Double Click on the SaaS Business Model

Current Wisdom

Yesterday, my colleague Maria Manning Chapman forwarded me an article from Tien Tzuo, a former marketing executive at

Wall Street Loves Workday, but Doesn’t Understand Subscription Businesses

I strongly agree with his title but vehemently disagree with the content in his article. Mr. Tzuo makes a compelling argument for why it is justified for SaaS based companies such as Workday to receive such outrageous valuations.  The crux of his argument rests on the importance of “deferred’ or “unearned” revenues. Currently, is sitting on top of over three billion dollars in deferred revenues. In their last annual report, Workday stated they have almost $300M in unearned revenues. To date, investors are clearly bought into the importance of these deferred revenues. The table below stacks Workday next to Oracle. As can be seen, Oracle out strips Workday in all key financial metrics except one: deferred revenues. Clearly Mr. Tzuo is on to something.



Fly in the Ointment

As Mr. Tzuo correctly points out, stock price of any company is a function of FUTURE potential, not past results. When a company has so much deferred revenue already on the books, the future looks very bright indeed. But, what if in the future, a company does not make any profit with these currently deferred revenues?  What in the future all of that deferred revenue and additional booked revenue barely pays the bills for running the company? Would investors still be so excited about the future of the company?

Theory of SaaS Profitability

SaaS companies are running to a pretty straight forward business model. They build platforms. As more customers get on those platforms, revenues will eventually outpace expenses and the business will generate profits. The image below documents the theory. All SaaS companies are navigating how to maximize upfront investment costs to propel them over to profitability.

SaaS Theory

The Realities of SaaS Profitability

The challenge with the theory of SaaS profitability is that is has been under accounting four critical factors:

  1. The increasing costs to support and serve customers
  2. The increasing costs of acquiring new customers
  3. The downward pressure on subscription pricing (as markets become competitive)
  4. The percentage of deferred revenue that becomes bad debt

Each one of these factors deserves a TSIA research paper in itself, so I will not elaborate further on them in this blog entry. I will only state that these factors are proving significant and they are resulting in SaaS business models that look more like the model below. This graph is the one you will clearly see reflected in the public data of companies like salesforce and Workday.

SaaS Reality

In reality, I am a massive fan of subscription based models for technology. Our last book, Consumption Economics, makes the case for why the entire technology industry will be moving to this model. However, I am gravely concerned that both investors and technology executives are unclear concerning the factors that will ultimately drive sustainable and profitable business models in this new world. A large chunk of deferred revenue, alone, will not guarantee profitability.


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4 Responses to “Double Click on the SaaS Business Model”

  1. Christophe Bodin Says:

    Great post Thomas. As you said, there is no doubt that subscription based is the path to the future (well, it’s already there) but applying old business logic to new model can be misleading as you pointed out. Assuming you are right, which I do, the way people are looking at the software industry and its valuation mechanism may change.

    Thanks for sharing

  2. Alan Crean Says:

    One of the points that I would like to see a bit more on from the Author is the customer churn conundrum

    It obviously does not always remain logical to try and retain every customer, but the complexity of products in the market, and the sheer number of business processes vendors look to serve as their nirvana implementations is an obvious point to worry about for an investor.

    I have implemented SFDC in four separate companies. Of those, only one remains a customer today, the others all ceased their use of it as it was nothing more than a glorified online address book.

    The SaaS model allows new entrants into a market quickly, but it also allows them to gain and loose market share quickly.

    At a 36 times revenue valuation for Workday……………..there is a very obvious bubble across the sector here, and I would like to see the Author’s opinions on the doomsday that might occur, and how quickly he sees that it could once/if it comes to pass.

    • Thomas Lah Says:


      I concur there is a bubble related to the current valuations of SaaS companies. The brutal reality is that SaaS companies are spending a massive percentage of their revenues to gain market share and to retain existing customers. At the same time, I also believe enterprise customers will be moving more of their IT spend toward SaaS (or OPEX) based spending models. Ultimately, I think the following trends will unfold:
      1. The valuations of SaaS companies will come back to earth. Wish I could predict exactly when!
      2. However, these SaaS companies are not like the companies of the late nineties. I do not predict there will be a doomsday for the SaaS model.
      3. The successful SaaS providers will invest in analytics and value added services to retain customers at a lower cost profile.
      4. Finally, the SaaS business models will stabilize with profitability that is higher than it is today (unprofitable) but much lower than current enterprise software companies.

      Time will tell if it plays out this way.

  3. Joel Skaggs Says:

    Who cares about deferred revenue balances? The only thing that really matters are the future free cash flows that can be generated by a SaaS company. I can’t imagine any investor worth their salt caring a thing about deferred revenues in a vacuum. People in enterprise software know this better than just about anyone. All you have to do is observe how combined services accounting impacts deferred revenue balances resulting in a complete disconnect of the timing of GAAP revenue streams from the cash paid and value received by customers for the related licenses and services.

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