Posts Tagged ‘Workday’

Double Click on the SaaS Business Model

April 17, 2013

Current Wisdom

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

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, salesforce.com 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.

Workday

 

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.