How much should my SaaS Business be investing in Sales and Marketing? A White Paper for SaaS Company CEO s and their Investors.

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1 How much should my SaaS Business be investing in Sales and Marketing? A White Paper for SaaS Company CEO s and their Investors.

2 How much should I be investing in Sales and Marketing for my SaaS Business? Few companies are satisfied with their return on investment in sales and marketing. New sales VP s never perform like you hope, and the new marketing campaigns seldom deliver the expected revenue pop. That said, we soldier on knowing products don t sell themselves, and the next great sales VP or marketing campaign might be just around the corner. So of course we all want to execute sales and marketing better, but fundamentally what we need to also ask is: Are our investments in sales and marketing creating value? Are they good enough to be increasing our company s value more than they are destroying it? If yes, invest more, if no, stop digging the hole! This paper will attempt to shed light on this important question from three angles. First, we will examine the relationship between sales and marketing investments and revenue growth. We will then examine the impact of revenue growth on a company s value. How big is the impact? These two examinations will provide the basis of a high-level sales and marketing ROI. The third perspective will be a closer look at peer benchmarking. How much are other similar software companies investing in sales and marketing? How does this differ by size of company, access to capital, and the current environment? If your company is investing a lot more, or less: why? The goals for the paper are modest. We simply want to arm CEO s and their investors with a clear context and understanding of SaaS company investments in sales and marketing and how they will impact the business

3 in the current economic climate. Significantly over- or under-spending can lead to a lot of wasted time and cash, or worse, missed opportunities. Part 1: Do higher investments in sales and marketing drive revenue growth? This question gets debated in board rooms across the country every day, and the answers are obviously different for each business, but there are data from the public companies that can help shape our thinking here. Do higher-growth SaaS businesses invest more in sales and marketing than slower growing SaaS businesses? The intuition here is not obvious as successful SaaS companies with a hot product could be spending less on sales and marketing, while weaker business pour money into growth but can t seem to move the needle. Both these cases certainly exist, however, in carefully looking at the data over the last two years, it s clear that the high-growth SaaS businesses invest more in sales and marketing than their slower growing rivals. The chart at the left compares the sales and marketing spend of 13 public SaaS companies for the first nine months of 2009 to their consensus expected growth rate for We use expected growth because for SaaS companies it s usually pretty accurate (much of next year s revenue is known) and it allows us to look at the most recent data while also allowing for the inevitable time lag between the time of the investment and the revenue it generates. The relationship is clear and surprisingly strong. Also note, no public company is spending less that 20% on sales and marketing, and more than half are spending over 40% of revenue despite the fact they are much larger than typical SaaS businesses. Going back a few years in the

4 data we find that the high-growth SaaS businesses have consistently spent more on sales and marketing. It s part of their business model and DNA, and reflects the fact that this is a long-term investment proposition. To be clear, this data shows correlation and not causation. That said, these are the top tier of all SaaS businesses that have collectively run hundreds of different marketing programs and many different sales models. If their high levels of sales and marketing investments were not a key component of driving their growth, they would have cut back their spending years ago. The relationship can also be supported by common sense examples. Firms like Salesforce.com, Omniture, and SuccessFactors have always been very open about the respective strength of their marketing and sales capabilities and their consistent investment in those areas. The companies in this analysis are the same ones as used by Pacific Crest in their weekly reporting except for Athena Health, which was excluded due to the impact of the Federal stimulus program. (If you are in a market like they are right now, you aren t reading this whitepaper anyway.) Part 2: Does the investment in Sales and Marketing pay off? Having established the relationship between investing more money in sales and marketing and generating higher growth, the question remains as to whether the higher growth leads to higher valuations that more than offset the ongoing investment. Part of this question has to do with how effective and efficient your investment is in driving growth, and part of it has to do with how growth translates into value. How efficiently sales and marketing dollars drive growth is very company specific. Much has been written about customer acquisition costs, CAC ratios, Magic Numbers and the like, and we won t dwell on that here. But just looking at the slope of the line in the chart above gives us a reasonable estimate of what is achievable based on a wide variety of recent SaaS company performance.

