It's time for cloud software companies to start turning a profit

There’s been a lot of commentary in the media recently regarding cloud software companies — from delayed initial public offerings (IPOs), poorly performing IPOs, and falling valuations and ultimately their contribution to the recent downturn in the tech market.

So what’s behind all of this?

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Could it be the one word that has never really been associated with the software-as-a-service (SaaS) industry: profit?

Some are even describing current market sentiment as akin to the 2000 dotcom bubble. That’s extreme from my point of view, but all of the heavy losses and resulting justifications over the years have concerned me a great deal.

The fact is that a very small percentage of SaaS businesses are profitable, including those that have been in the market since the SaaS model began. There’s a fundamental piece of the equation missing here, one that’s so inherently part of any business that it shouldn’t need to be stated: making a profit.

The current landscape

Let’s take a look the most glaring example of a truly disruptive SaaS genius, Salesforce.com. Today it’s the biggest SaaS company in the market and has penetrated almost every vertical conceivable; it’s bulldozed through every ceiling it’s been presented and today has an eye-watering $4 billion in revenues, with more than 13,000 employees. Counter these amazing numbers with the fact that’s it’s still loss-making (reporting full-year losses down $232 million in 2014), has $2.5 billion of debt on its balance sheet, and, according to its latest annual report, doesn’t foresee profitability anytime soon.

In my mind, we have a few conundrums. How can such success in the field not, at least at some point, be met with financial success? For how long will investors put up with this? After 15 years in the game and no sight of profitability, is Salesforce prone to being disrupted itself?

I used Salesforce as an example, as it is the most mature in terms of revenue and history, but the same applies to almost all SaaS companies across the spectrum.

Why profits don’t matter in the short term

The primary justification has been that the cost of customer acquisition (CAC) remains the same as the traditional on-premises software model, but switching from the historic model of upfront payment to a SaaS monthly payment plan means that break-even takes around 12-18 months, creating a short-term cash flow requirement. It is this funding gap that needs to be financed by third party capital. On the positive side, after payback, the client continues to pay, and the marginal profit of this revenue stream is extremely high — basically, the SaaS model assumes a higher customer lifetime value, but it’s paid over a longer period of time.

So, why don’t SaaS companies make profit after the payback period? Well, the argument is that while a company is growing, more and more new customers are contributing to the funding gap, compared with those that have reached payback. I can certainly buy this argument for the first five years in the life of a SaaS business, but at this point, the positive cash flow/marginal profits from historic clients should outweigh the funding gap created by new clients (assuming growth rates of less than 200 percent), so why are they still not making a profit? At what level of revenue and growth does the loss translate to a profit?

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Let’s take a closer look at three truly disruptive players that have been dominating the SaaS market over the past few years. We have Box with $124 million in revenue (and a $168 million loss), Workday with $470 million in revenue (with a $173 million loss), and then there’s the leader of the pack, Salesforce, with a whopping $4.07 billion of revenue, yet still no profit in sight. Even stranger is the fact that all of these companies are trading at double-digit multiples of their revenue. Are we in the middle of (another) tech bubble?

Why the model has to change

Given the funding gap scenario mentioned above, almost all SaaS businesses have been reliant on outside funding from a very early stage in their lifecycle (venture capital primarily), and we know that this money has been readily available, at times a bit too easily. The justification of sacrificing profitability for top line growth was the mantra championed by those that provided the funding, and founders/management teams bought into this philosophy (after all, most founders are techies, not business guys).

The fact is that the people running the business have not been incentivized to deploy capital efficiently or to actually think about when the company will turn a profit, knowing that they will be able to raise more cash (at even higher valuations) as soon as their financial resources have been depleted. Completing the circle, when all sources of investment capital have been exhausted (or they want their return on investment back), the next move has seemed to be strategic buyouts or public equity markets.

So far, this strategy has worked and the investment community has reaped rewards from the valuation strategy that they themselves have architected. I believe we are going to see a fundamental shift in this model, as sources of exit either dry out (strategic acquirers) or start to question the fundamentals of the business (strategic acquirers and public investors). What’s happening in the investor community at the moment is a fundamental correction in how these businesses are perceived and valued. Businesses that have either been focused on the idea of delivering software as a service via a profitable distribution strategy or those that can alter their trajectories into this path will clearly succeed.

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This correction is only a good thing for everyone involved in this industry and its long term sustainability.

Ajay Patel is a co-founder and chief executive of enterprise collaboration platform HighQ. Founded in 2001, the London-headquartered company provides software to some of the world’s largest law firms, investment banks, and corporations.