a16z Podcast - a16z Podcast: Why SaaS Revenue is Worth More Than Traditional Software Sales

Starting point is 00:00:00 The content here is for informational purposes only, should not be taken as legal business, tax, or investment advice, or be used to evaluate any investment or security and is not directed at any investors or potential investors in any A16Z fund. For more details, please see A16Z.com slash disclosures. Welcome. This is Scott Cooper from Andreessen Horwitz, and we're here with Ron Gill, the CFO of NetSuite, among other phenomenal accomplishments in his career. And we're going to talk a little about SaaS. And in particular, since we've got the benefit of Ron. being here a little bit of kind of, you know, the intersection and some of the differences potentially between how public companies think about SaaS and managing their businesses and also, you know, kind of how private companies think about running it. So maybe just to get the conversation started, let's talk a little bit about kind of the valuation environment today. And, you know, unless you want to, you don't have to tell us whether you think, you know, things are wildly over or undervalued. But probably at a more, you know, high level kind of, you

Starting point is 00:00:56 what's the argument for why SaaS businesses actually, you know, ought to have valuation premiums relative to kind of what their traditional, you know, you know, subscription or sorry, you know, perpetual licensed businesses have? Right. Yeah. I think there are some fundamental reasons why a dollar SaaS revenue is more valuable than a dollar of non-recurring revenue. I mean, there's the fundamental aspect that it recurs is, is valuable. That's probably the first thing I would say. It's just the annuity aspect is so valuable. If you look at a company like, NetSuite had a high retention, low churn, SaaS company, and you do a cohort analysis. You'll get a year-over-year increase in value of the entire install base of customers, so more than 100%. Even after attrition, after churn, a year later, the install base is worth more than it was the year before. And that means that acquiring a customer is a huge value. You're acquiring better than a perpetual annuity every time you acquire a customer.

Starting point is 00:01:56 So that dollar of revenue that's on the P&L this year, this quarter, represents better than a perpetual annuity of that revenue, which is fantastic. So that's the first reason. The second reason is really because that annuity is not very expensive to maintain, a company like NetSweed has a gross margin on recurring revenue that's 86%. So it's a very profitable annuity. The portion, you know, the biggest portion of SaaS P&Ls is spent on sales and marketing, but I would argue that that is being. spent on acquiring growth and a small portion of the of sales and marketing is going to maintaining that annuity and so what we see is that whenever a SaaS company turns down the growth we get profitability and cash flow falling out of the model very quickly very dramatically

Starting point is 00:02:43 for NetSuite it was 2009 the worst recession any of us have ever seen you know revenue growth slowed for recurring revenue slowed from in the 40s to about 16% in 2009 but that was the year we became net income positive. That was the year we became operating cash flow positive. That was the year success factors became operating cash flow positive. In the middle of the worst recession, any of us have ever experienced. And it's because nobody in 2009 was planning for 40% growth the following year, everybody was in a much more conservative place then. And in that environment, all of a sudden you get profitability, all of a sudden you get cash flow. So I think that's the second reason is that I believe that the SaaS companies really are

Starting point is 00:03:23 inherently quite profitable, quite cash flow generating, and that the profit and the cash flow is being used currently to purchase future growth to purchase more of those better than perpetual annuities, which is certainly worthwhile. And then the third reason I think that the SaaS company valuations are high that makes sense is there is a fundamental transformation taking place. I lived through the mainframe to client server transformation that happened in the 90s. I was at SAP, when R3 was coming out and sort of taking over the world then, nobody survived that transition. It was just a architectural, just a technical transition from a mainframe model to a client

Starting point is 00:04:04 server model. There was no business model transformation. It was perpetual license to perpetual license. And yet no vendor survived that transition. You ended up with all of the three-letter acronyms, ERP, CRM, supply chain management, all of those emerged in the client server market with no. nobody really making the transition from mainframe to client server. And I think I believe very much that that's what's happening again.

