Avoiding the Reasons why most SaaS Companies Fail
There are many reasons why companies fail, but it usually boils down to running out of money before you’ve been able to build something that can scale. Of course, companies can fail because management teams disintegrate or because shifts in the market turn a profitable business into an unprofitable one. But if we look at why most startups fail, it’s because there simply wasn’t a sustainable business.
For Software-as-a-Service (SaaS) companies, there is especially room for concern. We’ve heard that the vast majority of SaaS companies fail. Even in an era where it takes less and less money and time to start a software company, we’re still seeing SaaS company failure. As a SaaS company, we are particularly concerned. As such, we figured we’d look at the top reasons why SaaS companies in particular fail and how that failure can be avoided.
Failure Reason #1: Lack of Product/Market fit
The top reason why SaaS companies fail (or any company, for that matter), is because they’re simply not solving a customer problem that has sufficient enough pain. We see far too many SaaS companies that are scratching an itch that customers either don’t find worth scratching or have found another way to scratch it. The #1 goal for any SaaS company is not to prove they can develop a product — the barriers to entry for app development are at an all-time low — but rather, should be to find the optimal solution for a given customer problem in a market that is large enough to sustain a viable business.
One of the best solutions to avoiding the product/market fit problem is to adopt a customer-centric, iterative, hypothesis-trial-and-prove methodology such as Customer Development or Lean Startup approaches. In these approaches, most of the front-loaded effort goes into proving you have a viable and scalable business. Since it is far cheaper to adjust and pivot course early in a company’s existence than later, it goes without saying that approaches that help to optimize the product/market fit process will not only be more effective than other processes, but also lower cost.
Failure Reason #2: Ineffective Customer Acquisition
Assuming a company has managed to find the product/market fit, they can still fail if they can’t adequately acquire new customers. Customer acquisition should be the main concern for companies after they’ve validated their business. Of course, this is the primary challenge for most. Unless you are already a mover-and-shaker in your industry, it’s hard to go from a standing start to rolling with momentum in a short-enough time that you don’t run out of money before the engine starts rolling. I’ll address the issue of customer acquisition cost (CAC) in the next point, but this failure has to do with the inability to find an adequate means of acquisition, let alone a cost-effective one.
The only solution to avoiding this failure point is to learn not only about product/market fit as part of the Customer Development activities, but also what the best means for reaching that audience are. If your audience is most influenced by their peers, it makes no sense to place billboard ads in subway cars. Yet, I’m continuously surprised by how much money companies spend in wholly ineffective attempts at customer acquisition. An influx of venture capital money only exacerbates this problem. More money = more problems if you haven’t figured out customer acquisition.
Failure Reason #3: Customer Acquisition Cost > Lifetime Customer Value
Even if you have figured out how to reach your customers, you can still be doomed to failure if your Customer Acquisition Cost (CAC) is greater than the amount of money you get from your customers over their lifetime (LTV). This is obvious math here: there’s no way to get ahead if you spend more money to acquire a customer than you get from them. Yet, many SaaS companies have been relegated to the dustbin of history because they couldn’t manage their CAC.
Often, it takes very careful analysis and a focus on hardcore marketing metrics to avoid death-by-CAC. One rule of thumb is that CAC should be a third or less of LTV. If you haven’t figured out LTV, then you can use the Annual Customer Value as a substitute. In either case, the CAC should be no more than the appropriate customer value if you want to stay ahead of the game, given the effects of churn (discussed later below).
Failure Reason #4: Average Cost to Serve > Average Recurring Revenue
On the flip side, it shouldn’t cost more to serve your customers than the revenue you are getting either. If your combined customer support, infrastructure, and overhead costs averaged on a per-customer basis (ACS) are greater than your average recurring revenue, then you are in trouble. You are already starting out with a negative customer value, whether you calculate it on a lifetime or just a yearly basis. There’s no way to make this up on volume. In fact, just like the example above, you only dig the hole deeper with each new customer you acquire. You might as well just give up early if you can’t figure out how to control your CAC and ACS because at least the sooner you give up, the less it will cost you.
Controlling customer costs is about empowering users to self-service with customer support, finding scalable infrastructure and optimizing performance to the n-th degree, and focusing the business on sustainable growth. It also means that while you should plan for growth and build your SaaS architecture in a way that is easy to scale, you shouldn’t over-engineer the solution. The more overhead you build into the solution now (even if anticipating future growth), the more you are pushing ACS costs up. And if it exceeds your revenue, then you can be in a perilous position where you will run out of cash before you’ve even reached the point where the scale you’ve engineered is necessary.
