you read the full article, but one of the key points of the article was that if you fill a niche and have distinctive product/market fit with a set of customers, you can acquire customers very cheaply - up until a certain point, when you’ve maxed out the cheap customer acquisition channels and need to tap into more scalable channels. At that point it becomes a lot harder because the next set of customer acquisition channels will likely be much more expensive.

As a side note I’d add that the value of an eCommerce business with $10-20 million in revenue can be even more deceptive if a company has burned a lot of money to get to this level and has very low (or even negative) gross margins. The reason is that in most categories online shopping has become ultra-transparent (something which I’m not completely innocent of ;-) ) and that there’s a group of highly price-sensitive customers which always goes for the lowest price. So if you start an online shop, offer products at a loss, get listed on some of the biggest comparison shopping sites and do some affiliate marketing, you can easily get to tens of millions in revenue.

Now let’s talk about SaaS. In the last few years I’ve come to the realization that Josh’s observation can also be applied to the SaaS world: Building a SaaS business with $1-2 million in ARR is not that hard and not that valuable. Let me rephrase that. Starting a new company is always hard and most SaaS startups never get to $1-2 million in ARR. Every founder who accomplishes this deserves a huge amount of respect. The point is that getting to $1-2 million in ARR probably has less predictive value concerning a company’s ability to get to true scale than most people think – or at least thought some years ago.

The reason, I think, is that over the last 5-10 years it has become much easier to build a SaaS product and get initial traction:

  • Building a web application has become much easier, faster and cheaper. Whether starting an Internet startup has really become 10x cheaper depends on how exactly you phrase the question and is debatable. But creating and launching a SaaS product has without a doubt become much cheaper in the last ten years. Moore’s Law, cheaper hardware and more bandwidth are one factor, but the even more important factor is that today there are great products for so many of the issues which the previous generation of SaaS founders had to worry about (billing, analytics, server monitoring, application performance, live chat, to name just a few … even AWS didn’t exist 10 years ago!).
  • Ten years ago, there was nobody who SaaS founders could ask in order to learn how to do, for example, inbound marketing, low-touch sales or customer success. Many of the tactics that everybody is using today hadn’t been invented yet. In the last ten years the playbook has been written and subsequently published. As I wrote in my post about the rising table stakes in SaaS, today an abundance of knowledge about any imaginable SaaS topic is readily available online and events like the fantastic SaaStr conference last week allow founders to learn from people who’ve done it before.
  • As SaaS is quickly becoming the norm, it’s now much easier to get initial traction. In any given category, the number of potential customers who considers (and in most cases prefers) a SaaS solution is much higher than it was some years ago. This and the fact that almost everybody owns a smartphone today has given rise to new categories which previously weren’t software categories at all because people used pen and paper to get the job done.

So – it has become much easier to develop and launch a SaaS application and get initial traction, but if you have product/market fit in a small niche, which many SaaS companies do, it may be very hard to expand beyond that niche. And even if your market is large in principle, keeping growth up after you’ve picked the low-hanging fruits and reached a few million dollars in ARR will become increasingly difficult. In order to go from a $1-2 million in ARR to $10 million and eventually $100 million, you’ll have to find highly repeatable and reasonably profitable ways to acquire customers at huge scale. With few exceptions that means you either need to have a viral product (a.k.a. as hunting mice) or you have to go upmarket and dramatically increase your ACV over time.

Some SaaS businesses manage to do this and have a shot at building a $100 million ARR company, but for the majority of SaaS companies growth will taper off once they’ve reached a few million dollars in ARR, making it hard to ever grow significantly beyond $10-20 million. In a way, this isn’t surprising – not everyone can become a unicorn. :-) The non-trivial part of what I’m saying is that 5-10 years ago, many of these companies wouldn’t have gotten to a few million dollars in ARR. Put differently, there are more $100 million ARR SaaS companies today, but the number of companies in the $1-10 million ARR range has grown disproportionately faster. That’s my theory at least, it’s not scientifically proven.

If my theory is true, will this be bad news for people in the SaaS industry? It’ll depend on who you ask. It could make seed and Series A investing harder because the percentage of seed and Series A funded SaaS startups that becomes really big would decrease - and VCs need large outcomes in order to make their business model work. But it would also lead to the generation of a large number of small-ish but still very viable SaaS businesses, many of which could generate very decent profits for their founders. From that point of view, there’s never been a better time to start a SaaS company.

PS: You may have noticed that I’ve changed Josh’s “call me when it scales” to “call me to to discuss if it will scale”. Being a seed investor I’m trying to find SaaS companies that can scale before they have scaled.

PPS: If you’re wondering why Josh talks about revenues in the $10-40 million range when he refers to sub-scale companies while I talk about $1-2 million in ARR: The reason is that besides the fact that SaaS revenues are recurring, SaaS margins are almost an order of magnitude higher than eCommerce margins. $1 in SaaS revenues is much more valuable than $1 in eCommerce revenues (all revenue is not created equal!).

[Update 03/11/2016: I wrote a followup post to the post above.]

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