5 minute read 13 Feb 2023
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How SaaS companies can protect profits with product-led approach

Authors
Ray Anderson

EY US Value Creation TMT Leader

Seasoned executive combining experience in C-suite, board and consulting roles. Deep operational, M&A, finance, turnaround and strategy experience. Trusted advisor. Golfer, surfer, father, husband.

Karl Cheng

EY-Parthenon Principal, Strategy and Transactions, Ernst & Young LLP

TMT leader. Decades of experience with strategy and commercial diligence for corporations and private equity investors.

Ajay Khandelwal

EY-Parthenon Managing Director, Software Strategy Group, Ernst & Young LLP

Thrilled to help organizations on their journey to acquire, improve and grow software and software-enabled businesses.

Contributors
5 minute read 13 Feb 2023

Software companies need to focus on efficiency and profitability after years of seeking growth at all costs as the economy slows and interest rates rise.

In brief 

  • The exemplary growth in the software industry is waning with a slowing global economy, forcing a shift in focus to profit and free cash flow.
  • A product-focused approach can inform which levers to pull in R&D, sales and marketing and engineering costs while preserving future revenue growth.

Software companies that for years have focused on rapid growth are being forced to adopt a more defensive concentration on value creation. They are coping with a downturn that has caused the loss of trillions of dollars of market value and tens of thousands of jobs. 

The industry now finds itself needing to shift to improving cash flow, rather than just revenue and customer growth, with a product-led focus on which offerings will resonate with future customers This focus can help inform the tough decisions on R&D spending, engineering efficiency and infrastructure footprint that are needed to set up a leaner cost structure as growth wanes.

This is likely to require a mindset change for an industry that has been boosted by the adoption of digitization across all businesses, with companies relying on software to make them more efficient and innovative. Many software-as-a-service (SaaS) companies founded in the last decade saw revenue grow by 20%–30% annually (Figure 1). This growth has been accompanied by fast-paced spending, with some companies investing up to 20%–30% of their revenue on R&D and another 40%–50% on sales and marketing.

For high growth SaaS companies investors often use the rule of 40, which rewards both growth and profitability as a valuation metric. With a shift in focus from growth to profitability, this rule can still act as guiding tool with increased weight on EBIDTA.

Figure 1. SaaS companies: sales and marketing, R&D spending (as a % of revenue) and revenue growth

Sources: Capital IQ accessed on December 16, 2022, SaaS Capital Index

EY-Parthenon analysis of pure-play B2B SaaS companies that make up the SaaS Capital Index, selecting 51 companies that were publicly listed consistently through 2017–22.

  • Chart description#Hide description

    Boxplot chart representing SaaS companies’ sales and marketing and R&D spending as a percentage of revenue from 2017 through 2022. Many software-as-a-service (SaaS) companies founded in the last decade saw revenue grow by 20%–30% annually. This growth has been accompanied by fast-paced spending, with some companies investing up to 20%–30% of their revenue on R&D and another 40%-50% on sales and marketing.

However, with interest rates rising to their highest levels in more than a decade, software companies face slower growth or, in some cases, declining revenue. Many may need to shift the focus to the P&L and the balance sheet, eliminating products or features that are not part of their core business. 

To be sure, the need for new software will persist. Health care providers can continue to focus on digital transformation. Automotive manufacturers will likely add more software-enabled features. Financial services companies, industrial manufacturing and retail companies and a host of other industries can rely on software to improve their businesses and customer experience. But the pace of spending is slowing. For example, International Data Corp. (IDC) forecasts that recession worries and a focus on margin preservation will likely reduce growth in cloud migration to 17% in 2026 from 27% in 2021.1

To address this, companies need to control what they can. 

Determine the company’s financial situation to inform a unique value creation strategy 

Which levers to use and in what way depends on each company’s situation. Is the balance sheet healthy? Is the company treading water, or is it in immediate need of liquidity? Is it prepared for a prolonged downturn? A company’s position on the spectrum (Figure 2) dictates different actions, with distressed companies forced to immediately reduce their cost base and sell noncore assets to generate immediate cash flow. Companies facing less severe situations can move toward a new cost structure that focuses not on customer and revenue growth at all costs but defends the core business and tightly focuses investment on products and services with strong long-term potential.

Figure 2. Solving business challenges across all segments of the “value” spectrum

  • Chart description#Hide description

    Line chart framework depicting segments of the “value” spectrum and how to deliver the best possible outcome at pace, with a goal of engaging prior to loss of control. A company’s position on the spectrum dictates different actions: value transformation, value creation, value preservation and value recovery.

Companies need to determine their particular situation and then can address cash flow and profitability in different areas. Those that are not in a liquidity crisis can focus on several key steps:

1. Recreate the cost structure for challenging times 

Companies can review the cost structure, benchmark against peers that are managing costs well, and assess what factors are going to impact costs in the rapidly changing economic environment. 

