Category: SaaS

Three Thoughts on Balancing Profit and Uncertainty

Life is uncertain.  Any entrepreneur knows that to start a business, you have to take a chance.  You can calculate the risks, manage what factors you can, work as hard as you want, plan as extensively as possible, but there is always uncertainty and risk.   Frank H. Knight defined risk as events that have a probability and a severity and are calculatable.  Uncertainty is defined as those events without a probability and a severity.   We face both uncertain outcomes and risk in our lives.

As a professional CFO, I’ve worked to limit uncertainty and manage risk.   Eliminating risk and uncertainty however is impossible and will kill a business.  The very nature of profit comes from taking a chance and offering a solution for a customer.  A risk-free (and low uncertainty) business doesn’t exist.  The closest we have to a risk-free return is a 10 year bond, which is trading today at about 2.2%.  If you want to make more than 2.2% you are going to have to take on risk.

  1. Running a business is about balancing all the factors: risk and uncertainty, the operations and the market so at the end there is a profit and a return on capital.

Profit comes from risk taking.   The risk taking must be commensurate with the return, or it is foolish.  Steven Crist wrote a chapter (see here) on value in the book: Bet with the Best: Strategies from America’s Leading Handicappers.  Crist points out that even bets that are likely to lose (betting on a 4:1 horse, when the payoff is 12:1) can be a good investment.

Managing risk (and opportunity) sometimes means thinking about what could change.  What assumptions are foundational to the business model which if changed would result in a serious impact to the firm?  Although you think that there are relatively few of these, there are many, but thankfully they are relatively rare.

Many retailers were well aware of the impact of e-commerce, but few generated a capable response. Most dumped their catalogs and full product line on the internet and waited for customers.  Worse yet, few planned for the inevitable loss of market share or the increase in new competitive business models (Stichfix, Frank + Oak, Thred-up) that might arise on-line.

Nassim Taleb talks about the four largest potential losses in Las Vegas, one of which became real: Siegfried and Roy’s magic and wild animal act was ended when a tiger attacked Roy.    Roy later went on to say that he had high blood pressure and believed he had a stroke during the show and the tiger sensed that and was dragging him to safety.   If Roy had died from the stroke and not the tiger attack, the result would have been the same, cancellation of the show.  When a great deal of income depends on the health of one man, then there is a big assumption of risk.

  1. Business decisions can increase or decrease risk and uncertainty.

Every decision we make creates new risks and uncertainty.  Selecting a new ERP system?  Hiring a new executive?  Changing a key purchase policy?  All will create both a primary effect and secondary effects that are unknown.  Not making a decision, often called strategic dithering, creates additional uncertainties.  Mark Fields was recently replaced as CEO of Ford, apparently because he wasn’t moving fast enough on self-driving cars (see here).   I am not certain that a faster approach to self driving cars creates a lot more value than being second with a better product.  But either way is uncertain.

Too often executive teams ignore risk and uncertainty factors in making their decisions.  Anecdotes are easy to understand and are compelling although they are often sample sizes of 1.   In the hedge fund business we used to say “beware the narrative” as we were afraid of being seduced by the simplicity of a good story.   Balancing the trade-off between customers and operations without assessing the change in risk will likely lead to increased risky behavior and calamity.

  1. Invert the decision making model – think about increasing risk.

Risk is necessary for profit, but risk as I’ve noted is calculable.  Can you decrease risk for a customer and create greater sales and profits? Grouping uncertainty and risk can decrease overall risk.  That is what insurance companies do.  Offering a money back guarantee on products for a retailer is simple.  If you realize you can return the product, you are more likely to buy, even if you are extremely unlikely to return the product.  The highest margin item I’ve ever sold was warranties on electronics.  Most are never used.

If you are a SaaS business, how can you lower the customer uncertainty and increase your payout?   Most firms find buying a new system a major endeavor.  They’d like to be married, without the process of getting married (which is a hassle).  The risks are centered in the conversion, implementation, training and the first 90 days of the new system.  Firms will pay to have implementation risk decreased.

Playing safe isn’t always a good option (see here).  My local community has half a dozen businesses that are clever, deliver great value and could have a national presence.  They don’t because the owners are happy enough with a small local business.  Every couple of years change comes to the community or one of the owners and one of these businesses dies.   I am not arguing all small businesses should become Staples, but as John Shedd wrote “A ship in harbor is safe — but that is not what ships are built for.”

Conclusion

I think a lot about balancing risk and returns.  If you bet the long shot that is undervalued, you may win big, but you will most likely lose.  Losing isn’t bad in this case, it is just one iteration of a process that brings a profit.  Avoiding risk isn’t possible, but whatever approach you take, keep an eye on the tiger.

