Executive summary
As SaaS companies mature, their profit margins can dissipate. That’s because growth takes them into business that is harder and more expensive to acquire, deliver and retain. When SaaS companies remain fixated on revenue growth alone, they can become trapped in tangled complexities with thin margins. These companies must shift to a market mindset with a profitability owner who can align product, sales and pricing decisions around unit economics and strategic enterprise priorities. With disciplined leadership and data-driven priorities, companies can make the decisions that drive sustainable profit growth.
More than growth
Small SaaS companies often chase revenue. For a while, their top-line growth is tied to profits. But many reach a point where profits stop rising with revenue.
As SaaS businesses scale up, growth becomes economically harder. Companies must move beyond their core customers, products and delivery models. New business is progressively more expensive to acquire, deliver and retain. So, while companies might continue to show top-line growth, their profits no longer rise at the same pace. That can catch leaders off guard.
“A lot of companies in this sector are prone to pursuing the incremental dollar,” said Grant Thornton | Stax Global Practice Lead Paul Edwards. “But they might not notice that margin has gone from 80% to 70%.”
When profit margins shrink, companies cannot meet the targets on their growth trajectories. They become more vulnerable to risks or market shifts, and their valuations start to fall.
“Good companies grow, but great companies grow profitably,” said Grant Thornton Advisory Services Partner Kristian Rasmussen. So, why do so many SaaS companies fail to prioritize profit in their growth objectives? Sometimes, it’s because they get stuck in a race for revenue.
The race for revenue
The pursuit of PE, and other investors with a growth-at-all-costs mindset, can trap companies in a race for revenue. In recent years, the race was also fueled by low interest rates for companies that invested to buy size and market share.
This pursuit can even push SaaS businesses to try winning customers outside of their best customer profile, just to demonstrate a big potential market. But that move might not make business sense. “You might show that your SMB product can stand up in the mid-market, but your profitability in the mid-market is half of what it is with SMBs,” Edwards said. “That’s created tension for a lot of SaaS businesses, between running a business versus demonstrating a strong investment story.”
“The question was always, ‘Is it growing?’” said Grant Thornton | Stax Partner Kelsey Chisholm. “But the real question should be, ‘How is it growing?’” Some SaaS leaders recognize this issue, but hope that additional investment will let them grow into the larger market and recover profitability.
Unfortunately, larger and less profitable customers can create long-term burdens on business growth. “You might decide to close a large enterprise customer that adds millions in annual revenue, but that customer comes with significant customization and services wrapped around it,” Chisholm said. “Those costs all come later. You might be adding revenue now, but the full impact will show up over time.”
Customization constraints
SaaS companies might justify contract-driven product customizations as investments in future product development.
“I hear that all the time: Companies say they’re landing a big client and doing a lot of customization that will be great because they can sell it to others,” Rasmussen said. “The reality is that they probably can’t sell that work to others because most other customers are smaller or have a different profile. Even companies that do build business cases around those investments in the product tend not to be very good at holding themselves accountable to those business cases.”
This contract-driven development can also distract the company’s resources and growth away from a long-term product development strategy.
“What happens is that you scale your operating model and delivery model in an inefficient way, because it's not strategically structured or scalable,” Rasmussen said. “You have to be organized and disciplined about customer acquisition and how that cascades into your product decisions and R&D spending.”
To overcome the drumbeat that marches toward bigger revenue, bigger investors and bigger customers above all else, SaaS companies need a mindset shift. They need a strategic approach to growth, looking beyond the revenue goals that fueled their early gains.
Market mindset
Many small SaaS companies have prevailing mindsets that still echo their founders, often a product genius or a rock star seller. Sustainable enterprise profit growth requires another type of mindset, one that is more focused on profitable unit economics in the long term market.
“The challenge is that, when SaaS companies are trying to grow fast, their decisions are made by various functions individually and inconsistently,” Edwards said. The sales, product, engineering and customer teams can each make sensible functional decisions that collectively weaken customer economics for the enterprise. Profitable growth requires a different mindset, with an enterprise-level strategy that is focused on profitable growth and informed by unit economics, even if that means some tradeoffs at functional levels.
