The Rule of 35: A New Metric for SaaS Profitability

Randy Wootton (00:05):

Well, hello everybody. This is Randy Wootton, CEO of Maxio, and your host of SaaS Expert Voices, the podcast that brings the SaaS experts to you to help us understand where we are today and what's happening tomorrow. It's my distinct pleasure to welcome a guest who I've known now for 11 years, Thomas Lah, who is one of the co-founders and overseers of the Technology Services Industry Association. Been there for the last 18 years, also a professor at Ohio State for about 10 years. We won't talk about the game, Thomas.

Thomas Lah (00:34):

I appreciate that.

Randy Wootton (00:35):

Started his career at SGI still on graphics, and just has this fascinating story. And so Thomas, I'd like to spend just a little time talking about your background, but for people on the podcast, just want to say, you got to check out TSIA if you're in subscription businesses. It really is an incredible industry. The books, Thomas has written seven books and has about 350 companies that are broadly involved with TSIA on their platform, but they have about 1,500 people that attend their conferences two times per year. I've been several times, every time I've been, I've learned something. And so Thomas, congratulations on all your success. The fact you've written seven books, we were joking, I can't even get my first book out, so well done on that. Can you give a little bit of background in terms of how your journey from SGI into TSIA and then we'll talk a little bit about the state of the SaaS business models, what the impact is for specific B2B companies and then a special metric you guys have developed, The Rule of 35, not to be confused with The Rule of 40.

Thomas Lah (01:36):

Yeah, so my background, how I ended up in the chair I'm sitting in now, I actually started back in the nineties at Silicon Graphics right before the big dot com boom there, and I started in IT, but then I got recruited to help start a consulting business. And so I spent about five years helping to build a consulting business embedded. And when I left SGI, one of the executives there said, "Look, you should write a book about what you just did because it's hard to build consulting within a product company as you know." And I said, "I’ve never written a book before. I don't know how to get it published." And he said, "I've got connections, you should do it." So I did. I took time, I wrote a book, it got published, I started to interview to go back into an operational role, and suddenly my phone just started ringing when the book came out and people said, "Hey, did you work at our company?"

(02:24):

And I'm like, "No, why?" "Because everything you're describing is exactly what we're dealing with here at our company on PSO." So I started working on a second book and when I was working on that, JB Wood, who's the CEO of TSIA gave me a call and he said, "Hey man, I'm going to start this association model. I think it's going to be really interesting." And I'm like, "Yeah, I'm not so sure." And he goes, "Oh, let's give it a try." So we took a run up the hill and I've been doing it 18 years and it's just been a great way to drive data and insights for the industry. So I really enjoy what I'm doing.

Randy Wootton (02:53):

Well, that's great. And then I remember coming to you in 2012 having been at Salesforce, which is clearly a subscription business model and Marc Benioff and all that he did in terms of championing it as both a software as a distribution model through the cloud, but then also the monetization from CapEx to OpEx. And I remember my first conference with you all, I think you said something like 40% of the companies, broadly software companies were cloud-based, 60% were still on-prem, and this was back in 2012. Over the last 11 years, what have you seen? How has that transformation continued to unfold and what's the current state in terms of on-prem versus cloud-native?

Thomas Lah (03:36):

Yeah, no, it's a great question. So if you think about software companies right now, if we just focused on them, there's really three profiles right now. There are the born-in-the-cloud companies like a Salesforce. And the key thing there is they've always been in the cloud, which means they're connected to all their customers. The customers are all in a common platform and they have this recurring business model, pricing model. The other extreme are software companies that are still basically on-prem, disconnected from their customers, and they have still a traditional license and maintenance model. So there's still a few of those out there. That's definitely the minority percentage now. I would say that the biggest chunk is in the middle. And what you see is a lot of legacy software companies, whether you pick an Oracle, an SAP, whoever, it doesn't matter. And what they've done is they've moved their pricing models to recurring.

(04:31):

So they have a lot of subscription revenue. So if you look at their 10Ks, you'll see these big growing subscription revenue streams. Underneath the covers, some of that is coming from true SaaS, but there's still a lot of on-prem out there that is simply in a recurring business model now. And so I put that on the table because there is a lot of the software industry that still has to eat through what we call this financial fish of moving from an on-prem model to a SaaS model because I think there's no doubt that's the winning distribution model. I think you would agree. I mean, for customers, I mean, any software company that was started after 2006, I mean, they're not building on-prem software, they're building it in the cloud, but there's still a lot of migration that needs to occur underneath the covers.