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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses.  If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

SaaS – Churn, Ansoff and Unit Economics

Unit economics is the name for the analyis of an investment at a detailed level based on the customer, store or unit.  This is the analysis we do when we are approving a capital project.   A good recap of unit economics by Cleverism is here.  This article uses Ansoff’s matrix and SaaS metrics to compare different businesses to illuminate the gaps between current business metrics and what different sectors can learn from each other.  

I’ve written about Ansoff before (see here).  Ansoff says that there are two axis to growth, product and customers.  Ansoff’s matrix splits the opportunities into four segments.  Selling current products to current customers, finding new customers for current products, selling new products to current customers and finally, selling new products to new customers. For different kinds of businesses, each of these segments are tracked by different metrics.  

Turnover or churn is the statistic that tracks how long customers use your services or purchase your product.  Different concepts result in different levels of churn.  Parents buy diapers only as long as their babies need them, a couple of years.  Certain B2B services might stay with a company for the life of the business.  Even this, however, is not forever.  

You can classify consumer businesses by their lifecycle, basically the length the product remains relevant to the customer.   Churn works along Ansoff’s customer axis, and begins with the square titled market penetration and moves towards product development.  When a customer signs up a for a service, their potential to stay is not always apparent.  Some will stay for a long time.  Some will not.   Some concepts have very wide age range (McDonald’s) others are much shorter (say Rue21).  

I am on the board of a small company that teaches music to 1-4 year old children and their parents.  Every year a new cohort of 1 year old’s join and four years later they graduate out of the program.  Annual customer turnover is over 25% based on the business model.  Real turnover is higher because some families move and some families quit, and some children join at age 2 or later.  I’ve calculate the churn by individual children, but if you saw the basic unit as the family, then churn would be lower, as some families have two or more children.  

Defining the unit in different ways offers new ways to thinking about your business.  For example, retailers usually define the unit as a store, while Wal-Mart saw the primary unit as the distribution center and the related regional stores.  They wouldn’t open one store in a market, but would open one distribution hub, and many stores.  

Subscription businesses like SaaS track churn as a way of monitoring customer lifecycle, see here for a great outline of SaaS metrics by David Skok. Selling only current product to current customers results in a slow decline in sales, because customers will eventually leave for one reason or another.  Corporations have unlimited lifespans in theory, but in actuality they don’t.  Innosight suggests the average S&P 500 company listing lasts about 18 years now (see here).   Although a lot of firms last 100 years, even then firms aren’t immune to change, Radio Shack was over 115 years old when it declared bankruptcy.  

Defining the implicit natural churn rate helps define the business model and SaaS firms should use that data to better identify add-on products or additional services to be offered.   As client firms move through their lifecycle, SaaS can be a responsive force, focusing the solution so that software, service or solution remains relevant.  This is moving across to the product development side of Ansoff’s model, offering different product to the current customer .  In the case of the pre-school company, we are working on programs that extend our reach to 5-6-7 year olds. Adding additional years means that the churn rate will decline, but it will never get to zero.

If you can convince your current customer to buy more, typically subscribing additional services or purchasing more products, you increase the value of the customer relationship. Ansoff would call this selling current customers new products.  Sales growth for a cohort of customers could grow, rather than decline.  SaaS businesses call this negative churn.  If churn is low enough and the service supports a rising price (either it was underpriced or continues to add value) then you can achieve negative churn without selling additional goods or services.  Negative churn is very profitable because no additional selling costs are required, yet sales and margin increase.  

Retailers would call negative churn an increasing “share of wallet”.  Increasing your share of wallet was about selling more stuff to the same customers.  Retailers have a concept called “same store sales”, which tracks the change in y/y sales through the same number of outlets.  This is not the same as negative churn, but it is close.  Same store sales could increase due to increasing customer count (new customers for current goods) or sell more new goods to the same customer (share of wallet) or higher prices.  Positive comp sales also have a very strong impact on profits, as store location costs and location overhead are leveraged.   Retailers focus extensively on the store as the unit, and would benefit from seeing customers as a unit also as SaaS businesses do.  Recognizing that some segment of a population is aging out of your sweet spot gives direction to marketing and customer acquisition efforts.  

In the wholesale business we track sales by dollar churn and by customer wins.  Dollar churn is the similar to churn but instead of using number of clients, we use dollars of sales.  That way big customers are more relevant.   Wins relate to obtaining business from new customers.  If it is a technology solution, a win would imply agreement by an organization to use a specific tool or platform, which as adopted through the business will result in additional seats and sales growth.   Sometimes a win is just an initial “test” order from a customer which uses many suppliers.  Either way this can be a significant step to increasing sales.  