To implement this strategy, companies need to make disciplined decisions across functions. That cross-functional discipline requires leadership from someone who centrally owns the organization’s profit growth.
Who’s in charge of growing profits?
Profit growth requires cross-functional discipline, but many SaaS companies do not have a central leader who owns it.
“Product-focused leaders want to build the best thing possible, and the sales-focused leaders are pursuing revenue, but the strategic CFO can become the third leg of the stool,” Edwards said. “They ensure things are monitored, managed and built into the strategy going forward. You don’t fix poor contribution margin tactically. You fix it strategically by better tracking it, managing it and making it a core part of the growth plan.”
A strategic CFO who understands the business can hold commercial and product teams to account, asking questions, challenging decisions and keeping others from getting distracted by a big potential customer logo or an innovative new product feature that lacks business justification. “When that person holds functions accountable for business cases, pricing and discounting, they can be a cross-functional leader,” Rasmussen said. “If you leave a SaaS company to its own devices, it typically won’t get there, because most don’t have that kind of mindset.”
Once a company has a strategic market mindset and a strategy leader, it needs a strategic focus. The focus should be customers, but maybe not the ones you’re thinking about.
What customers are the most profitable?
Even if SaaS companies have been customer-focused, their focus needs to evolve as they grow. This evolution is central to profit growth.
As new customers become harder and more expensive to acquire and retain, some companies try using discounts or offers. However, that approach reduces the value of the customers, and the likelihood that they will stay around after discounts end. “As you think about scaling, keep an eye on customer acquisition cost and payback. Those become even more important,” Chisholm said.
Companies need to look at customer metrics with enough granularity to see their segments and unit economics. “A cohort of customers in a certain market, at certain size ranges, may be trending at a lower margin. If you can see that it’s costing more to recruit and keep them, has pricing kept pace?” Edwards asked.
Companies need granular customer and unit data to build confidence in differentiating decisions. When you confidently understand the profitability of customer segments, you can make the tough strategic decisions required to realign your business strategy with profit growth.
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Data granularity
Strategic discipline can require tough decisions and tradeoffs that depart from what you did in the past. So, you need data to back up your decisions.
Many SaaS companies focus their data analysis on growing annual recurring revenue. They might not even have the right customer or unit financial data to analyze other profitability factors. “As some SaaS businesses move to greater levels of maturity in size, product complexity and customer expansion, they talk about averages but don’t have the underlying data and aren’t managing their business to the underlying data,” Edwards said.
To move beyond averages and manage the business based on profitability factors, companies need metrics like contribution margin by customer, product and unit. They need to share these metrics across functional leaders as they make decisions.
“If you push pricing increases, that might impact retention. If you simplify your product, some customers might churn because you're no longer building custom features for them,” Edwards said. “Even if it’s the right decision for the company, it might not be the decision that a product leader, sales leader or marketing leader would have made on their own.”
At the center of it all, companies need their strategy to see down into the unit economics that will ultimately determine profitability.
Unit economics at the core
To fuel profit growth, SaaS companies need the right mindset, strategy, guidance and priorities. They also need the right economics.
Profit margin is important, but it is a lagging indicator. By the time deterioration appears in aggregate results, the root causes may already be embedded in customer acquisition, pricing, contracts, product decisions and delivery complexity. Companies can be left with drastic actions and reactive cost cuts.
Instead, companies need granular data that informs their unit economics. Then, they need to build that perspective into the core of the strategy they drive across the organization.
“Numbers drop, and companies ask how to reverse the cost structure and get contribution margin back up,” Edwards said. “But that’s a backwards way to think about it. If businesses put unit economics at the core of their growth architecture and strategy, it makes for a better strategy.”
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This Grant Thornton Advisors LLC content provides information and comments on current issues and developments. It is not a comprehensive analysis of the subject matter covered. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this content.
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