Randy Wootton (05:18):

Do you have a general sense from the people you talk to and the tracking of the industry as you do in terms of the split in terms of the percentage of software companies that are now born-in-the-cloud versus legacy on-prem versus hybrid?

Thomas Lah (05:32):

Yeah, I don't know the exact percentage. I mean, there's a lot of software that is under these big legacy companies that have been around for a while who have big install bases. So that's probably still the biggest percentage is with these companies that are in that hybrid mode. They've got customers in on-prem, they've got customers in SaaS. I'd say they probably own the majority of the market still followed by the pure born-in-the-cloud companies. Again, what that exact breakdown is, I'm not sure.

Randy Wootton (06:01):

Yeah, I remember Steve Ballmer talking and having this debate about the private versus public cloud and that whole playing out of are you going to have your own servers for some service that you're offering versus being in the cloud? And clearly his motivation was transparent for why he was advocating for that. But then you have Satya come in who then goes all in on Azure, and just such, what a transformation of the public cloud thinking. And he came out of the developer database division and I left before he joined, radical transformation, even in the short time he's been there around the entire business model of Microsoft.

Thomas Lah (06:43):

Yeah, no, it is interesting and that debate in some ways still continues in terms of public versus private, whether you're worried about security, whether you're worried about intellectual property... Whatever. And so that still goes on. What's interesting is, again, you think about this migration. You see a lot of traditional software companies when they start to first move customers to more of a cloud posture, it's often in a managed service type of offer where they say, look, we'll build a cloud just for you, an instance just for you, and we'll manage it just that way and they'll do that. So the customer's getting out of the business of owning infrastructure, they're getting the advantages of the cloud, but it's just for them. The only downside with that model is the economies aren't there the way they are. I mean, the reason that the public cloud is so attractive is because of the economies. I mean, that's why it becomes such a dominant model.

Randy Wootton (07:33):

So speaking of public companies, one of the things you guys do is you have your TSIA Cloud 40, which tracks the state of the software companies that are the cloud, the top 40 public markets, and you have a lot of different insights. We focus primarily on private companies and our Maxio Institute growth report looks at 2000 companies and talks about what's happening, because we have the billing and invoicing data and we were chatting in our pre-brief a little bit about what you saw happening in the broader Cloud 40 and wanted to give you a chance to talk about, well, what are you seeing? What's going on with growth and what's happening under the business model?

Thomas Lah (08:06):

Yeah. And I'm sure things we're seeing in the public data, and we benchmark a lot of privately held smaller SaaS companies as well, their operating models. And I have a feeling that you and I are seeing the same things in our data sets. So 2022 was a watershed year for SaaS companies as you know, because it just was this cold bucket of water that basically said growth at any cost is not okay anymore. And by the way, the Wall Street Journal today had a large article in the business and finance section about the state of technology business models. And in reiterating this point that tech companies are being way more cautious around their spend and how they grow and they're realizing they've got to do it more profitably. So that reality hit in 2022.

(08:52):

And so if you move forward to what we're seeing now this year we just took the Q3 snapshots, we track 40 of the largest publicly traded cloud companies out there in this Cloud 40 Index. And the good news is they're growing, on average they're growing 14%, but I will tell you that's down from a couple of years ago when they were used to growing north of 20% on average and some of them growing much faster. So there's been a slowdown in growth. The gross margins are improving because they are starting to really get serious about costs. On average, SaaS companies are doing about 70% gross margin. That's gap gross margin. Their sales and marketing expenses are getting chipped down. They used to be on average about 40% a year ago. For these companies down to 36%, that's not insignificant. So they're moving that.

(09:37):

Those moves are helping improve their operating incomes. That's the good news. But on average, these companies are still from a gap perspective, unprofitable. So it was about a negative 7% across the board there. And even the largest SaaS companies in the world like the Salesforces, they are profitable now. They've really focused on that, but their profitability profile is still about half of what you used to get in an old traditional software business model. So if a traditional enterprise software company could throw off 20, 25 points of operating income, even these large, well-managed SaaS companies are still only throwing off around eight to 10 if they're lucky, 12%. So it's a different model.

Randy Wootton (10:20):

And is that because, I remember at Salesforce, this was years ago, was there, yeah, we're not profitable now, but any point we could be because we're going to stop spending on X and we have this recurring revenue and it's just going to continue to grow. So if we don't spend... 80% of their revenue was booked because they had annual multi-year contracts. Is that still kind of the pixie dust?