SaaS businesses offer fremiums or lower cost options, which like wholesale’s initial test order, start the customer getting familiar with the product or service.  Given the value of a customer it seems obvious that most wholesalers/retailers should consider this strategy.  

Investment and Life Time Value

The average selling price (ASP or  average transaction size) and annual volume (also known as Annual Recurring Revenue – ARR – for SaaS) define a business model.  If ASP is low, then the amount of service given at the transaction must be low.  McDonald’s has an average transaction in the $5 range.  This is why there is no service.  The ASP for a Mercedes is $50,000, which means you get service at the point of sale.  

The lifetime value of the customer (LTV) is a calculation of the total operating margin of all the sales to the customer.  Obviously the higher ARR, the longer the customer remains, the higher the margin, all  result in a higher LTV.  If the LTV is low, then the amount you can spend obtaining a customer is low.  A higher LTV allows for more investment in the customer.  Obtaining a business customer that pays $20,000 a year in service fees could result in a typical SaaS LTV of $150,000 or more.  That allows for a number of sales calls and demonstrations.  If you are selling a $100 annual subscription, pretty much it has to be handled via email and on-line, with automated responses.  

SaaS firms often use margin for the LTV calculation while “four wall” profits are used for retailers.   Having the LTV can help you define how much money you can spend to obtain a customer (normally, cost of acquiring customers, CAC or CoCA).   The CAC is the total investment required to acquire a new customer.   In a retailer it would be the cost of a new store, in a catalog firm, the cost of a new catalog.   Four wall profits are the variable costs driven by the addition of a new unit and typically don’t include any headquarters or regional management costs.  

 

Although margin is a good proxy for profitability, it isn’t perfect.  Skok recommends (see here) deducting the cost of the retention and expansion teams and the cost of service from margin.  This would make the net margin SaaS calculation the achievement of the steady state of the business. Normally I’d have the cost of expansion in the cost of customer acquisition calculation, and leave it out of the net margin calculation.   Theoretically it should only be in one place because the cost of service and cost of retention (the account managers) are variable costs driven by customers, while the cost of expansion (sales team) is discretionary.  This isn’t unusual and it treats the account managers the same as the sales team.  A lot of retail new store models also include some costs on both the investment side and the operating expense side.  As long as you are consistent in assessing projects, it is fine.  

 

The rule of thumb for SaaS is a 3x return on CAC.  This is similar to the typical unit economic model of a retail store, which over it’s first ten years should generate 3.5x-4x the investment cost of the unit. SaaS companies ideally should discount the long term cash flows (DCF) of the expected life of the relationship to better reflect the LTV to CAC comparison.  Most of the SaaS business models have been developed in a low interest rate environment, with relatively cheap capital so this hasn’t been an issue.  As SaaS relationships extend out, a DCF makes a lot more sense.  If you do use a DCF, the rule of thumb isn’t valid, and LTV/CAC ratios less than 3x can be profitable.

Retail is a little different because it fulfilled a demand for a product line in a geographic area.  So if you are selling car parts, you cared about the vehicles owned in the area, not so much who owned them.  As long as cars were owned, they will need parts.  The CAC for retail is the cost of opening the store and stocking it.  Unit economic slides for years boasted 40% ROI’s on stores by hiding inventory investment and other relevant costs.  Sales forecasts were often suspect too.  Hiding costs may look good in the short term, but overall ROI is driven by the accumulation of unit ROI’s, and smart analysts generally ignore unit economics that don’t aggregate to company economics.  

The aggregation of LTV minus overhead costs should approximate the economic value of the business (debt + market priced equity).   Usually there is an additional “option value” for the on-going business and the opportunity to enter new markets and develop new products.   Standard DCF calculations that Wall Street analysts use attempt to convert the stream of profits over 10 years to an economic value.  Unfortunately, usually 50% + of the value is wrapped up in the “in perpetuity” assumption, which is dropped in the 11th year to cover for the expected future stream of income.   A good LTV model with realistic assumptions will help a CEO/CFO better plan for the long term value of the business, and communicate that value to investors.

Winning a loyal customer is valuable, but understanding the math is even more valuable.  Returning to the diaper business, when you can calculate the number of diapers a child will use you can calculate the lifetime value of obtaining the parent’s diaper business.  This gives a place to begin budgeting marketing expenditures, planning sales efforts and valuing the business.  You can do this while still knowing that one day the parent will no longer purchase diapers and you will need to find a new customer.  Thankfully people keep having babies.  

There is a lot of similarity in unit economic calculations and enough differences to create some interesting ways of analyzing, displaying and investing in new operations.  

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Dr. John Zott is the principal consultant at Bates Creek Consulting and works as a CFO for growth oriented businesses.   John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses.  If you are looking for a CFO for your e-commerce/SaaS/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.