This evaluation may be long overdue as the software industry has evolved in the last 15 years from an on-premises, perpetual software model to a software-as-a-service (SaaS) subscription model. This shift means that while software companies may have a more predictable revenue stream, the operating cost structure may be more complex as the provider is responsible for maintaining the infrastructure to deliver and support the software. SaaS gross margins often range from 75% to 85%2 , but the growth-at-all-costs attitude meant many high-growth companies struggled to reach profitability, typically due to high R&D and high sales and marketing costs to support their growth targets. 

Ultimately, the profitability of a SaaS business model hinges on efficiently delivering software and services, pragmatic R&D spending, and scalable and efficient sales and marketing programs. A product-first lens with ruthless but pragmatic R&D investment prioritization, tightly controlled hosting COGS, an efficient software delivery engine, and smart data-driven sales and marketing operations can help companies improve costs in these areas while assuring they remain effective.

2. Ruthlessly prioritize R&D spending while staying competitive

R&D optimization starts with reviewing product strategy and priorities. An analysis of R&D spending by companies in the S&P Software & Services Index highlights how R&D spending and growth are aligned: companies in high growth cohort (>20% growth) on average spend 30% of their revenue in R&D, while those in low growth (<20%) spend around 20% of revenue in R&D. (Figure 3)

Figure 3. SaaS companies: R&D as a % of revenue (2017-LTM’22)

High-growth represents companies having last12 months (LTM) revenue growth >= 20% (n=34)

Low-growth represents companies having last 12 months (LTM) revenue growth <20% (n=17)

Sources: Capital IQ accessed on December 16, 2022, SaaS Capital Index

EY-Parthenon analysis of pure-play B2B SaaS companies that make up the SaaS Capital Index, selecting 51 companies that were publicly listed consistently through 2017–22.

  • Chart description#Hide description

    Boxplot charts representing SaaS companies’ R&D spending as a percentage of revenue from 2017 through 2022. Left chart shows high growth SaaS companies (>20% growth) on average spend 30% of their revenue in R&D. Right chart shows low growth SaaS companies (<20%) spend around 20% of revenue in R&D.

R&D spending is necessary to stay relevant in a very competitive software market. The key question is how to adjust R&D in a slow-growth environment while remaining competitive. It’s a tough problem, requiring an approach that considers a potentially prolonged downturn and competitive threats.

One way to do this is to reassess product priorities, considering potential short and long-term changes to assumptions about customer purchasing behaviour, competition, retention, upselling and cross-selling. 

In the last several years, some software companies focused on innovation and differentiating features and capabilities to attract new customers. Some spent heavily on significant, even signature but unprofitable products. Now is the time to re-examine those and consider whether it is time to shift investment toward more profitable growth opportunities. 

That does not mean that R&D budgets can be slashed In fact, during the 2008 recession, software companies that continued to invest in innovation despite the focus on costs emerged as long-term winners. Successful companies apply a balance of offensive and defensive strategies to retain existing customers and revenue streams and strengthen their product and platform for growth.

To do this, leaders can classify their R&D activities into strategic product priorities:

  • Customer driven requests
  • Sales prospect-driven initiatives
  • Regulatory compliance initiatives
  • Technology platform improvements

Some of these, such as regulatory compliance, will be more essential to address. Requests from a significant number of existing customers may also be a priority, while those from the sales team may be less essential. Not all technology platform improvements are urgent. In the current environment, companies likely need to focus on capabilities they can bring to market while cutting spending on experimental projects. (Figure 4) While this may be difficult in an industry that thrives on innovation and R&D, making these critical tradeoffs is fundamental to success.

Figure 4. Strategy for quick wins

  • Chart description#Hide description

    Scatter chart framework depicts capabilities that a company can bring to market while cutting spending on high complexity and/or low value projects, with a goal of focusing on quick wins.

Once the decisions are made, product leaders may want to be extra careful about communication between engineering, sales and product teams and must understand how changed priorities impact products and projects. Lastly, we believe companies can keep their eyes wide open for M&A opportunities. Build vs. buy decisions can be reexamined given current depressed valuation trends. 

3. Optimize the software supply chain

Today’s software is complex to build and maintain. It is common for software applications to leverage hundreds of open-source and commercial components and support various user interfaces like mobile and web. Most software also supports programmatic integrations with API and data exchanges.

All this contributes to the cost and complexity of building, deploying, securing and supporting software. Mid-market and vertical SaaS companies, specifically, are at various stages of their journey to modernize their software supply chain. Those companies born in the cloud typically have modern software engineering practices. However, for SaaS companies evolving from an on-prem model to cloud or managed hosted solutions to a true multi-tenant SaaS, serving verticals like health care, financial services or biopharma, there is much room to unlock value both in terms of cost as well as speed to market. Software supply chain improvements are necessary both from an economic point of view as well as a quality and security perspective. 