Thomas Lah (10:42):

Yeah, yeah. I am so glad that you said this, because I spent the last eight years of my life arm wrestling with SaaS executives about this very point. So the logic has always been, because we've been ringing the bell about SaaS profitability for quite a while because we've always believed at some point the music stops and you have to sit down on a chair that is a profitable business model. You just can't keep justifying, "Hey, don't worry about it." And so what has happened, and in 2022 proved it is the message came out loud and clear, "Hey, you have got to get more profitable to all these SaaS companies." And I was talking to these executives, what they painfully realized is, okay, I can start to work my cost structure, but I can't cut sales and marketing in half to become profitable because where is my future growth coming from?

(11:31):

It was a bit of a red herring, that this argument. And so what you're seeing is they're chipping on it, they're getting sales and marketing to go down just like Salesforce. They didn't cut things in half, but that was really, I think, a false narrative that has proven that it's just not what you can do and it's going to take a lot more work for these companies to get into a profitable posture.

Randy Wootton (11:53):

Well, two thoughts on that. One is I just saw a recent article literally I think it came out yesterday or two days ago from TechCrunch that referred someone else and said there were 240,000 tech layoffs year to date, which is 50% more than all of 2022, 50% more than all of 2022. So we still have another month to go, there could be more layoffs. And I do think the early companies, they lay off quickly, VCs are banging on them, extend their cash, and we're seeing big swaths of large companies doing it. To your point, Microsoft laying off 10,000 people is not a huge layoff. As total absolute number of people being laid off, it is, but they're doing this chipping like, where can they trim?

Thomas Lah (12:34):

Yeah. Well, and I'm going to give you some numbers that are stunning and I'm glad that you brought this up. So what a lot of SaaS companies did in 2022 to basically start to right the ship is they said, well, the easiest thing to go after is headcount, obviously. So you start taking headcount out. But let me give you some numbers. So there's a website that tracks this on tech layoffs. During the dot com bust, which you and I lived through, which I thought that was Armageddon when that happened over a two year period, tech took out 300,000 jobs over two years. Starting in 2022, and we're not even done with 2023, so not even a complete two years, tech has taken out almost a million jobs.

Randy Wootton (13:18):

Holy smokes.

Thomas Lah (13:19):

Yeah, it started in 2022 because the numbers you're talking about are just this year to date, you got to go back to 2022. So you put those two things next to each other, the dot com bust and this now, the talk track as well, tech was bigger and we did a lot of over hiring, yeah, but a million jobs is a million jobs.

Randy Wootton (13:38):

Yeah.

Thomas Lah (13:38):

It's a lot of headcount that came out.

Randy Wootton (13:40):

And this is the third recession that you and I have been through. At 2021, I was at a company Avenue A, where one day we let go. We were 500 people, we let go 250 the next day, so cut off 50%, but we're profitable the next day. And it's one of these lessons I've learned and held closely is the advantage of being profitable. You control your own fate and be profitable. And I think that leads to this next conversation around The Rule of 40 and that there is a real difference between being 100% grower and 60% negative EBITDA versus a 40% grower and profitable, because if the 100% wobbles at all, you have this enormous cost structure that you've got to take care of. And if the market macroeconomic effects, you're screwed. And so do you have any thoughts on that? I know we're going to get to the TSIA Rule of 35 in a second, but just on The Rule of 40 and how you're seeing that playing out for SaaS companies.

Thomas Lah (14:37):

Yeah, so what I think is interesting about The Rule of 40, and it's an important rule, basically investors have used it as a way to hold it up to a company and say, look, if you're growing 40% and you're breakeven, that's okay. Like you said, if you're growing 60% and you're losing 20 points on operating, that's okay because that was sort of a bumper that was used. But the crazy thing about it, and when you look at these companies in the TSIA Cloud 40, again, some of the largest cloud-based companies on the planet, there's very few of them that are Rule of 40 companies. And that has been true for several years. So it's almost become a myth. And so companies will say, "Well, I'm a Rule of 40 company." And you'll look at it and you go, "Well, no, you're not." And then what they start doing is making up new definitions for the Rule of 40.

