When you are a growing, bootstrapped, tech company being ‘capital efficient’ is a requirement. I believe, even when you are not bootstrapped, investment efficacy is just good business. This article looks at the things I like to spend money on and the things I don’t. It looks at the SaaS P&L through the lens of dollars spent and their expected upside in growth.
I’m going to go through this the same way I look at a P&L each month (or week or day). I’m not going to address the basics that are non-negotiable (well, I may mention some of them). I’m going to talk through the things that are controversial and divisive—some may even rise to the level of religious belief. I’m pretty passionate about responsible management, and not too worried about offending anyone. And, I have managed for both profit and growth for 20+ years.
As CEO, I always referred to pushing and pulling on levers in the P&L. There’s only so much cash each month and how that scarce resource is allocated dictates how much more is in there to work with in future periods. It’s that simple. How I use my P&L this quarter dictates how much will be in my P&L next quarter. The only caveat to any of this is that you actually have to collect your revenue on time, but that’s for another article and we’re going to go through the P&L assuming that’s happening. Here’s how I look at the lean P&L…
SaaS P&L: Cost of Revenue (above the line)
Everything variable for the delivery of revenue is above the line. Revenue minus cost of revenue is gross profit and if you’re a SaaS primarily selling software, your gross profit should be north of 75%. I’m not digging too much into what’s happening above the line, since that’s highly specific to a business. What’s up there is typically hard and soft product delivery costs: hosting, variable licensing, account management and support wages, and related account management and support expenses. These types of costs may include travel and entertainment as incurred in servicing existing accounts. I have always been very particular about having every variable dollar correctly up above the line, so a portion of T&E would fall above and a portion below, depending on who incurred it and why.
SaaS P&L: Operating Expense (below the line)
Here’s the meaty stuff that can make or break capital efficiency. This is where businesses choose to waste or conserve capital. Being lean-minded means erring on the side of conservation, but that’s not always as straightforward as it sounds. And, it doesn’t translate to being miserly or Grinch-like.
Each year, the board-level question is ‘what are we managing to and why?’ Are working founders being compensated within the P&L or from the balance sheet? Are shareholders expecting a return? Is the top priority growth or profit? Depending on scale and price/cost/growth dynamics, what’s the target sum of profit (%) and growth (%)? I could not manage a P&L without answers to questions like these.
What are you optimizing for?
Keep in mind that the answers to those questions likely vary over time and stage. If you’re exit minded and you’re in a space that values on EBITDA more than revenue, then you’re likely managing for profit. If you’re in a space that doesn’t give a rat’s ass about profit, but values on revenue and growth, then you’re reinvesting everything to break even and maximize growth. And, if you’re holding and milking, you’re likely profit taking which could happen in the P&L (salaries/bonuses) and/or in the balance sheet (dividends/distributions).
I like consistency and would advocate for managing to double-digit EBITDA and double-digit growth (for a sub-scale tech company). There’s plenty of ‘rule of 40’ noise that says the sum of profit and growth should exceed 40%, but I think that’s unlikely below $200M in revenue. I know folks like to pontificate that it’s ‘expected’ north of $50M, but I think that takes unusually positive circumstances. In any case, I digress. Let’s go through some expenses based on targeting modest 15% EBITDA working down from 25% cost of revenue, leaving 60% in operating expense—all shooting for 15% YOY growth. That would be a ‘rule of 30’ for those of you in the mindset of adding profit and growth as a health indicator.
I would like to make an assumption relating the scale of the workforce to the scale of the company. Since we’re in tech and delivering revenue for 25%, I’m going to say we’re generating $200,000 per head ($10M revenue would be 50 heads). In order to set budgets that tie back to headcount, we have to know that efficiency per head. It impacts a lot— from square footage (facilities expenses) to benefits, taxes and insurance.
General and administrative expenses include rent, insurance, professional fees, travel, meals, utilities, maintenance and everything else not captured above the line, in sales & marketing or in R&D. Given 60% of total OpEx, with 20% in sales & marketing and 10% in research & development (see below), that leaves 30% for all other expenses.