Starting point is 00:04:29 That's what I believed in when I came to NetSuite in the first place. And I really see that happening. So I think the third reason of the high valuations in SaaS is because there really is a transformation. And I really believe that the SaaS companies really are going to take over a lot of the markets. It's a much harder transition this time. It's not just I need to build a similar solution on a new architect. It's I've got to do that and transform the business model from everything up front to deferred over time. And that's a very hard transition for companies to make.

Starting point is 00:05:02 So I think a lot of the SaaS companies are really going to take over the space that they're entering. Yeah. So that's interesting. Maybe just to tease out a couple of those things. So, you know, one thing that you mentioned, right, is this idea of the inherent leverage and scale in these businesses and that sales and marketing expense, which is really kind of a forward-looking measure of where you think the growth can be is a lot of what when people complain about, gee, these SaaS businesses are great. but we're not seeing anything dropped to the bottom line. It sounds like, you know, one of the, you know, things that you believe is we could inherently get these businesses profitable tomorrow if we decided we didn't want to grow at 25 or 30 or 40 percent a year. And so the leverage is there.

Starting point is 00:05:35 It's just that the future growth opportunity is so high that, you know, the investments in sales and marketing are, you know, are scaled so that we can actually get to, you know, what we think is long-term market dominance in these companies. Yeah, that's exactly right. And you certainly want to make sure that you're investing in such a way that you're getting the yield. So there's a whole bunch of other metrics that you're going to use to make sure that the money that you're spending in sales and marketing is doing what you're trying to do with it. And it is turning on a bunch of perpetual or better than, you know, better than perpetual annuities, that it is really yielding, yielding as it has before. Maybe even that yields increasing. You don't want to be just spending money foolishly. So you're going to use other metrics to tell that.

Starting point is 00:06:15 But fundamentally, if you're looking at the sales and marketing expense on the P&L of a SaaS company, you're comparing that to the revenue. You're comparing that to the revenue this period on the P&L of the SaaS company. You're comparing the wrong thing, right? You're comparing an investment that's being made in future annuity to a revenue that's just today. If you have an extremely successful quarter in SaaS, you may turn on a lot of annuities. You'll see none of that in the P&L in the quarter that you do that. Yeah, that makes sense. I want to come back to the metrics comment you made earlier because I think people would be interested to hear about that.

Starting point is 00:06:46 But one other comment I would just also mention is you described, obviously, you know, what's different this time? And you mentioned kind of the transformation from mainframe to client server and now obviously from client server to cloud. And clearly there is a technological transformation as you talked about, which is, you know, how do you think about the architecture? How do you think about multi-tenancy? The other thing which you alluded to also, which I think is happening also is there's a difference in terms of how IT is purchased and deployed within companies that actually has a big, you know, big ramification. So one of the things that we've talked, for example, with some of our companies about is, you know, in the client server world, the gating item to deploying multiple applications in a company was how many applications could the IT organization support and deploy and integrate. And so because you had on premise stuff, you know, the IT organization really was the kind of gate both from a budget perspective as well as an ultimate support perspective for in-house applications. And one of the things I think that people underappreciate on SaaS is we've eliminated one of those big gates, which is we've now said, look, you IT organization aren't responsible for the day-to-day management and, you know, you know, kind of deployment of this application. And therefore, you know, we can have, in theory, many more applications deployed in a enterprise environment

Starting point is 00:07:55 than we had historically in the client server era. I think that also, in some respects, you know, causes budgets to get, you know, moved out from the CIO into departmental level things, which allow kind of bottoms up selling. So I'm curious whether, you know, as you think about your business, you know, you think that's a real transformation. And, you know, does that mean that we ought to expect over time, you know, just more applications in the SaaS world in an enterprise than we had historically seen and kind of, you know, broader dislocation of budgets potentially from centralized purchasing, much more out to departmental level purchasing. Fundamentally, yes. I think the phenomenon you're talking about is very real, and it really

Starting point is 00:08:32 started with Salesforce, you know, years ago sort of emerging the, initially not even the head of sales, initially somebody down in the sales organization, emerging that person as a buyer of IT when that person had never been a buyer of IT before. And they weren't before because they had to go through not just the CIO, but the CIO and the CFO together. And the CFO and the CFO together were probably the primary purchasers and certainly the primary gateway you had to get through to purchase IT. So you get an emergence of a new buyer there. And certainly then they're making decisions differently. They're getting more point solution oriented. And you're exactly right. You don't need the IT department to then maintain that solution.