(15:22):

"Well, I'm Rule of 40 if you take this out and you add this and multiply this and you square this. Look, I'm a Rule of 40 company." So I think that, to be honest with you, it has lost its value in the conversation, number one, because it's just become so confusing in some ways, so convoluted, and go back to the article in the Wall Street Journal today, it's not what investors are focused on. If you're growing 40% or 50% and you're losing 10 points, investors are concerned right now because money's not free anymore. So it's really hard to justify that high growth and just say, "Well, don't worry about me losing money. It's okay." It's like, "No, no, no, no, no, it's not okay. Because that is expensive to fund that growth."

Randy Wootton (16:08):

To that point, a private company guy, I was public company for a little bit, but private company CEO, my whole orientation in the age of free money was just about EBITDA. But then all of a sudden you got to say, with high interest rates, you got to cover your interest nut.

Thomas Lah (16:23):

That's right.

Randy Wootton (16:24):

And all of a sudden you're thinking, oh my gosh, I have to generate EBITDA to cover debt. That's a really different way, even before you're investing in the business, you got to cover your debt. And I think a lot of companies are taking debt, equity is expensive, they took free debt and now they're paying the piper.

Thomas Lah (16:40):

They are. And as I'm sure you're aware, and maybe most of your listeners are your particular audience, but the tax rules changed as well in terms of how much of that interest rate you can write off. So it got even more expensive. You had to pay this, and then there wasn't this huge tax write-off that you had historically.

Randy Wootton (16:58):

Yeah, no, great. So as we shift, there's The Rule of 40, and then you guys, just to make things complicated, introduce this TSIA Rule of 35 and it's going to take a minute for you to explain it. And as we talked about it, I was like, gosh, that is a really compelling way of looking at the business. So could you talk through Rule of 40, why you thought you needed to introduce a new Rule of 35, and what are some of the insights you're seeing from that?

Thomas Lah (17:25):

Yeah, absolutely. So the reason we put this Rule of 35 on the table a couple of years ago is to start to get the lens around the operational efficiency side. Because again, The Rule of 40 is rewarding growth, but the question is, okay, are you growing cost effectively? So The Rule of 35 is actually very, very simple. You just take your revenue 100%, here's my revenue, subtract the percentage of your revenue you're spending on the cogs. So to get that gross margin, if my gross margin is 70, that means I'm spending 30% on cogs and subtract how much you're spending on sales and marketing, because those are the two big cost buckets that are driving your efficiency, your infrastructure cost, and then your sales and marketing. And you take those two out, you should have at least 35% of your revenue left, and you're covering G&A, R&D, and profitability.

(18:12):

It is just sort of a floor, just a base to say, look, that's where you should get to start to feel that you have an operationally effective SaaS business. And the reason that rule is so powerful is every quarter, and I do this in my public webinars on these indexes that we do that anybody can attend, is we put The Rule of 40 and The Rule of 35 together, and we create this nice little 2X2, and in the upper right-hand corner are technology companies that are both Rule of 35 and Rule of 40. And on the bottom left-hand corner are companies that are neither. And what I can tell you over the last two years is the companies that are Rule of 35 companies, their valuations are holding up much better than the companies that are in the bottom left. And the bottom left are all these SaaS companies that are no longer Rule of 40 companies, and they're operationally inefficient. They're not Rule of 35 companies, and that's the one that investors, they're just pummeling them.

Randy Wootton (19:07):

We were chatting a little bit, it was interesting, I've written an article on the two metrics that investors and operators can agree on. And one of them is very similar to what you described. I got it from Battery and my general partner, Chelsea Stoner beat this into me. It was that you have two engines, you have a cash engine and you have a growth engine. And the cash engine, the way they calculate it, slightly different, but same idea is you take your gross margin, you actually subtract out G&A, R&D, and then you want to have what's left over is what you're willing to invest in growth. And that growth could either go to sales and marketing or it could go to a rainy day, or it could be your fund to start building cash for M&A. So you have this cash engine and their targets were 30% minimum, 50% best in class.

(19:57):

So 50 cents of every dollar after you covered cogs, G&A, and R&D, you could put into growth. And then the growth engine is another thing you got to get super clear about in terms of payoff and return. And so two different ways to look at it. I'd love your Rule of 35 and the plotting that you're done. And at the end of our podcast, we'll make sure people know how to get in touch with you and where to hear you talk about it because it's super interesting to see that play out as you represent that and see it play out in the public markets. And I do think it provides this great seesaw between the EBITDA growth and operating leverage. Talking about the growth engine though, you have this really interesting metric that you guys use called RAC versus CAC. So can you introduce that metric and what you've seen, why that's helpful and why should people think about it?

