SF Has An S&M Problem

It’s a Friday night, and I am on the prowl. I’m with my friend Edgar, and we are looking for evidence of the increasing S&M problem among the denizens of America’s startup capital. We all know the story the past few months: it’s really bad right now, but don’t worry, everything will get better in time. But it is not getting better, and it’s time to call out our collective dirty little secret.

Our Sales and Marketing costs are killing us.

For years, subscription-based pricing popularized by Software-as-a-Service (SaaS) startups has been pitched to us as a way of reducing S&M costs. Traditionally, software was sold as a license along with a maintenance contract that ensured deep upfront revenues and a continuous stream of income.

Unlike the complexity of that on-premise implemented and managed software, SaaS was supposed to be simpler for customers to use and pay for. That simplicity not only saves on maintenance costs for overburdened IT departments, but also theoretically lowers the sales touch required for a sale, generating revenue efficiency for the provider. By pricing software as a subscription, startups forego upfront revenue from a license fee in exchange for higher and more reliable renewable revenue.

It hasn’t worked out that well.

The evidence is strikingly poor for the subscription model when it comes to actual dollars and cents. My friend and wingman Edgar, the SEC filings database, has all the proof. Just take a look at some of the recent technology IPO filings from the past few months to get a hint of the problem. Hortonworks, the Hadoop provider, filed its S–1 with the SEC last week, and the losses are mounting. The company made $33.4 million in total revenue in the first three quarters of 2014, but its S&M costs were $44.6 million in the same period.

New Relic, the SaaS application monitoring startup, announced its IPO earlier this month as well, and its earnings record is similar. The company had revenues of $63 million in the year before March 31, with $58 million in sales and marketing costs.

These high ratios between revenues and sales and marketing expenses are certainly not new for companies heading to the public markets. When I criticized Box and Square back in May, one component of that analysis was the companies’ high costs to sell a product to their customers. Box in particular had $124 million in revenue in the year ending January 31, but $171 million in S&M costs.

Now, I know the standard excuse here is that these subscription companies are “growing rapidly” and this is all just “an investment in the future.” With subscription pricing, the entire model follows from renewals, with the logic being that once you have acquired a customer, the profit margin will rapidly increase as active sales costs come down.

The challenge is that low-touch sales never seem to be low cost. If a customer is shelling out a serious amount of money from its IT budget to pay for a service, there is going to have to be constant attention paid to that customer to ensure that they are happy with the service while ensuring that they don’t defect to a competitor. This goes far beyond a support subscription, which handles the day-to-day maintenance of ensuring performance of the service for the customer. The CIO needs to know the provider is listening to their concerns, and that means a sales infrastructure.

Furthermore, gross margins for SaaS startups in particular are lower than for companies selling traditional software licenses, since these startups don’t just sell code, but also have to manage data centers and other infrastructure to maintain the software service. With less margin, startups should be more efficient with S&M spending.

But we don’t see companies lowering their S&M costs post-IPO. More than a year after its public debut, FireEye, a security platform for enterprises, had S&M costs that almost equaled revenue in its most recent quarter.

Even a company as massive as SalesForce has arguably not found its marketing scale yet. In its most recent quarter, SalesForce’s S&M costs represented more than 51% of total revenue, and more than 67% of gross profit. While the company is still expanding at a fast clip with year-over-year revenue growth of 28.5%, it seems hard to see the moment when its S&M costs will simply melt away with renewals continuing.

This is particularly noticeable when we move away from the SaaS IPOs to other technology startups. OnDeck, the small business lending startup, announced its IPO a few weeks ago, and its operations appear much more reasonable. The company had about $107 million in gross revenue and $48 million in net revenue in the first nine months of this year, with “just” $21.8 million in sales and marketing expenses.

Does SaaS still offer a compelling model for some startups? Sure, just take a look at Slack. Given its innate virality as a social tool in the workforce, it is entirely credible to believe that the company can have an off-the-shelf product with a subscription pricing model and avoid the S&M problems that plague others in the enterprise space. But it has an advantage with organic growth that few other B2B startups share.

Frankly, one of the reasons for the popularity of subscription is that founders believe they can simply avoid sales by putting a price matrix online and waiting for customers to come to them.

It might be time to admit that sales and marketing are crucial to startups from the day they are launched, and find better ways of building up efficient revenues earlier. That message needs to be heard particularly by technical founders, who should grapple and become comfortable hiring sales teams much earlier in their startup’s growth. SaaS is not an excuse to ignore higher-touch sales.

For in this competitive world, where startups targeting enterprise are competing not just with entrenched players but also other startups, sales matters more than it ever has. The winner of these markets is going to be the company that figures out how to get revenue growth without breaking the S&M budget. While we may have an addiction to S&M spending as an industry, we also have the tools and know-how to fix it, and it starts by placing product development and sales on an equal level.