5 Based on the data above, it s certainly reasonable to assume that increasing sales and marketing from 30% to 40% of revenue can drive growth (over time) from 15% to 25%. For smaller companies the increase in growth rate might even be more dramatic given it takes less total new business to drive the growth rate. So, what would that kind of change in growth mean to valuation? How sensitive are SaaS valuations to growth rates? In a word: very. The chart below shows the relationship between expected 2010 revenue growth and the revenue multiple for public SaaS businesses. The faster you are growing, the more your business is worth. High-growth SaaS business command a 6x to 7x trailing revenue multiple, low-growth SaaS business trade at 1x to 3x. The difference is quite substantial. The other variable on the chart is the size of the business (size of the dot). Larger business are more stable and predictable and earn higher multiples for their given level of growth. Also, the larger businesses are still growing fairly rapidly, but their growth rate tends to be slow simply based on their size. So what about profitability? Surely the profitable businesses are valued higher? Actually: no. The profitable SaaS businesses trade at a small.6x revenue premium to the unprofitable companies, and that entire difference can be attributed to Salesforce.com. Currently, there is little to no correlation between profitability and valuation. Over time, there certainly will be a relationship, but right now public investors are comfortable with the notion that a SaaS business can generate profits (almost whenever they want), and investing in growth now will payoff in larger companies with larger profits later on. So is growth an important factor in valuation? Of course. The key take away here is that growth is the most important valuation factor by

6 several orders of magnitude. All other factors are essentially noise at this point. But why is growth such a huge value driver in SaaS businesses? The answer is straightforward. For many types of companies, growth in one year might be lost in the next year. Big deals come and go as do hot products. For quality SaaS companies, however, 90% of the new revenue you brought in this year sticks around next year, and the next year etc. The simple ROI on the payback when customers stick around for 5 years or more is huge. Everyone in the SaaS business has recognized this for years, but now the public capital markets are reflecting that value as well. So what s the payback? If your incremental marketing spend drives new revenue, your business grows in value two ways. More revenue equals higher value AND it drives a higher growth rate that equals higher valuation multiple for all your revenue. A quick example: Lets say a $5 million in revenue SaaS company doubled sales and marketing from $1 million to $2 million and was able to drive an incremental $500,000 in annual recurring revenue from their previous level of $750,000 in new revenue the year before. This would take the business from a marketing spend of 25% of revenue to 40% of revenue and from a 15% growth rate to a 25% growth rate. These are all reasonable assumptions given the relationship between spending and growth outlined in the first chart. The two-fold payback is: the new revenue, $500,000, times the appropriate revenue multiple, plus, ALL the existing revenue times a new higher revenue multiple based on the higher growth rate. Just based on the data above, the higher growth would push the revenue multiple from around 3.5X to a 7X. Since this is a small private company, lets say that move is from just 3X to 4.5X. Even cutting the public growth premium by more than half, the company still grows in value from $17 million to $28 million. An 11x return on the incremental $1 million investment.

7 Low Investment High Investment Base Revenue $5,000,000 $5,000,000 Normal Growth 750, ,000 Incremental Growth 0 500,000 Total Revenue 5,750,000 6,250,000 Growth Rate 15% 25% Valuation Multiple 3.0X 4.5X Enterprise Value $17,250,000 $28,125,000 If you can make your sales and marketing investment work even modestly well, the resulting impact on growth will drive significant value in your SaaS business. This analysis is based on public company data that gets massaged, manipulated and extrapolated. Do these relationship hold for private companies and their valuations? The short answer is yes. While less efficient and fluid then the public markets, VC s and PE investors consistently pay a premium for growth over efficiency. At the extremes: a zero growth but profitable SaaS business is unlikely to raise equity at any price in the current environment, while an unprofitable but highgrowth SaaS business (30% to 50%) growth will attract significant interest. Part 3: How much are other (non-public) SaaS business spending on Sales and Marketing? What are the trends? According to the leading software benchmarking firm, OPEXEngine, SaaS businesses across all stages are spending about 47% of their recognized revenue on sales and marketing. Breaking that down further, they spent 31% of revenue on sales, and 16% of revenue on marketing in OPEXEngine s trend data for 2009 for all types of software companies (SaaS and non-saas) shows a modest decline in overall sales and marketing spending in the first 6 months of 2009 as would be expected. However, the marketing component of that was actually up 27% from 12.1% to 15.4%, while the sales spend was down 18% from 29.1% to 23.7%.