Thomas Lah (20:52):

Well, CAC is so interesting because it is so important. Our customer acquisition costs, what are we paying there to get a dollar of new revenue? It's been a foundational metric in SaaS companies forever, but I can tell you, and you've been in the chair as CEO, you look across a lot of companies, a lot of companies struggle to really get their arms around that number. And we've tried to benchmark it for years, and it's super noisy data, super noisy. So what we did is we created a proxy and we basically just said, okay, here's the simple math. Take how much you're spending on sales and marketing. Let's say you're a SaaS company and you're spending 40% of your revenue on sales and marketing, and let's divide that by your annual growth rate. Let's say your SaaS company are growing 40%, 40 divided by 40, that's your revenue acquisition cost.

(21:41):

In that case, the number would be one. And the question is, okay, is that good, bad, or ugly? And we basically published that number every quarter, again, from the public data. And I can tell you right now from Q3, the average RAC number for cloud companies is actually 2.84. So they're spending 2.84% of revenue to get 1% of growth. And the really important thing is that there are SaaS companies that their RAC number is much lower than that. Salesforce, it's 1.24, so less than half. ServiceNow, 1.72. Zscaler, 0.46. So what does that tell you? If you're a SaaS company and you can do this very simple RAC calculation, you can compare yourself to public companies, your competitors, et cetera. If your RAC number is higher than your competitors, you have a problem. You have a serious problem because you are not as efficient at generating revenue growth, and that's going to catch up with you.

(22:38):

I mean, your ability to... How much time and treasure you're going to have to spend to get market share, you are handicapped. And so again, I like it because you can use public data to look at it. And the other thing I'll also mention here is the RAC numbers went down last year when people started whacking all their headcount and getting their costs, but they've been creeping back up. So SaaS companies are spending more and more, if you will, to get that next dollar. And I think you probably talked to a lot of your customers, I know our members, they're feeling that headwinds of getting revenue, it's harder.

Randy Wootton (23:11):

Yeah. So a couple of follow up thoughts. One is under CAC, yes, agreed. I think being cloud native, SaaS native, it's one of these metrics you've been hearing about forever. You can use benchmarks out there. Ray Rike's Benchmarkit study shows by size of company and your average ACV, what a good CAC is. The only thing with CAC is you can totally game it. You just go grab a bunch of new customers and it lowers your CAC for that quarter. And so you have to tie it in with churn and how much did you spend? The other thing, I think the nuance that we talk about with CAC is being able to assign costs to drive new logos versus current customers. And so how do you think about new revenue versus expansion revenue? And in a recession time, it's often easier to monetize your customer base. So how do you shift your marketing and sales and focus?

Thomas Lah (24:07):

Well, and just to pause on that one, so we actually took a run up the hill several years ago. We published a paper around what we call CAC, CEC, and CRC. So what is that? CAC is your acquisition of your new customers, CEC, customer expansion costs, how much are you spending to expand existing customers? And then CRC was CRC, customer retention costs, what do you spend on renewals? And our argument was that CAC should be the highest, obviously, CEC should be a little bit lower and CRC should be the lowest. But you know how many companies we found that actually did that analysis and understood those three buckets? The number's close to zero. Again, but that's the right way to think about it, exactly what you just said is really dialing, getting those dials right, and saying, hey, I'm not just going to have this blunt instrument called CAC. I'm really going to be looking at how much it's costing me to expand and renew, because that's where the high margin dollars are for a SaaS company anyway, as you know.

Randy Wootton (25:03):

Yeah, totally. Not that you're intending that... There's a total tee up for the Maxio advertisement is if when you have a system of record that's tracking your billing and invoicing and doing your RevRec, you can absolutely get those metrics and you press the button on day one and you get the MRR scheduled, you get the ARR waterfall, you get all of this insight by product, by segment, by customer, by region, and you're able to do all your customer cohort analysis. So it is really, a main part of the reason I came to this company was because my last company, we were trying to get those metrics through Excel and Excel would bog down, someone would change the formula or blow up. And we were a relatively small company. I can't even imagine what large companies do is gigabytes of data terabytes, whatever the biggest thing is of data trying to make sense of it. It's just madness. And because there's no GAAP rules, it's all the wild wild west, you kind of make it up on your own.

