Faster Growth = Lower Profits
Why hitting breakeven might not be the win you think it is.
I remember charting a possible future for ScreenCloud (the SaaS company I cofounded) when we first started. In my naive way I figured that the team we had was the team we would always need give or take and other than payrises, our costs wouldn’t shift that much over time. After all, the whole appeal of SaaS is that as you weren’t selling time, your revenues weren’t constrained by the number of hours you could bill people out at.
This meant that it was really easy to predict when we would be break-even. It probably looked a bit like this.
The ramp ups in costs you can see here were us giving ourselves a pay-rise as we hit various revenue milestones. My big error here was a breakeven point of 18 months was woefully wrong (probably out by a factor of six).
What wasn’t wrong was the growth trajectory. That green line was more or less what we did. I’d just massively misunderstood how much growth costs.
What happens when you grow faster?
Intuitively you’d think that the faster you grow, the more money you have coming in and therefore the closer you’d be running towards break even. But in fact the opposite is true. That’s in a large part due to your Customer Acquisition Costs.
Typically it costs a SaaS company about 12 months’ worth of subscription revenue to cover the CAC. This is called the Payback Period. In other words, if you charge $12,000/year for a subscription, you would be looking at a cost in sales and marketing of a similar amount.
That means that it takes a year before your new customer is contributing positively to your revenues. Up until that point, you are effectively paying for the privilege of servicing that customer. Obviously, the reason it works is because on average your customers will stay being a customer for several years and so will more than cover the initial investment made to acquire them in the first place.
BUT, if not’s obvious, the faster you grow, the more customers you add, which means the more you have to invest in your upfront costs to acquire customers who won’t have finished covering those costs for another year. Which in turn means you make more of a loss.
Even if customers pay annually in advance you still have to wait until they renew 12 months down the line, before you start to see any positive contribution. And often times, annual payers tend to be for higher price SaaS and as your Average Revenue Per User (ARPU) increases, statistically so too does the payback period. It may well be closer to 18 months.
I’ve written elsewhere that 12 months Payback Period is a good rule of thumb. If your customers only pay you a few hundred dollars a year, then you have to rely on automations. If they pay you a few hundred thousand dollars, then the customer is going to expect to spend a lot longer deciding, which will include of time with a sales person and possibly some training too, so the costs are that much higher.
Hypothetical Impact on Cashflow based on New Customer Acquisition Rate
I’m basing this thinking on the excellent work that David Skok at ForEntrepreneurs produces. Let’s imagine a company has a product that people subscribe to at a rate of $1,000/month on average. And their CAC is $12k - in other words, there is a 12 month Payback Period. Let’s look at three scenarios:
Scenario 1
We grow cautiously, adding one new customer a month.
Scenario 2
We grow at a medium pace, adding five new customers every month.
Scenario 3
We go hell for leather and add 20 new customers each month.
Obviously I’m massively simplifying things here: I’ve assumed we are able to add exactly the same volume of customers in month as in month 36, and I haven’t allowed for churn.
But what would the impact on cashflow be over three years, for each of these three scenarios? Well, it would look like this:
There are a few things happening here:
For each scenario, we don’t see a positive cumulative cash position until about Month 23. This is because, although it takes 12 months for a single customer to deliver a positive cashflow, we’re adding a new customer each month (with all the associated up front CAC).
As you can see, the impact on cash is more acute where we are adding 20 new customers/month. In this example, the total amount of money that is invested before we get to positive cash position on the ‘one customer per month’ scenario is about $1m. Whereas for the 20 new customers per month it is, not surprisingly, around $20m.
However, look what happens after Month 23. The upside is significantly more for the 20 new customers/month than for the 1/customer a month because it now has 720 customers contributing $1k/month, as opposed to the 36 customers the 1 new customer/month scenario has delivered.
I often hear founders say something along the lines of, “once we get to about $XX, we should break even and then I can’t really see our costs going up much”. This is fine if they follow it up with “and I’ll also be happy with our growth plateauing at that point”.
But the reality is, we kind of assume that growth will increase, too. If you are adding $100 in MRR in your first month, you would think that by the time you get to $100k in MRR, you’ve haven’t got there in monthly incremental steps of $100 (because that would take you over 80 years).
And, as I’ve said in a previous post, if you are growing slowly, your churn will eventually catch up with you and you’ll start to go backwards.
The faster you grow, the further you push out break-even
The scenario above suggests that if you are able to add 20 customers a month, you’ll just keep things there. But in fact, the smarter thing to do is push harder, especially if you can see a predictable way to grow. But as we’ve seen, growing harder would put more pressure on your profit and would likely require you to push out the point at which you break even (assuming you had the funds to do so).
Entrepreneurs seem to be blissfully unaware of this in the early stages. I described myself being guilty of exactly this at the beginning of the article, and more than once in the last year, I’ve seen an investment deck with forecasts that show both massive growth and a break-even point 12 months or so, post-raise.
What can we conclude?
Growth doesn’t come for free. If you want it, you have to know that it will cost the business up front. This is a big reason for raising capital: it can pay for that growth. BUT…. the great thing is, if you do it well, the rewards on the other side are much higher, too.
Raising investment isn’t the only solution, though. It is possible to bootstrap your way to success. There are plenty of companies that have done it. But you have to go in with your eyes wide open. And of course, be looking at ways to manage your CAC.