Starting point is 00:09:11 especially if you get, if it's a true multi-tenant SaaS model where you're constantly running on a current version and where customizations can be perpetuated through multiple versions without additional work, there's a much less need for the IT department there. So I think that absolutely continues. We're seeing the emergence of additional buyers in the organization as the head of HR, the head of marketing, emerges buyers as well. So I definitely think that phenomenon is true. at the same time, I wouldn't completely eliminate the need for the IT department there, certainly maintaining integrations between systems. I think that can be underestimated. There's, you know, SaaS systems, in terms of a multi-tenant SaaS system, you know, being constantly updated itself, not requiring a re-implementation when there's a major upgrade, that type of thing. Wonderful.

Starting point is 00:10:04 But fundamentally, if you integrate two of them, somebody will have to maintain that integration. somebody will have to do that integration and somebody will have to maintain that integration. And there's no guarantee that as you upgrade the two systems that you don't break that integration. So you don't completely get away from it. But certainly in terms of the scale of the IT function needed to do this, it's vastly different. Yeah, I think you're right. Yeah, the IT organization, I agree, is not going away. The nature of what they do might be changing, which is more heavy emphasis to your point on integration. And also things like security, user administration, you know, stuff like that that might be more relevant. So let's come back to kind of. one of the fundamental concepts we talked about, right, which is, you know, the idea of sales and marketing and investing in the future for growth and, you know, that that, you know, when you look at the P&L today, obviously you might be, you know, people might be over extrapolating in terms of what the actual expense base is relative to what the growth opportunities are. How do you, so we've talked a lot about metrics and I'd love to hear how you guys use them. So there are metrics at least in theory that are supposed to help inform that decision process like things like KAC and LTV and what the relative ratio is between those. You know, a lot of commentators talk about, kind of these magic numbers, right, which is what's the kind of, you know, magic triangle for how these things should look at. You know, as someone who obviously, you know, kind of manages, you know, a public, you know, SaaS company, how do you think about those to help inform decisions about investing in sales and marketing and kind of how slavish or not do you get to magic numbers

Starting point is 00:11:27 versus kind of, you know, understanding the underlying economics that you're dealing with? Sure. And in one sense, I'm a big fan of that fundamental metric, the LTE, VDIC, so the lifetime value of the customer compared to the cost of customer acquisition. I'm a big fan of that metric because I like how holistic a metric it is. I think it captures, because it has within it, the gross margin on recurring, which really speaks to the architectural efficiency. It speaks to the quality of the operations team. It has into the retention number, which of course speaks to your ability to satisfy

Starting point is 00:12:00 customers, your ability to keep customers. It has the sales effectiveness metrics in it. What does it cost to acquire a customer? And so because it has so many of those which are such core SaaS success metrics sort of rolled into it, I'm a big fan of the metric overall. I'm not a giant fan of the absolutes. If the number is this to hit the accelerator, if it's this, you know, slow down. I'm not a big fan of those necessarily because I think there's just too much variety in models. And there have been too many times when somebody's been able to build a base and then shift and turn on something in a very dramatic way.

Starting point is 00:12:35 the way we use those metrics internally is first we certainly measure them longitudinally we're always looking at ourselves against our past with almost any metric we do and trying to get better at what we've done and so are is the metric tracking better than it's been in the past do we know how to make it track better in the future is probably the fundamental way we use almost any metric so longitudinally we also fairly regularly do a regression analysis on lTV to cack again because there's so many component pieces that drive it I really want to understand understand if things have been getting better, why have they been getting here? Which one of the drivers has been the driver that's been driving that improvement? Our lifetime value of a customer has slightly more than doubled in the last two years at NetSuite. And if you looked at that for the last two years and did that regression analysis, you'd find a very different driver than if you looked in the sort of 2010 to 2013 period and looked at the drivers then. If you looked back in, say, 2009, 10, 11, you would have seen improving retention rate as a lot of the drivers. as being a dramatic driver in improving LTVD KAC.

