Not so fast
Do you dream of owning your own internet company? Maybe carve out a little service that is inexpensive to build, maintain, and profit from? It is a nice thought, but building, running, and making money off monthly subscriptions is much more difficult to pull off than you may think. I am not trying to put a damper on your dreams, instead I attempt to provide a more accurate depiction of the costs associated with trying to start your own software-as-a-service company.
I have worked with 25+ web-based software companies and I would like to stomp out any myths that make most people believe that this business is trivial to execute, inexpensive to maintain and will be acquired for millions of dollars. There are many ways to make money both online and off. Consider these truths when wanting to build a web based business.
Cheap and easy
The biggest and scariest myth is that building a web-based business is easy to do. For people who build websites or applications for a living, yes it is much easier and less expensive. But even for the most qualified designers and developers it still requires an investment of time. We built Electric Checkbook in 48 hours with 3 people. It’s free and serves as an easy to use single-entry ledger for thousands of customers. If we had performed the same work for a customer at our standard hourly rate, it would have cost nearly $35,000 to create the first version of the application. For that type of investment, we created a marketing website and very simple application. It took even more time to correct some bugs and add a few key features. The application is very simple and that is why we were able to create it so quickly. If we added the influence of a customer, subscriptions, and in-depth support, the price to build the application could easily double.
Subscriptions make money
I have had the unique opportunity to work with both direct marketing and software-as-a-service companies that use subscriptions to generate revenue. First of all, your least expensive or free plan will be your most popular. That means a majority of customers will pay no more than $5-$15 per month to receive 95% of the same services that your more expensive plans offer. While diehard advocates that need your comprehensive services don’t mind paying extra, they are the minority. Second, you need to consider retention and customer acquisition. Retention is how long you keep a customer after they signup. If you offer a 30-day free trial and you have a 1 month average retention prior to canceling, then you are not going to make any money. It is important to establish your retention rate prior to offering free plans or trials. Acquisition is the cost of getting customers to signup. If you are popular, costs can be next to nothing. Most of us don’t have the luxury of being instantly popular and must advertise to find new customers. Advertising is a very expensive proposition; if you go this route then you need to build the cost of interrupting users into your subscription cost, and also account for length of retention of that customer. Let’s say it costs $100 in advertising to acquire 1 new customer: if your average plan is $15 a month, then that customer must be retained at least 6.5 months before that investment breaks even. Think about that next time you want to offer a 30-day free trial.
It gets easier over time
You would think the initial push to launch your new product is the hardest you will need to work before you start making money with it. Untrue. Developers and customer service are going to significantly affect the bottom line — so much so that your company will reach an equilibrium. It will cost more to acquire new customers than it did in the beginning. The flip side is that your rise in popularity with a current customer base will increase support, bug fixes, and new feature requests. This will require your developers to spend more time maintaining the service rather than adding new features, which increases overhead. At some point your budget will only be enough to cover the costs of ongoing maintenance, and you’ll need to shovel advertising money out the door just to have enough profit to make any new significant upgrades to your product. It is a very expensive and vicious cycle.
Popularity versus profitability
The results are in, free applications are far more popular than their paid counterparts. If you want to charge $12 a month for a product that is only a little better than a product that serves the same need for free, good luck. Would you pay for Gmail? Probably not. It is a great app, but there are just too many great alternatives that are cheap or free to have to pay for it. Keep this in mind when devising your product and service. Building something that solves a real problem, that people want to use is one thing; building a service that people think is worth paying for is something else entirely. If you charge a subscription fee, that will significantly affect the amount of customers you have. If your goal is to dominate your space and be the most popular brand, then you may want to keep your product free and find an alternative way to generate revenue.
Selling your company
Only a very small percentage of companies get acquired. They are usually purchased because they provide a larger user base, generate revenue, have long retention, and low customer acquisition cost. Very rarely do they serve the purpose of augmenting the larger company’s family of products or offering a significant technology boost. After all, the company that has enough money to buy your application probably has enough to build it themselves – so it isn’t the technology they are interested in. What they really want is the attention your product receives, market position and the loyal customer base. If the generated revenue is large, that is a big plus. Ryan Carson recently posted a story on his process of trying to sell an application to another company.
“There’s no way around it: you’re going to spend a fortune on lawyer and accountant fees. We spent around $20,000 and the DropSend acquisition was very straightforward.”
“Do everything you can to structure the deal so that you avoid over-paying on tax.”
_"One of the hardest things about selling a web app with paid subscribers is handing over the merchant account." _
“The buyer will ask you to prove that you are receiving the amount of revenue that you reported to them. The usual way to do this is send a faxed copy of your bank statement, so a separate account for your app makes this a lot easier.”
Ryan had been working for extensively to find a suitor for DropSend. Many deals didn’t work out and the process was quite involved. His article really explains the process and I think it is absolutely crucial to learn from if acquisition is your exit strategy.
Investing into applications
I have seen millions of dollars invested into the planning, design, and development of software-as-a-service products. While initially the ability to become the biggest vertical solution without any direct competitors seems realistic, it is much harder and expensive than you may think. We all can’t be lucky enough to receive a TechCrunch post that generates a ton of new interested customers at virtually zero cost, so the customer acquisition and retention rules apply. If it costs you millions to bring your product to market and you don’t have a strategy for keeping it fresh and acquiring customers at a very low cost, your investors are going to get impatient when they don’t receive their annual dividends. This will also affect your company’s perceived valuation as your fictitious projections meet actual market results.
Big ass SaaS
I know many companies that have taken on millions in investments, hired tons of people and set out to build a new product that will take the world by storm. The bigger the company, the longer it will take to create, and the harder it will be to maintain. If you have hundreds of thousands of dollars of overhead a month as you are trying to get your product off the ground, it is going to get difficult to generate profitable revenue. While your war chest may provide enough of a runway to get you where you need to go over the next few years, you have to consider that a better, less expensive product will come along to challenge your offer. My rule is keep it small, make money early, and drive the high costs out of the business. Most companies that accept huge investments will have to sell their company to provide returns to the stakeholders after the capital runs out. Alternatively, they can continue to raise large amount of cash in order to create a longer runway, but the same rules will apply sooner or later.
Note: 37signals executed the alternative option perfectly. They switched from being a paid consultancy to a subscription-based product only when the revenue and growth potential became sound. They didn’t try to force the product to pay the bills, they waited until it did. Try selling a service to the core audience first face-to-face. After you understand their needs, create a a web-based product with the resources you have on hand. Start as a service, evolve into a product.
To learn about their process checkout Getting Real.
The final word
I would like to sum up my advice. While these rules don’t really apply to the super popular or early-to-market, they do for anyone trying to start a new software-as-a-service company today.
1. Stay lean and mean to reach profitability equilibrium sooner
2. Understand your exit strategy as it will determine your route
3. It gets more expensive over time
4. Drive the cost out of acquiring new customers
5. Find ways to keep customers as long as possible
6. Subscriptions yield far fewer users than free alternatives
7. Avoid investment unless you really need it
8. It is much easier and cheaper for designers and developers
9. Try selling your product face-to-face, then create the online version
10. Patience is critical to creating a profitable service
I hope by providing some insight to what the challenges are for the majority software as a service companies it will help prepare you for whatever endeavor you embark upon.
This work is licensed through Creative Commons.
Posted on Mar 16, 2009 by Kevin Milden
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