The Capital Needed to Create a SaaS Company

This is a follow on to my post on July 18th, 2008 titled “Does it Really Take $100M to Build a SaaS Business? Say it ain’t so, Joe!”. As part of some research I’ve been doing, I wanted to dig into the actual amount of capital it takes to make a successful SaaS company.

Wachovia Securities issued a report in May 2008 on the state of the SaaS market. On page 25, it shows amount of capital paid in prior to an IPO for 18 out of the 28 public SaaS companies. Here is that list below:

Blackboard                     $100.7M
Concur Technologies     $  30.2M
Constant Contact           $  37.3M
DealerTrack                    $  48.0M
DemandTrack                 $  42.0M
HireRight                        $  29.2M
Kenexa                            $  54.5M
LivePerson                      $  41.6M
NetSuite                          $  84.9M
Omniture                        $  66.9M
RightNow Technologies  $  32.2M                      $    5.7M               $  64.5M
Solera                              $   5.7M
SuccessFactors               $  54.5M
Taleo                               $ 36.9M
Ultimate Software            $ 25.1M
Vocus                              $ 26.4M

Mean                               $43.5M
Median                            $39.5M

So, it doesn’t really take $100M but the data seems to suggest it is still an expensive proposition. Let’s call it $40M — this is still 2-3X the amount of capital required for a traditional model software company to reach profitability/IPO.

However, this is where the details matter. It turns out that these public SaaS companies, on average, raised about $25M at strong valuation mark ups and invested this amount primarily on sales and marketing in the year prior to going public. For example, raised $47M in November 1999 at a 224% step up in valuation and IPO’d just five months later in March 2000.

This makes sense when the data shows that Wall Street gives much better valuations (multiples that are possibly 2x-3x greater) to those SaaS companies able to demonstrate strong revenue and subscriber growth rates.

Consequently, if you eliminated this average $25M investment from the paid in capital, SaaS companies don’t look that much different from traditional software companies in terms of total capital required to either reach a liquidation event (e.g. IPO) and/or profitability.

All that said, SaaS companies do need to aggressively monitor and manage their customer acquisition costs (CAC). If Annual Contract Value (ACV is the expected annual stream of cash flows expected from each subscriber) is relatively low against the cost to initially acquire the customer, then the SaaS company can quickly get into cash trouble.

This is why I like my portfolio companies to constantly monitor and manage their customer acquisition to ACV ratio. A good target ratio to strive for is 1 or less — far less being the goal. That is, when you divide the total customer acquistion costs by the first year ACV, the resultant should be a number equal or less than 1. Customer acquisition costs should include: all direct and indirect marketing costs, commissions, and T&E.

In order for the SaaS business model to work, it’s critical to keep sales and marketing costs as low as possible. This means highly leveraged marketing programs that make the product as “viral” as possible — enabling current customers to easily tell others about the success they are having. And, sales costs must be kept down by using the website to answer as many questions as practicable, using customer video testimonials, self-service demos and web conferencing instead of travel for sales meetings.

In fact, if you’re a SaaS CEO, for 2009 I suggest you consider compensating your sales and marketing executives based upon achieving a pre-determined CAC/ACV ratio. This will force your sales and marketing organizations to work far more closely together — what a concept.