Software is Eating the Income Statement

Pushing Back on “Understanding SaaS” from Andreessen Horowitz

Joseph Bentzel, Platformula1

“Everybody mad when their paper don’t stack right.” 50 Cent, from ‘Window Shopper’

One of the benefits of being a veteran marketing professional in today’s youth culture tech industry is that you still have things called memories and experiences.

And sometimes those memories and experience, e.g. of the dotcom bubble, prove to have some value. This is especially true when things come along in the course of a day that you find so inherently disagreeable that the only really rational response you can muster is to smack those disagreeable things upside the head—-kind of like when HBO Silicon Valley’s Erlich sitcom-sucker-punched a child dope dealer.

It is in that spirit that I share my thoughts on the essay by Scott Kupor and Preethi Kasireddy titled “Understanding SaaS: Why the Pundits Have It Wrong” published on a16z.com.

Let’s begin.

1. Setting Up a Dotcom Bubble Straw Man

“The businesses that failed in the last tech bubble were valued on metrics that were both poor indicators of business health (“eyeballs”, anyone?) and were nowhere to be found in generally accepted accounting principals (GAAP).” Kupor/Kasireddy

Sorry to be blunt here, but the above statement is patently untrue on its face.

While many less-than-sober ‘new economy’ metrics were floated to justify bubble era IPOs, it is also a fact that high growth enterprise and B2B players like Commerce1—-that imploded during the bubble years—-were not valued on ‘eyeballs’ at all, but on explosive top line revenue growth that was then perceived by Wall Street to be a leading indicator of ‘landgrab’ or pre-emptive ‘winner take all’ economics. And their ultimate decline—-as the bubble burst—-was based on the kind of execution issues that plague many high growth businesses in emerging categories, not faulty eyeball metrics per se.

It’s a similar story with bubble era landgrab poster child Broadvision, a pioneer in personalized ‘1-to-1' ecommerce platforms. Broadvision was definitely not an ‘eyeballs’ company and had (at the peak of the bubble) reached a revenue run rate of more than $50 million per quarter for multiple quarters and was even declared by analyst firm IDC to be a leader in ecommerce platforms.

My own view of the implosion of Commerce1 and decline of Broadvision—-which I put forward in my 2006 book “Asymmetric Marketing: Tossing the Chasm in the Age of the Software Superpowers”—-is that ‘disruptive innovation’ is not a one way street.

Simply put, established IT alpha vendors are more agile than they appear to be, and adapt to market threats through the use of asymmetric marketing countermeasures against disruptors. How? Simple.

They use their installed base and installed partner market power to carry out ‘category regime change’ against their upstart opponents. The mechanics of this are well documented. One way they do it is to systematically ‘featurize’ the disruptor’s offerings within their own cross-category enterprise suites. Oracle, IBM, HP, SAP, Microsoft and others were beneficiaries of the decline of Commerce1 and Broadvision in B2B hub and 1-to-1 ecommerce software.

Even Mr. Andreessen’s own company, Netscape, fell victim to a form of featurization from the OEM marketing muscle of Microsoft during the ‘browser wars’—-forcing it to prematurely exit the market by breaking itself into 2 pieces—the portal going to AOL and the enterprise software going to Sun.

So while Mr. Andreessen’s famous statement of that era, “The browser is the new desktop” was absolutely true at the technology marketing abstraction layer—-It was the king of the old desktop, i.e. Microsoft, that realized the market benefits of his statement through the practice of asymmetric marketing and browser category regime change. A similar point of view on the issue of featurization and category regime change was recently expressed by Chris Ciaccia of the Street in his piece “Box IPO Filing Shows It’s a Feature, Not a Company”. By the way, Box is in the Andreessen Horowitz portfolio and has recently delayed its IPO after its S1 filing revealed that it is spending more than $2 dollars for every $1 in top line SaaS revenue it takes in. Why go into these all these old facts….I hear you asking?

Because one can not arrive at truth by setting up a ‘SaaS vs. the bubble’ straw man argument at the outset. If the authors want to make a comparison to the bubble in order to defend their view of SaaS economics, then they should do so in a historically detailed, not anecdotal fashion. Let’s continue.