8 For those of us in the business, that s not a surprise. SaaS businesses are still in the early stages of understanding and leveraging marketing automation solutions and web 2.0 techniques. As those solutions mature, marketing will play an ever-increasing role in demand generation. Another supporting data point is that in 2008, SaaS businesses spent about 16% of revenue on marketing while pure perpetual license business spent about 8%. Confirmation that companies selling SaaS, and those most receptive to buying it, embrace the web to conduct much of the transaction. OPEXEngine also captures data by the size of the software business, which they break into five different size categories. I can t share all their data here, but it does generally show that sales and marketing investments do scale over time and over large changes in revenue levels. The $250 million and above software companies were spending below the average levels referenced above, while the less than $10 million in revenue companies were spending considerably more. Conclusion: Despite some recent gyrations in the capital markets and a conservative bent to almost all new investing activities, the SaaS model clearly rewards those companies who can generate growth. SaaS is inherently stable by its very nature, so if you can get it to grow quickly and become large, it is even more valuable. It s good news for SaaS companies that the capital markets now recognize this. However, if your SaaS Company is not investing in growth, (as in 30% to 50% of revenue) the data shows the growth is not likely to happen on its own. The bar has been raised and there are multiple SaaS offerings in each vertical and horizontal segment. Customers will not beat a path to your door because you are SaaS. Quiet SaaS companies can grow and be profitable, but they do not create value like those who invest in growth and become leaders. Remember, however, the goals of this paper were modest. Investing more in sales and marketing might be a bad idea for many SaaS companies: a weak market, or product, or execution team can render the investment useless. And for other firms, the required capital is unavailable at any costs.

9 For many firms, however, the data presented in this paper should be fully incorporated into the overall set of considerations. Growth is an extremely powerful lever for SaaS companies, much more so than other business models. Increasing growth significantly increases value and liquidity options. Marc Benioff, Josh James, and Lars Dalgaard did not drive their respective SaaS companies to $15 million in revenue and then cut back on sales and marketing and stay up all night worrying about profitability or weak CAC ratio. SaaS businesses do scale, it is a sound business model, and even aggressive and somewhat inefficient sales and marketing investments deliver positive ROI s if you have the courage and capacity to sustain the short-term losses. The reward at the end of the rainbow is a very valuable cash machine. Post Script: The CAC ratio and when not to spend. A higher level of sales and marketing spend will drive down your CAC ratio. (Some less enlightened investors won t like this.) The business will become less efficient at customer acquisition on the margin as it tries to attract customers from an ever broader pool of prospects. In addition, the time lag between the investment and revenue is substantial and hard to predict or even track. It s OK to become less efficient with sales and marketing with each new marginal customer as long as it still delivers a positive ROI. That ROI should be determined by changes in the company s enterprise value as we did above, but it also needs to be reviewed on a per customer basis. If, for example, higher spending brings in new customers, but they don t stay very long, or your product does not deliver much incremental contribution margin, you might be driving top line growth but you might be taking an actual economic loss on each new customer. And while overall corporate profitability might not be critical during these ramp-up years, unit economics are. Growing a business with bad unit economics just destroys value faster. Generally speaking, compare your average customer acquisition cost to your average lifetime contribution margin.

10 In practice, very few SaaS business have bad unit economics, and the ones that do tend to flame out very early. The firms that need to watch this metric most closely are those with a below 75% gross profit margin, or those experiencing turnover above 15% per year. Appendix: Data Table for Public SaaS Companies as of 3/1/2010 Sales and Marketing Investment Company Revenue Multiple 2010 Growth Equity Value CNQR % 2,000 31% 30% KNXA 1.1 4% % 20% LOGM % % 67% RNOW % % 50% CRM % 8,616 46% 50% TLEO % % 32% ULTI % % 27% VOCS 2.2 9% % 45% SFSF % 1,331 54% 88% SLRY 0.7 8% 40 49% 68% CTCT % % 48% DMAN 1.8 6% % 27% N % % 52% Mean % 1,249 40% 44% Median % % 47% SaaS Capital Advisors is a strategic financial services advisor to software companies in the areas of M&A, partnerships, capital raises, pricing and valuations. We can be found on the web at saas-capital.com. OPEXengine is the leading benchmarking provider to the software industry and can be found on the web at OPEXEngine.com to participate in their surveys or purchase their reports.