Right-sourcing software engineering talent is another area to address. During the post-COVID-19 era, the war for talent led to many decisions (such as lowering hiring criteria) that may be worth revisiting. Similarly, optimizing an efficient and offshore delivery is another area to explore. Suboptimal offshore delivery may occur for many reasons, such as lack of proper training, domain expertise and communication challenges between onshore and offshore, leading to not realizing full value from outsourcing or offshoring initiatives. 

4. Rein in COGS 

Cost of goods sold (COGS) for a typical SaaS company can range from 15% to 25% of revenue3. These costs typically include infrastructure cost like cloud and data center, 3rd party software licensing, customer support, subscriptions for tools to monitor and support the platform and personnel cost required to deliver services to existing clients.

Business leaders can address several of these areas: 

  • Licensing and subscription costs

    Assess subscriptions line by line. Which tools and services have teams bought/subscribed to in the last several years, which are they using and why. Don’t take away important tools required to support and service the customer base, but teams may utilize redundant tools for tasks management, logging, monitoring and other tasks. Also, renegotiate subscription prices where possible.

  • Hosting/cloud cost

    A large portion of COGS is typically cloud or hosting cost. We have seen a massive adoption of cloud services by software vendors in the last decade. At the same time, we often observe a lack of cost control due to inexperience in managing cloud environments, loose governance, or lack of proper financial tools. If cloud cost is significant and growing rapidly, it is time to address the issue. 

  • Personnel cost

    In addition to infrastructure and tools, companies need people to monitor and deliver services reliably. These personnel include roles like system administrators, support engineers, cloudops personnels.  Often these services are offshored, but the goal can be to automate many mundane tasks increasing operational leverage.

Overall, companies can carefully select the levers that provide not only short-term cost reductions but also support long-term margin strategy.

5. Challenge the sales and marketing approach 

Sales and marketing expenses vary widely for SaaS companies (Figure 5), making it an attractive target for cost-cutting as demand shrinks. Just like other parts of the organization, leaders may want to review the efficiency of their sales and marketing engine. How well does the sales and marketing engine scale? Is it using the most cost-efficient marketing channels? What can the company do more with less? Leverage sales and marketing enablement tools. Companies may need to be open-minded about adopting successful techniques from product and sales lead strategies, especially as sales and marketing budgets are more constrained. Keep in mind that in shrinking demand environments, sales should focus on retaining existing paying customers and upsell opportunities. Focusing on net dollar retention and lowering customer acquisition costs is the key to profitability.

During high-growth periods and a battle for the best talent, companies may hire salespeople that don’t quite fit the role. In a software business, it is important that salespeople really understand their product and the problem it solves. This slow-growth period is a good time to improve the capabilities and effectiveness of the sales organization.

Figure 5. SaaS companies: sales and marketing as a % of revenue (2017-22)

Sources: Capital IQ accessed on December 16, 2022, SaaS Capital Index

EY-Parthenon analysis of pure-play B2B SaaS companies that make up the SaaS Capital Index, selecting 51 companies that were publicly listed consistently through 2017–22.

  • Chart description#Hide description

    Boxplot chart representing SaaS companies’ sales and marketing spending as a percentage of revenue, compared to revenue growth during 2017-22. This shows a positive correlation, during high-growth periods, sales and marketing expenses typically increase.

Conclusion

As software companies shift to a focus on profitability and cash flow, executives have several levers to pull. Using a product-first lens helps refine these decisions.

  • Show references#Hide references

    1. IDC Market Analysis Perspective: Worldwide Software as a Service and Cloud Software, 2022
    2. Ernst & Young LLP internal analysis.
    3. Ernst & Young LLP internal analysis.

     

Rahul Agrawal contributed to this article.

Summary

Software companies that have prized growth at all costs now need to shift to a focus on profit and controlling costs as the economy slows and interest rates rise. A product-focused lens can help inform which value creation levers to pull in areas like R&D, sales and marketing, and engineering without putting future growth at risk. More information can be found here.

About this article

Authors
Ray Anderson

EY US Value Creation TMT Leader

Seasoned executive combining experience in C-suite, board and consulting roles. Deep operational, M&A, finance, turnaround and strategy experience. Trusted advisor. Golfer, surfer, father, husband.

Karl Cheng

EY-Parthenon Principal, Strategy and Transactions, Ernst & Young LLP

TMT leader. Decades of experience with strategy and commercial diligence for corporations and private equity investors.

Ajay Khandelwal

EY-Parthenon Managing Director, Software Strategy Group, Ernst & Young LLP

Thrilled to help organizations on their journey to acquire, improve and grow software and software-enabled businesses.

Contributors

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