Thomas Lah (25:53):

Yeah, exactly. Which I'm curious, you and I didn't talk about this before, but I am curious, what you're seeing is if you think about SaaS companies, you think about SaaS CFOs, I would say pre-2022, getting down to some of the nuanced metrics you're talking about was not a top of mind issue for a lot of these CFOs. It's not what they were focused on. And I was listening to this podcast, this guy had a product to help SaaS companies take out costs around, I forget what it was there. And he said pre-2022, he talked to tons of CFOs, no interest whatsoever. 2022 hit, and suddenly his phone starts ringing off the hook. And I'm curious for what you guys are doing for a living, are you seeing that same dynamic where it's suddenly like, oh, wait a minute, Randy, the metrics you're talking about, I did not really worry about that, but I've got to get my hands on it now.

Randy Wootton (26:42):

Yes. I think that what you're finding is this interesting ecosystem movement. The VCs have always been really interested in the metrics. So as a private company, CEO, before I was at Maxio, we had to deliver templated Excel files to the analysts, and then they got wicked smart kids grinding the numbers and coming back to us and doing some of the math for us. The challenge was having a consistent definition, a regular representation, but I do think that they're smart VCs and then even in the PE construct, perhaps more so because the PE model is around EBITDA leverage. And so they are much more interested in what you were describing in that tension between Rule of 40, Rule of 35 and then RAC and profitability. And so I think companies private backed VC, PE backed CEOs and CFOs are getting it. It's part of the reason we have 2,300 customers, it's a need. What I would suggest, the challenge is old school CFOs, and I think that's my generation in particular, they want to do bottoms up builds of models and they want to be able to control all the information. And so they still feel most comfortable with Excel. It's like you can't pry Excel from their cold, dead hands. And I was talking to someone yesterday about this idea of how the CFOs of the future need to shift from a spreadsheet model of data entry at the sale level to a database model where they need to think about data in terms of tables, and they have to be able to let go of data in the way that they thought about QA-ing it within a spreadsheet. And it's those [CFOs] that are now moving from compliance and governance and financial reporting to being strategic partners to CEOs, CROs in terms of monetization strategy.

(28:27):

So I think there's a new breed. I think everyone's going to go there. And that's what I tell people is, look, buy my technology or by someone else's, every B2B SaaS company needs to have a system of billing and invoicing that allows you to get these operating metrics so you can run your business. Also, you can manage your board, but one of our old adages was get funded, stay funded. When you're going through due diligence, the number one issue that kills deals is accounting issues. And it comes down to ARR, comes down to ARR. And so that then, you know your ARR, you're able to drive all of these insights. And so I think it starts with a common understanding of data, a system that allows you to make sense of it, and then a CFO who is curious about that and wants to drive from the back office to the front office.

Thomas Lah (29:15):

Well, you put something on the table there, which is important. Something you and I talked about before this podcast was sort of the changing role of the CFO. And I do, I mean, you've seen it more than I do, but when I spend time with these executive teams, they're all in the room and I'm listening to the questions coming from the CFO, and it's changing, because to your point, they were kind of focused on the reporting and the governance and stuff, but they do need to be a partner with the CEO around what is our profitable economic engine for this company? What is that going to look like? And I will tell you, there are a lot of SaaS executive teams that have never ever managed a profitable software business model. They've always been the high growth-

Randy Wootton (30:01):

Me.

Thomas Lah (30:03):

Not profitable. And so now think about that, you're a CFO and suddenly people are asking these questions about, well, tell me how high is high for your operating income? What do you think that's going to look like two years from now, three years from now? And they're going, "Gosh, I've never really had to think through that and how I'm going to get there." And so I think that there's a new muscle that's getting built there, and they really do need to be a strategic partner with the rest of the executive team to help get a vision around what the profitable business model is going to look like.

Randy Wootton (30:37):

And I do think, again, as kind of a private, fast-growing high growth company, Todd Gardner, another industry luminary wrote this article. He calls it the porpoise principle, where you get profitable and then you can go unprofitable again. But you have demonstrated the ability to control it, and it just forces you to make a bunch of, tighten up some controls here, do this, do that. And then it's almost like you come out and you look around and say, okay, now I'm going to invest here. But you're explicit about it, so you still could go unprofitable and you're taking down your cash, your debt, but-

Thomas Lah (31:13):

Well, that's a great concept. I love that concept. And again, it's proving that you can have the discipline and it's proving that, that you're saying, "Look, I have a viable business model here. Here's what it is, and I can see it there. It's real." And you say, "But hey, by the way, next year, whatever, we're going to make these investments. We're going after this new market, we're going after whatever." And you have a great story there, but you have street cred where so many of these SaaS companies, they've never breached the water in your model there. They've never had the air.