Starting point is 00:13:39 And then we could see that that was getting very, very good. It was probably getting as good as it could. The remaining churn that we had is primarily companies going out of business, companies getting acquired, things that are going to be very hard to address with a better product or better support. And so you start to look for what's going to be the next lever. I know this one can't take me to the next step where the lever's going to be. And if you looked more recently, you'd probably see average deal size as being a significant lever.

Starting point is 00:14:05 And so we're constantly doing a regression to sort of see what are the drivers that are moving the needle today. We do a sensitivity analysis to see what's the – where could I get the most bang for the buck by tweaking something now? And so that's the way we use those metrics. And I increasingly see private companies getting more and more sophisticated about these metrics, really using them internally a lot. I see the management teams, the boards having more experience with them, and I think they're just being more and more widely used. The other way that they're very useful, of course, is segment analysis. If you've got very clear segments that you can separate in your business and look at this, it is very informative there about where the investments yielding the best today. Interesting.

Starting point is 00:14:46 So what's interesting and presumably, you know, you've got the challenge, which is you're a public company, obviously. So all the things you're talking about are it's data and access that you have certainly internal to the company that you can use to manage the business. But presumably, you know, you spend a significant amount of your time kind of managing, you know, equity research analysts in the street. you know, how do you kind of compare or contrast or what are the things that they care about that they're looking to for measures of health of the business, whether those are things like deferred revenue or other aspects, how do you think about kind of managing both internal metrics that you haven't yet, you know, kind of or probably can't really in a very, you know, logical way exposed to the street versus what the street can actually access by looking at your financial statements and trying to conclude about the health of the business. That's right. And certainly, you know, internally, you're going to be much, much, much, much more granular, much, much, much more detail than you. you're going to be externally, both because of just the information that's visible externally and because of probably the appetite for digesting that information. So externally, you know, it's really evolved that the street pays a lot of attention to calculated billings for better or worse.

Starting point is 00:15:49 You're going to spend some time talking to the street about – I spend a great deal of time talking to the street about why the calculated billings number is not very meaningful. Nobody pays any attention to me. Maybe just for the audience. Maybe just give people a sense of kind of what calculated billing looks like and why people – the research analysts care about that number? Absolutely. So calculated billings is a number that research analysts can get from the public financial statements. They do it by taking the change in deferred revenue plus revenue. And in a completely stagnant booking billing environment, that would be a great approximation of billing. It wouldn't be a great approximation of booking necessarily,

Starting point is 00:16:23 but a good approximation of billing. So they take that. And for SaaS companies like ourselves who don't provide a bookings number externally, they're going to use that as a proxy for the King's number. And so, but it gets affected in strange ways by billing term. It gets affected. We, you know, we, we have made an intentional effort to do, for example, more time and materials professional services work. And we make that decision because it's the right decision for the business, because of the way those projects are managed, work better for that type of project. The result is, though, that, you know, fixed price projects are billed up front, time and materials projects are billed monthly in arrears. They look very different from a calculated billing's point of view.

Starting point is 00:17:02 we don't care, we're going to manage the business the right way we think for the business, but it means I need to do some explaining sometimes as to how those things impact what can be seen externally, which is calculated billings from deferred revenue. Do you think there's a scenario, do you think there's a scenario in the future as SaaS becomes, you know, presumably more mainstream as a software platform that the actual public metrics change and or, you know, God forbid, but maybe Gap actually, you know, figures out internal metrics that the companies use actually might become, you know, ought to be standardized and ought to be external gap metrics that people can use for the business, or do you think

Starting point is 00:17:34 that's just a crazy idea? It's a good question. Certainly one of the challenges today, and there are some companies that publish some of the what you would think of as SaaS metrics, whether that's our average revenue per customer or a retention metric or a cost of customer acquisition. There are some companies that publish those things. The real challenge is a lack of standardization of definition, right? And so, you know, I think the good news is as long as people are intellectually honest, they can define those metrics in a way that makes sense for their business.

