Berlin VC: Here’s what we look for in cloud software startups

More than two years ago, I wrote about what we look for in early-stage Software-as-a-Service (SaaS) startups. Since then we’ve looked at hundreds of SaaS startups and have gained additional insights through the work that we’ve been doing with the SaaS startups that we have invested in. Therefore, I thought it would be time for a follow-on post with some additional thoughts.

In the original post I focused primarily on early metrics as an indicator of product/market fit and of a favorable customer-account-cost/combined-loan-to-value ratio in the future. Today I want to put more focus on factors that kick in a little later in the lifecycle of a SaaS company — aspects that have an impact on a company’s ability to scale customer acquisition, increase average revenue per account, and create lock-in. In other words, factors that can make the difference between a good business and a great one.

Note that none of these factors are must-haves for building a successful SaaS company. For each one of them, you’ll probably find some great counterexamples. The point is that all other things being equal, these characteristics increase the odds of creating a big SaaS success:

1. High search volume combined with limited search engine marketing (SEM)/search-engine optimization (SEO) competition

Search volume on Google is a good indicator of the awareness for the problem that you’re solving. You may have a fantastic solution for a big problem, but if no one is looking for it, marketing it will be much harder. It means you’ll have to spend more effort on educating the market and that you may not have a lot of low-hanging fruit on the customer-acquisition front.

Related to search volume is, of course, competition for the relevant keywords, both with respect to SEM/pay-per-click (PPC) and SEO. If there’s lots of competition for your keywords, PPC advertising might be cost-prohibitive, and SEO will be much harder.

If, in contrast, there’s high search volume and limited competition, this not only indicates demand for your product, a gap in the market and potential to acquire customers via SEO/SEM. It also means that you have an opportunity to establish yourself as the thought leader in your space by doing great content marketing.

2. “Land and expand” and “bottom up” customer acquisition

Selling to big enterprises is tempting, because one big enterprise deal can be worth tens or hundreds of thousands of dollars. But it’s also tough: Sales cycles are long, you need to convince various stakeholders, there are special requirements for the product, and you have to hold multiple meetings to get the deal. Anyone who’s done or tried it knows what I mean. Conversely, selling to small and medium-sized businesses is much easier, but the value of each customer is obviously a lot lower as well.

A “land and expand” or “bottom up” customer-acquisition strategy has the potential to give you the best of both worlds. There are different variations of this strategy, but the idea is always that a single user or a small team of people inside a company starts using your product, making the initial sale easy (if any “selling” is involved at all). Over time, more and more people inside the company use it, and eventually you can sell an enterprise account to the entire company.

Perhaps the most famous example of a successful bottom-up adoption is enterprise social network Yammer. In the two years after launch, the company’s freemium distribution model attracted users from 80 percent of Fortune 500 companies and got Yammer into more than 90,000 customers. According to Mashable, 15 percent of these companies subsequently upgraded to a paid plan.

If you want to follow in Yammer’s footsteps (or just copy some pages from their playbook), here are some of the things you should keep in mind:

• Since you want to sign up users with little to no sales efforts, you need a great marketing website and frictionless onboarding.
• Your product needs to provide value for a small number of users inside a company but even larger value if more people use it.
• Your pricing needs to be highly differentiated, Make your product cheap or even free for a small number of users to maximize distribution and make money out of bigger accounts.
• Once you want to sell bigger team accounts or enterprise accounts, you need to provide the functionalities required by bigger companies (a sophisticated role/permission system, service-level agreements, audit logs, etc.) while still keeping the product easy to onboard and use.

3. Virality

It’s very rare for business-to-business SaaS applications to get really viral, i.e. have a viral coefficient of over one. However, even though your SaaS product will never get Hotmail/Skype/Instagram/Snapchat-like growth, any level of virality is valuable, because it means you’re augmenting your paid-user acquisitions with free users.

There are two primary ways in which a SaaS application can be viral:

a) “Sharing”
A use case that involves communication, collaboration, file sharing, or the like with external parties. Examples include project-management software like Basecamp (where, e.g., an agency invites a client to a Basecamp project), e-signing solutions like EchoSign (where the person who is asked to sign learns about EchoSign during the process), or file-sharing providers like Dropbox (you got the idea). The more affinity there is between your target group and their “collaborators,” the better it is for you, since it means a higher “invite to signup” conversion rate.

b) “Publishing”
A use case where your customers use your software to create something that gets published on the Web. Examples: Shopify, SquareSpace, MailChimp, or our portfolio company Typeform. Another example is Zendesk’s feedback tab. The signup conversion rate is much lower in this case, but it can be offset if your product gets exposed to large numbers of people.

You can’t force it if there’s no sensible “sharing” or “publishing” use case for your product, but you should think about it carefully. If sharing or publishing doesn’t make sense for you, you can still get some virality in other ways:

• Employee fluctuation: If you have a product that is used by lots of employees inside a company, try to make everyone an ambassador of your software who will suggest using your product in future jobs.
• Referral programs: FreeAgent’s user-to-user referral scheme is a good example.
• Incentives along the lines of “get XYZ for a tweet,” where users can, for example, unlock features or remove limitations by inviting people to your product.

4. Economic moat

In the first couple of years, you shouldn’t worry too much about your long-term competitive advantages. Oftentimes execution is everything. Working harder than your competition, innovating faster, and just doing everything a little bit better goes a long way.

Having said that, the best and most profitable companies in the world are those that manage to create wide moats around them — sustainable competitive advantages that allow them to keep market share and profit margins in spite of aggressive competitors. The best examples for wide economic moat are patents (think pharma) and natural monopolies (think eBay).

These two examples aren’t very relevant for SaaS companies.There is no simple silver bullet for creating sustainable competitive advantage, but there are a couple of factors which can create moat around a SaaS business:

• A platform. The best example is the Force.com platform. The large number of applications that integrate with Salesforce.com make Salesforce.com the most comprehensive CRM solution on the market and give the company a huge competitive edge. This is a classic example of a virtuous circle: More customers attract more developers, which in turn attract more customers. When a platform has reached a certain size, it’s very hard for competitors to attack you.
• Distribution channels: If you have thousands of partners who have been trained to sell your software and make a lot of money doing it, this can be another very valuable asset. Admittedly the role of value-added resellers (VARs) and other distribution partners is typically lower in SaaS than it is in traditional enterprise software, and the best example of an extremely valuable VAR channel is probably SAP.
• Lock-in: A great product with a fantastic user experience alone can create significant lock-in. But different types of SaaS products have different levels of lock-in. The more people inside a company use your product, the more business partners interact with the software, and the deeper the product is integrated into a company’s core business processes, the higher are the switching costs.
• Network effects: Great examples include Freshbook’s billing network and MailChimp’s Email Genome Project. What these two examples have in common is that (at least in theory) every user makes the product more valuable for all other users.
• Big data: If you have tens of thousands of customers, the massive amounts of data created by your customer base might allow you to draw insights that you can then give back to your customers. Zendesk’s benchmarking reports come to mind as an example.

Christoph Janz is a co-founder and managing partner of Point Nine Capital.