Randy Wootton (31:42):

Just on that point, so I've been actually for about a year and a half and conversation with my board's great, but I come in with this VC mindset. I'm like, "I want to do all these bets and this is going to be a growth bet and this is going to be a growth bet." And I got a little bit of an NPV analysis around it and I'm like, "Yeah, yeah, this is the return we're going to see on it." And they're like, "Randy, you're just like every other venture-backed CEO. It's all about growth and you at least have done an NPV, but we don't believe you. What you need to do is get the core business, make sure you've got that locked down and you can show it's a profitable business." And that's where we framed, I changed to embracing the old McKinsey model about Horizon one, Horizon two, Horizon three.

(32:22):

And just isolating the core business is saying, for this core business, this is the profile it needs to have. If we're going to go out and do M&A or we're going to build in another capability, this is the profile it's going to look like for year one, year two, year three, but we're going to be deliberate in terms of the gates we have. Is it working? Is it not? Will we fund more? Do we pull back and what do we cut? And I do think that there's a portfolio approach that large companies do with that when they do acquisitions, they probably get a little lazy if they got a lot of cash and they can say, "Oh, well, we'll give an extra year or so." But I think if this new market reality, you got to get growth, you got to be deliberate about it. Is it going to be through organic growth, inorganic growth? You have segment expansion, regional expansion, capability expansion. As the CEO and the executive team, you got to be focused there. But to your point also, the core has to be working to enable you to have growth conversations. If the core's not working, you can't talk about the other things you want to go do.

Thomas Lah (33:18):

That's absolutely right. That's absolutely right. And I think that's a new reality for a lot of SaaS companies to be honest with you, that they're now grappling with.

Randy Wootton (33:24):

I made a note on this. We were talking about this in our pre-call about if SaaS companies, how to make them more profitable, what are the levers they can pull? You had a paper on it and then I think you had a book, Digital Hesitation, which is around the new data-driven growth levers. Can you talk a little bit about those resources that people might be interested in pursuing?

Thomas Lah (33:45):

Yeah, and the papers out there, it's in the public domain, it's called The C-Suite Playbook for Profitable SaaS and sort of the executive summary. So there's a 12 plays we outline there, but there's really three big thoughts. I think every SaaS company should have to improve profitability. Number one is you should be monetizing service motions. A lot of SaaS companies have given away their CS, they've given away all their support. Their PS is breakeven or they lose money. And again, that was okay when it was about growth, growth, growth, but I can tell you we have all the data on it. There are SaaS companies that are very successful at monetizing their services. They're not giving it all away for free. That brings in real revenue to the business model, real margin dollars that helps the gross margin get higher and helps the bottom line. If the CFO says, "Hey, that's dilutive to my business." Look, the math doesn't work out that way. So that's number one, and that's important. Number two, it's how you take the money off the table. So we call this migrating commercials. You should have a nuanced model. You can have renewal specialists and customer success managers owning renewals. You can have product-led growth. The product itself could be handling some of the commercials. And so not having every transaction go through the account executive is an important thought. And then the third thought and Digital Hesitation, the book talked a lot about these growth levers, this world. And the beauty of SaaS business models is you are connected to the customer. You have data telemetry on what they're doing. The question is what are you doing with it to feed cost-effective growth?

(35:13):

So for example, we have a concept of customer led growth, it means following the customer data to prioritize expansion, cross-sell, et cetera. And so salespeople, every day they wake up, it's not like, well, who am I going to talk to? They should be following the data to find out who to prioritize. So that's just one example and AI is just accelerating those new growth levers for sure. But anyway, I recommend the paper again, this topic of how we get profitable. The good news is there are proven practices to get SaaS businesses profitable. I mean, I'm bullish, these businesses are not all going to be unprofitable in the long term. You can do it, but it takes building some new muscles.

Randy Wootton (35:51):

This podcast going to come at a better time for people as they're building their fiscal year '24 operating plan and dealing with the reality of constrained capital, expensive debt, how to drive to profitability. We talked a lot about the different metrics you can use to set context for your journey, where you are today, what does world-class look like, where you need to go. And I think your playbook is a great recommendation for people to read as an executive team and just talk about it. I know for example, monetizing services is one of the things we need to think about, which we've under indexed compared to what I was doing at Salesforce. I think the migrating the commercials and how to think about broadly the commercial relationship that you have with the customer and who does what where when is really interesting, especially in our business model.

