Every company is unprofitable from the moment it starts. Many require a significant upfront capital investment before making a single sale.
In traditional business models, products are developed, manufactured, marketed, and sold to make each discrete sale profitable. This makes the path to profitability straightforward — it hinges on the direct sale of a product, and the economics of the business can be inferred from the economics of a one-time sale.
For example, let’s say you purchase a car. The $30,000 you spend to purchase that car covers not only the cost of production but also the cost of transporting it to the dealership, marketing that car to you, and the commission paid to the dealer who sold it to you. At the time of the sale, all costs are recouped. The transaction is either profitable or not — and it better be profitable for the business to be viable.
The Software as a Service (SaaS) model is different since the initial sale rarely covers the cost of acquiring the customer. Instead, SaaS companies recoup their upfront investment over time, often in monthly or annual subscription fees.
Meet the “Triangle of Despair.” This is what the economics of a SaaS business look like for a given customer. The business is stuck in a zone of unprofitability until the cumulative monthly payments from that customer offset the initial cost required to acquire them.
This dynamic almost guarantees that a SaaS business will be unprofitable from the outset. Furthermore, the faster the business grows, the worse their initial losses. Acquisition costs from each new customer accumulate, negatively impacting cash flow and pushing the company deeper into the financial trough. Rough right?
So why are subscription businesses so popular these days? The answer is in the recurring relationship a company establishes with its buyer. If a company can convert an initial sale into a long-term customer relationship, more value accrues over time for both the customer and the company.
The beauty of the SaaS model is that it aligns customers’ payments with the value as it’s realized. Customers pay less upfront but more over time as they continue to use the product. If the value they’re receiving from the product doesn’t align with what they’re paying, they are likely to churn, and the company loses money on its upfront investment.
This model also reinforces the expectation that SaaS products are continuously updated so they never become obsolete. Imagine paying monthly for a car and getting a better version every month. Who wouldn’t want that? That’s the beauty of SaaS.
This recurring revenue model provides a pathway to higher long-term profitability for the business. Once the initial acquisition cost is recovered, retaining customers over the long run can be wildly more profitable for the company. The potential for higher future returns enables the business to pay more to acquire customers upfront, knowing they’ll eventually be able to re-invest in growth and increase market share using the profits that come later.
As a result, while a SaaS business pursues growth, earnings are a poor indicator of its profit potential. SaaS businesses need specific metrics that help investors and operators “triangulate” the Triangle of Despair. Metrics that help them gauge whether despair is warranted or if there’s potential for a business to eventually become viable and, ideally, wildly profitable.