Starting point is 00:18:09 They can define the churn metric in the right way for their business. So for us, we only ever look at a dollar-based churn metric, for example, never look at a customer-based churn because we've got, you know, we have customers anywhere between a few thousand dollars a year to several million dollars a year. The churn rate is significantly higher. And the smaller customers, again, because going out of business and getting acquired is the number one way. number one and two ways to churn. And so to look at a customer count churn is not particularly meaningful. To look at a dollar churn is meaningful. For a different company, though, maybe the dollar, I mean, maybe the customer count number way would be right.

Starting point is 00:18:41 So you're able to define those metrics in the way that makes sense for your business. The challenge with having to file them publicly is a lack of standardization, right? And so I don't know because they are non directly financial, so they don't impact the statement of operations, the balance sheet of the cash flows in a direct way. I'm not sure whether we'll get that standardization. But that's the challenge. Where companies have filed those today, they typically come with several sentences of explanation of how the calculation is done. And it's still often still not clear how the calculation is done.

Starting point is 00:19:17 And there's a real danger of having complete diversity of calculation method for something that everybody gives the same name. And it's actually more confusion than clarity. Yeah, this is the fundamental challenge, of course. Ron, one of the things that at least we look at a lot in this market is you mentioned kind of the transformation from mainframe to client server and kind of, you know, that there was a lot of companies that could make that transition in part because of the architectural changes. And we've been talking a little bit this morning about how significant the architectural changes are from client server to SaaS, as well as kind of the sales and go to market motions that happen in these companies. You know, when I look at kind of a lot of the big incumbent players out there, whether it's an Oracle or an SAP or others and they're competing, you know, against, you know, market segments. that NetSuite and others have, you know, how do you think about kind of, you know, if you're

Starting point is 00:20:02 inside those companies, how difficult is it to move the business from a perpetual license business to a SaaS business? You know, how do you think about engineering cycles? How do you think about sales cycles? What are some of the kind of, you know, if you were running those companies, you know, how would you actually manage a transition like that, you know, if at all? Yeah, it's a really interesting question. I think it really is a difficult transition. And it's funny because I, there's sort of two aspects of it. There's the engineering side. we need to rebuild a product, rebuild a functionality set in a multi-tenant SaaS model. And then having done that, we need to then transition the business to delivering that way instead of the old way.

Starting point is 00:20:38 And I have – I had been thinking for so long that the engineering part of that was the easy part and that these are big technology companies. They know how to develop software. They'll develop cloud solutions, and then they'll really be challenged on the sales side. I've been largely wrong about that because it's been, it's taken much longer than I expected for those companies to really come up with good cloud solutions. We see a lot of acquisition, but we don't see a lot of perpetual license companies really growing solid cloud solutions in-house. Once they have cloud solutions, then the real challenge becomes how do you transition the business? And that's the difference. The last time this happened, just an architecture change, no change in the fundamental licensing model.

Starting point is 00:21:24 Now you've got the architecture change plus a business model change such that a deal that sold last year for $100,000 that hit the P&L, the quarter that you sold it, now shows zero on the P&L and it's going to show $8,000 a month for the next 12 months. And so you get, it's very difficult to manage, especially for a public company, that transition. And it's very difficult. Everyone always wants to say, how do I incentivize my sales? rep to get through that transition. And the first question you really need to get crystal clear on is what exactly do you want? Because usually the conflicted part of the organization is actually much higher than the sales rep. So do the CEO and CFO really have a clear understanding of how much of the business they want to transition, how fast? Because that's very much going to affect the way the earnings calls look for some time. If they're crystal clear on that, then I think it's fairly straightforward to give incentives to do that. that to the sales organization, so they make the transition. But it's the challenge to get crystal clear on exactly how fast you want to make the transition, because it's a painful transition. Right, right. Maybe just one more question just on that topic, which is around