(36:36):

One of the things just last point and then we'll wrap this thing up is price increase. So I saw an article somewhere that every single SaaS company now, because of the pressure on the revenue growth, they're not seeing the take up on new logos, that they're doing price increases. And I know Salesforce in August came out and said, they're raising prices 9% across the board, and you're like, holy smokes, it used to be you would have kind of a four to 6% increase embedded in your contract. You went in with six, you got negotiated down to four, but 9% is mind-boggling. What are you seeing in terms of price increase, price levers broadly across the SaaS landscape?

Thomas Lah (37:13):

Yeah, it's funny, I was just talking to our CIO about this, because we're a SaaS shop. We have everything we're using is SaaS. And I said, "So what are you seeing?" And he is absolutely seeing people pushing across the table, these double-digit increase asks. That is absolutely the thing that's happening. But I will tell you in my conversations with companies about the state of this, so inflation over the past couple of years absolutely kind of gave us the ability to go to a customer and say, "Hey, things are more expensive. Everything's more expensive in my business model. And so if inflation is running 6% or whatever, I've got a bigger price increase this year." And so I think customers understood that logic. They were feeling it themselves and they onboarded that. I am suspect about these price increases this coming year because inflation is stable here.

(38:09):

But customers are not going to just basically onboard double-digit price increases. They're not going to do it. So I think what we're going to see is that contracts are going to come across the table to the customer and they're going to push it back. And there is going to be some intense... I mean, that's what we're going to do. We're going to be like, "Hey, that is just too big of an increase." And I think for a lot of these SaaS companies, I mean, if you are dominating in your marketplace and you feel super confident in your position, okay, you might be able to get away with it this year. But that's not a lot of SaaS companies, as you know, it's hyper competitive out there, hyper competitive in a lot of these marketplaces. So if you're coming to the table with a 10, 12% price increase and somebody else comes in and say, "Hey, I can get you on my platform and I'm not going to do that to you." That's going to happen. So I think it's going to be kind of ugly.

Randy Wootton (38:57):

And I think that there's the must have versus nice have, vitamin versus aspirin, the Oracle play where they get you and then they just stick it to you and you're resentful for the rest of your contract with Oracle until you can... I'm sorry for all the Oracle users, they provide a great product, but I think their strategy is that get you in and then they hike the prices up, because they got you. And the stickiness is just incredible. But I don't think that's true for lots of SaaS companies, to your point, they can be replaced. And so as a CEO, CFO thinking about what is your unique value, it's not just lock the customer in, but you continue to give value. So it's a value conversation versus a price increase conversation.

Thomas Lah (39:39):

Yeah, absolutely. You're spot on. And just to put a wrapper around this, I mean if you think about making SaaS more profitable, the first lever is “I take head count out.” Now the second easiest lever is “I do a price increase.” And what I'm advocating for is there's this middle ground of your overall operating model that you've got to be changing, to your point, to deliver different value proposition, more cost effectively. That's the hard work, that's the hard work, and I think that there's a lot of companies that have to lean into that.

Randy Wootton (40:05):

Awesome. Well, that's a great way to end our conversation, Thomas. Every time I talk to you, I learn something. I really appreciate you making time for us. For other people that want to get the Thomas Lah free base, what is your best ways to track you down and to stay in contact?

Thomas Lah (40:20):

Yeah, I would say just go to the TSIA website at www.tsia.com and you can click into all the stuff we have and our webinars and our free content and learn about what we do for a living.

Randy Wootton (40:32):

Yeah, and most of it's un-gated. Most of your content is available for people to read.

Thomas Lah (40:37):

Well, we have a lot gated for members in the different areas, but we do have a good chunk out there in a freemium type model that people can take advantage of and learn a lot.

Randy Wootton (40:48):

And then the most recent book that you've published, I haven't read it. I'm still a big fan of B4B. I push it to everybody. But what's your most recent book and the challenges you were taking on in the book?

Thomas Lah (40:57):

Digital Hesitation, and that really is about having a more digital business model, which again, is just becoming even more critical with the AI advancements that are occurring. So I think that's a good one. And the one before that I think for the audience would be really good is the as-a-Service Playbook, which is really about the plays you run to have a more profitable model.

Randy Wootton (41:15):

Awesome. Thomas, I really appreciate it. Thank you very much. Have a great day.

Thomas Lah (41:19):

Yeah, my pleasure.