Failure Reason #5: Churn > Growth
SaaS companies have a particular mode of failure in which customer turnover (churn) is greater than the new customer acquisition rate (growth). Joel York does a fabulous and commendation-worthy job of explaining a whole range of SaaS metrics in his Chaotic Flow blog including the point that SaaS companies will quickly plateau even if they are achieving consistent customer growth in the face of constant percentage of churn. That is to say, the only way to make sure you don’t flatten or die is to make sure that the percentage rate that you are acquiring new customers is greater than the percentage rate of customer attrition through churn.
Obviously, to avoid this failure mode, SaaS companies need to minimize churn. Churn can never be completely eliminated since customers do go out of business or their priorities might change. However, churn due to disappointment with the product, poor service, or better alternatives in the market can be avoided by providing excellent customer support (without pushing your ACS too high), introducing the smallest feature set possible to achieve the highest rate of satisfaction (thus focusing development effort where it matters most), and constantly keeping an eye on the competition. By doing so, you can make sure your growth rate always exceeds your churn rate.
Failure Reason #6: Growth > Rate of Customer Return
This failure mode might not be obvious and even counter-intuitive. There is such a thing as growing too fast… and in fact, it can be fatal. Joel York does an awesome job explaining the “J” ratio – that is, Joel’s Saas Magic Number, which is computed as the Average (Annual) Recurring Revenue minus the Average (Annual) Cost to Serve all divided by the Customer Acquisition Cost. This ratio in essence is the rate of customer return — the gross profit made on each customer (revenue minus cost of goods) divided by the investment in that customer. The smaller the number, the more time it will take to break-even on a per-customer basis — this is obvious in the case of high CAC and ACS.
But high rate of growth can kill a company too. To achieve sustainable growth, you need to be able to pay for new customer acquisition from the gross profit earned from current customers. If you are acquiring customers faster than existing customers are able to pay for them, you will go broke. In this scenario, the well is pumping oil faster than you can put it in the pipeline and you’re going to drown. If there’s only so much cash around, then you can only sustainably grow based on what the cash contribution is from current customers. Joel writes this as the rate of customer return (J) must be greater than or equal to the growth rate (g).
Failure Reason #7: Churn > Rate of Customer Return
Following up on the above, Joel York also relates that if your churn rate is greater than the rate of customer return (not to mention your growth rate), then you will also go broke. Simply put, if you are losing customers at a rate faster than what current customers are returning in gross profit, then you will never be profitable. Your pipeline has holes in it and you just can’t get enough pressure to get the oil to where it needs to be. Combined with the above, if you truly want to avoid the death knell of the cash crunch, then you need to make sure that your rate of customer return is greater than both the growth and churn rates, preferably, greater than them both combined. If your rate of customer return, say, is 30% and you have a 20% growth rate and a 10% churn rate, you’ll have enough cash to cover both new customer acquisition and the loss of customer revenue through churn without having to dip into your piggy bank. That’s good. Less digging = less need to raise money.
Failure Reason #8: First-to-Market vs. Fast-to-Market (or the Fast-Follower advantage)
So, if you can meet customer needs with a good product/market fit, cost-effectively and adequately acquire new customers, control your customer acquisition and service costs, limit churn and build for sustainable growth, then you should be on the path to glory, right? Not necessarily. There is such a thing as being too early. First-mover advantage has been proven to be overrated. Even if you build a successful business, a new company can see where you’ve had success and which mistakes you made, and build on those successes while avoiding the mistakes to take your market away from you. If you don’t believe me, you should read this description about how Mint.com took the online personal finance market away from Wesabe, even tho the latter had a distinct early-mover “advantage”. There are many examples of this in the marketplace cited by Steven Blank and others, so it doesn’t bear repeating here.
What is worth mentioning is that if you are an early player in the market, and (gulp) first, then you should be extra careful. Someone out there is looking carefully at how you’re running your business and is ready to snatch it away from you when you are just gaining traction. You’re going to spend the money proving the market, identifying the customer pain, building demand, and generating first product in the marketplace only to have someone else thank you for your development efforts and build a better product with more effective customer acquisition. The only way to beat the later-comers is to have a fast-mover advantage, a supremely excellent and constantly evolving product, amazing customer support and experience, and a customer acquisition strategy par excellence. Sounds difficult? You bet. This and the above reasons are why most SaaS companies fail.
Now, every SaaS company believes that they won’t be the ones to fail. Of course, statistically it’s not likely. Statistically you will fail. As such, you have to face that fact with both eyes open, an understanding of all the failure modes above (and probably others), and a resolve to continue to iterate and pivot until you can make it work.
Are there any other failure modes particular to the SaaS business that we missed? If so, let us know below!