AirTree Ventures

SaaS I’m so confused

By Paul Bennetts via

I move to a new town. I begin getting my groceries from Walmart. The prices are low, the selection is large and it’s a five minute drive from my apartment. I shop three times a week. Sometimes, I get groceries from a different store but mostly I’m at Walmart. I’ll live in this town for the next few years.

I don’t subscribe to Walmart. But my repeat purchase rate is pretty much a subscription. Let’s say I spend $100 per week ($5,200 per year) and their gross margin is 25%. Eventually, I’ll churn from this town but not for at least two years. In this fictional town, you could say my lifetime value to Walmart is $1,300 per year for at least two years ($5,200 x 25%). How much should Walmart spend acquiring me as a new customer?


From Sam Walton’s autobiography, Sam opened the first Walmart store in 1962. He was 44 years old at the time. From the moment he first opened that store he would obsess over his customer. This meant continuing to find ways to offer lower prices and broadening product selection. Every dollar saved in the business was passed onto customers as lower prices. Lower prices brought more customers, creating more buying power for Walmart, resulting in even lower prices.

Walmart now operates on a steady 25% gross margin. For Walmart, every line item is an expense to be managed. Even advertising. Walmart only spends 0.5% of revenue on marketing to new and existing customers. Year in, year out. Many people have said that Jeff Bezos is the digital age incarnation of Sam.

“More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.” – Jeff Bezos.

The famous VC Bill Gurley extends this point further.

“If you are a company that spends millions and millions of dollars on marketing, wouldn’t you be better off handing that money to the customer versus handing it to a third-party who has nothing to do with the future lifetime value of the customer?” – Bill Gurley.

After its fixed cost base, Walmart generates a consistent ~6% operating income margin (EBIT). Last year, this amounted to $27.1bn. The market is currently valuing that operating income at a 10.3 times multiple. Or in our terms, Walmart is valued at 0.6 times last twelve months revenue.

In SaaS businesses, it’s unheard of to spend only 0.5% of revenue on sales and marketing. In SaaS businesses, it’s not unusual to have a 6 to 18 month customer payback period. That is, it will take months of customer revenue to payback the sales & marketing expense to acquire that customer. The rationale for this is the 1:3 CAC to LTV ratio rule of thumb. And the resulting high revenue growth rate it can produce.

As a thought experiment, how much extra revenue growth do you think Walmart could achieve if it increased its advertising spend 10 times from 0.5% of revenue to 5% of revenue? What do you think its operating income margin would fall to? 1%? Walmart has been around for 53 years. One could argue that Walmart is past its peak growth curve and has to have the discipline to grow only in a profitable way.

SaaS I’m so confused. Have we taken the 1:3 CAC to LTV ratio added lots of marketing dollars and taken it too far? I wonder what a SaaS company looks like if growth slows down.

SaaS businesses typically have gross margins between 60-70% and low single digit churn rates. Based on the 2014 Pacific Crest SaaS Survey of 300+ SaaS companies, SaaS companies generally have a fixed cost base made up of G&A spend at 17% of revenue and R&D spend at 26% of revenue. Let’s take a look at a poor and a good SaaS business based on these ranges.

Our hypothetical SaaS businesses each end the previous year with $100 of revenue. The poor SaaS business has a gross margin of 60%, a 3% churn rate and a customer payback period of 18 months.

During the year, the poor SaaS business loses customers at a rate of 3% per month. With no new customers, the poor SaaS business will end the year with $71.5 in revenue. But, it can spend sales and marketing dollars to maintain its $100 in annual revenue. To do this, it needs to spend $1.5 on sales and marketing for every dollar of incremental revenue (given an 18 month customer payback period). As a result, to plug the gap of churn, it has to spend $42.7 on sales and marketing. It now ends the year with $100 in revenue. But it will only have a contribution margin of 17% to cover its fixed cost base.

The good SaaS business has a gross margin of 70%, a 1.5% monthly churn rate and a customer payback period of 6 months. It will end the year with $100 in revenue by spending $7.7 in sales and marketing to plug the churn gap. It will have a contribution margin of 62% to cover fixed costs and will generate a profit. While the poor SaaS business will have substantial losses.


The good SaaS business now has a choice. It can payout that 19.3% operating income margin to shareholders as profit. Or, it can reinvest it to grow future revenue. It could achieve up to 40% revenue growth based on a 6 month customer payback period. So long as it’s a choice though, as Charlie Munger points out.

“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” – Charlie Munger.

At a steady state, the good SaaS business is valued at 1.9 times last twelve months revenue. This is based on applying the same operating income multiple as Walmart (10x). Walmart has been growing at only ~2% for a number of years.

From the period 2004 to 2011, the average public SaaS company held an enterprise value to forward revenue multiple of 3 to 5x. Since 2011, that figure increased to 5 to 10x. At the beginning of 2014, those multiples stood above 10x. From early 2014, they have been declining. Today, they stand at approx. 4 to 8x – depending on the selected comparable set.

Unfortunately, monthly revenue churn and customer payback period are both non-GAAP measures. That means companies are not required to disclose them. This makes it harder to easily understand what’s really going on.

Once you look through the growth, it’s interesting to see how small changes in operating metrics add up in SaaS. And to be fair, there are further nuances to SaaS businesses. Some can achieve negative net churn through expansion revenue of existing customers. On the negative side, some customers can also churn before the payback period completes. This increases cash burn.

A high growth rate can be confusing, particularly in SaaS. A high growth rate can hide a poor and good business, so it pays to unbundle it.