Starting point is 00:22:37 sales commission and sales organization. So, you know, in a SaaS model, obviously, where, you know, there might be, you know, there might be a tendency for people to want to do multi-year deals, either coming from the customer side or from the sales side. You know, how do you at NetSuite or how do you think about kind of in the canonical case, you know, what's the right compensation, structure for sales guys how do you think about separating potentially you know hunters from farmers you know in the you know kind of overall you know scheme right so we we primarily measure our sales measure bookings on annual contract value and so we're gonna we're going to look at we do primarily one-year deals but even when we do a multi-year deal we're really going to

Starting point is 00:23:16 look at its one-year value and not there's no reason for me to think of a three-year deal as more valuable than a comparable one-year deal. Our retention rates are very high. We're going to get the second and third year, even if it's not locked into that initial contract. So that's the way we look at the business. We very much use one-year contract value as the way to measure thing. That is the fundamental basis for sales comp as well. That's the commissionable amount. That's what quotas are set on. So new business reps are really there to sign up new accounts. They'll own that account for a certain length of time to make sure the customer's up and live and happy. And then we're going to hand it over to an account management rep, different compensation model for an account

Starting point is 00:23:54 management rep to keep customers happy in the long term and keep that renewable base going. You know, I had one question for you, and that is given some of the things that we've talked about and sometimes the challenges of getting the street to understand the SaaS model, the amount of time a public company CFO spends talking with the street and some of the difficulties of operating as a public company. I wonder what you guys are thinking. We are seeing private companies sort of stay private longer. We're seeing later and later rounds by what have traditionally been public company investors, the fidelitys of the world. I wonder what kind of advice you're giving your portfolio companies in terms of when they should be thinking about

Starting point is 00:24:35 going public and how compelling it is to be a public SaaS company. Yeah, it's a really good question. And right now, the advice we're giving our companies in general, quite frankly, is to stay private, you know, as long as they have access to the capital resources that they need. to grow the business in the private markets. And I think the reason for that is a lot of the stuff you mentioned, which is it gives them the ability to think about, you know, KAC and LTV and other metrics and hopefully give them, you know, a broader base for growth without having to deal with some of the issues that, you know, you have to deal with in the public markets.

Starting point is 00:25:04 I think the reality of it, though, is at some point in time, kind of the companies will go public, probably for a couple reasons. One is that we do think, you know, at some point there has to be a more formalized liquidity market, particularly for employees. And what we see in the private markets today is you do see some kind of. of, you know, small tender offers that companies are doing where they're saying, gee, if you've been here for a couple of years, you know, we're going to let you once a year or sell up to 10% of your stock at, you know, some predefined price. And, you know, so we kind of take a little bit

Starting point is 00:25:30 of the edge off and give people some liquidity. And I think that's a good interim solution. But my senses at some point in time, you know, you kind of probably have to have a more fully formed, you know, liquidity opportunity for a broader employee set. And then the other area is, to the extent acquisitions are important for these companies. You know, it's still very hard to do private to private acquisitions where, you know, you spend so much time fighting about my relative value versus your relative value. And, you know, the one thing that the public markets do well is, look, they give you a report card every day, right? So we know what the price is, and at least it does make it easier if you're particularly on the acquisition side to think about acquisitions.

Starting point is 00:26:03 So those are really, I think, probably the most compelling drivers that will ultimately get people to go public. But I think the phenomenon we're seeing is something that's not going to go away for a long time, which is, you know, as long as capital is available to the extent that it has been in the private markets, there's going to be a strong tendency for companies to stay private as long as they can. So we're going to wrap for today. Thank you, Ron, again, for spending time with us. This has been great, and hopefully we've, you know, demystified some of the SaaS questions

Starting point is 00:26:26 people have out there. Thanks very much.

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a16z Podcast - a16z Podcast: Why SaaS Revenue is Worth More Than Traditional Software Sales

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