2. SaaS is Eating the Income Statement

“The income statement alone therefore can no longer tell us everything we need to know about valuing a SaaS business.” Kupor/Kasireddy

In “Understanding SaaS”, the authors break down—-eloquently and with masterful attention to detail—-many basic moving parts of SaaS business model economics. From their discussion of customer acquisition costs (CAC) to customer lifetime value (LTV) to billings, churn, deferred revenue and everything in between, their logic comes off as compelling and internally coherent. But it’s what they choose not to focus on that bothers me. Here it is.

Their model, as articulated in the essay, assumes that ‘SaaS’ is delivered as a branded, downstream end customer offering—-with its attendant demand generation ‘ground game’ and high cost of sales. What they are describing is really SaaS 1.0.

The alternative model—-the SaaS 2.0 ‘passing game’ that I recommend innovators embrace circa 2014—- is best described as a next generation “XaaS” or anything as a service model—-characterized by an upstream partner-advantaged marketing approach.

When an innovator in 2014 goes to market not as a downstream focused SaaS 1.0 offering but as a partner-focused ‘API-as-a-product, or an AWS Marketplace 1 Click AMI, or a white label SaaS offering, or a XaaS plug-in or enhancement ingredient inside today’s cloud/mobile ‘new stack’ architectures—-then one has a different set of numbers on the income statement. Numbers that do pretty much will tell us ‘everything we need to know’.

And it is this kind of upstream-focused, developer-targeted, partner-advantaged, non-disruptive go-to-market model (and attendant income statement) that made Microsoft the king of the hill in PCs (their original upstream OEM deal with IBM), Google the king of the hill in search (their upstream deal to embed the Google search box on the Yahoo home page) and VMware and RedHat the kings of the hill in data center and server infrastructure respectively (via server vendor bundling deals).

By the way, when it was time for an incredibly well-branded downstream innovator named Apple to launch the iPhone, they did so with an exclusive 5 year upstream distribution deal with a Telco partner, AT&T.

I call this upstream partner-advantaged growth model pioneered by many of the above vendors the ‘Superpower Pattern’.

So I would contend that it isn’t so much ‘SaaS economics’ per se that eats the income statement—-as the authors of “Understanding SaaS” contend—-But a downstream customer focused SaaS 1.0 marketing mentality that is no longer the only game in town for innovators. That’s why, to return 50 Cent’s lyrics, the SaaS 1.0 ‘paper don’t stack right’ and the burn rates are through the roof.

3. The ‘Gatsby Startup’ Is the Real Issue

“When it comes to SaaS, however, such simplicity can lead to bad investment decisions.” Kupor/Kasireddy

The author’s ‘Understanding SaaS’ argument is framed as professional advice for retail investors from what is arguably the most high profile venture capital firm in Silicon Valley.

Simply put, the whole essay boils down to “Don’t make short-sighted investment decisions by looking at front-loaded subscription software businesses the wrong way.” Fair enough.

But context matters and in this case is everything. The context here is not simply the on-again, off-again selloff of various publicly traded SaaS equities driven by ‘pundit’ commentary. It’s bigger than that. It’s what I call the ‘Gatsby startup’ model itself.

As the moniker implies, the Gatsby Startup is long on the expensive, well-attended downstream marketing party and short on the much needed sober after-party income statement cleanup.

The immaturity and seeming absence of cross-generational tech industry institutional memory that characterizes Gatsby Startup culture is one of those things they make fun of every week on HBO’s Silicon Valley. Once again, let’s backtrack to the Box S1, which provides a virtual template of Gatsby startup financials.

The question retail investors should be asking is this. Is a company that burns $2+ of expense for every $1 of top line revenue really a sober candidate to go public at this time, especially when it has ‘pivoted’ from its landgrab-rationalized ‘freemium’ model—-subsidized by massive amounts of VC cash. Or is Box a candidate to go public simply because the VC advocates of the over-funded downstream SaaS 1.0 Gatsby startup need it to go public in order to shift the burden of unsustainable SaaS 1.0 economics onto public retail investors? I’ll let you make up your own mind on that one.

And while the recently announced GE deal is certainly a positive development for Box, here’s where I’ve ended up after reading “Understanding SaaS.”

Anything-as-a-service (XaaS) startup founders and management teams cannot continue to bank on the perceived thought leadership of venture capital firms—-even the most celebrated ones—- when it comes to SaaS economics and their desire to re-engineer the income statement.

In other words…

“Everybody mad when their paper don’t stack right.”

Joe Bentzel is the senior consultant at Platformula1. Email me at joe@platformulagroup.com.