Rent and Infrastructure
Big chunks in G&A that need controls include rent (6% of revenue); IS/IT (4% of revenue); insurance (including health) (5% of revenue); payroll-related expenses (taxes) (4% of revenue); telecommunications (connectivity/mobile) (1% of revenue); professional fees (1% of revenue); meals (1.5% of revenue) and travel (2.5% of revenue). That’s 25% total. The other 5% of revenue is the sum of many small line items—everything from recruiting; dues & subscriptions; licenses, permits, charitable contributions, auto expense; utilities; repairs & maintenance; and so on. I want to hit some of the big G&A buckets with some explanation…
Rent needs a mention as it’s often ego-driven and overspent (in my opinion). I have always worked hard find great, safe, cool, clean buildings within reasonable cost parameters. I know plenty of CEOs who would spend more than I would on rent.
IS/IT really needs some explanation as I approach it very lean. I believe in essentially next-to-zero IT staff and no on-site IT infrastructure—no servers; no storage; no backups. That’s only possible by embracing SaaS and cloud solutions across the organization—ops, HR, finance, file storage, marketing, sales, etc. The 4% in IS/IT expense is SaaS/cloud subscription expense with light IT staff admin oversight. Everything is stored in the cloud and machines are thin laptops (think MacBook Air). Telecomm is another 1% and it’s all VoIP—thin or soft phones—and mobile reimbursements. Again, low overhead, outsourced/all-inclusive admin as a service.
Insurance includes health benefits which must be strong in order to attract and retain top talent. Obviously, year-over-year health insurance expenses are painfully going higher and higher. Most tech companies are competing for scarce talent and everyone needs the best people. Staying competitive means paying whatever it takes to offer a strong benefits package. I would never skimp here and this is one of the larger single line items in the P&L.
In some ways professional fees are what they are. But there are always ways to save—bring contract negotiation in house to reduce unnecessary outside counsel expense; push the annual audit to soft months for the CPAs, reducing their fees. Things like that make a difference.
Meals are interesting. I like using food as an employee benefit. A well-stocked kitchen, catered lunches and fridges filled with craft beer are all cheap compared to employee churn or high recruiting costs. I’m happy to take that 1.5% of revenue largely as a competitive human resources tool and consequently keep recruiting expense low (using in-house labor for most hires) and employee referrals high.
I left travel to last in G&A on purpose. I have an unpopular disdain for business travel. I think it’s generally a resource drain of epic proportion. This is true of both hard costs and soft ones (lost productivity). Some travel is necessary and healthy—at risk customer visits; high contract value deal closes; trade shows; expansion revenue customer presentations; etc. But superfluous, unchecked travel is not for me. It’s too costly. Ironically enough I’m also a huge believer in the value of seeing people face to face, which is why I advocate for every call to be a video call (those expenses are in the IS/IT expense line item above).
Sales and Marketing
What does it take as a percentage of revenue to generate one NEW percent of revenue? The answer to that question depends on far too many variables for this article. (I will get into that in a future post.) I have always set goals for the number of months it takes to recover the fully loaded sales and marketing cost to acquire a customer (CAC). I like to recover CAC in six months (against gross revenue) or nine months against gross profit. So, if it costs $5,000 to acquire a customer and initial 12-month contract value is $10,000, that’s six months of gross revenue to recover CAC. At 75% gross profit, it’s eight months to recover. Either way you look at it, that’s healthy.
In my experience, an efficient sales and marketing P&L can deliver healthy CAC and growth budgeted at 20% of revenue (I actually prefer 18%, but for the sake of simplicity and rounding, we’ll run with 20%). Of that, the sales vs. marketing split depends on the mix of sales generated vs. marketing generated effort, sales model, sales force composition and compensation, and so on. Like I said, a lot of variables. But, the idea of spending 20% of revenue to deliver 30% of revenue in new contract value (no allowance for revenue churn in that gross number) makes good, efficient sense. To answer my own question, that translates into 0.67% of revenue per 1% in new contract value. The net revenue growth from that will slide up or down depending on your positive or negative revenue churn performance (again, for another post).
I can’t see keeping pace in fast-evolving tech spaces without at least 10% of revenue being reinvested in engineering research & development. I find it penny wise, pound foolish to cut into that for any reason. It will bite you in the ass competitively or with churn if you cheap out in R&D.
Ironically enough, the most costly things are NOT in the P&L. Employee turnover and customer churn are the two most universal examples of non P&L cost vortexes. Both of them can be mitigated or exacerbated by how the P&L is managed. If I was too skimpy in G&A with employee perks, satisfaction might decline and turnover might increase. And, if I was too much of a tight ass with travel and entertainment for sales or customer service folks, the lack of face time might increase churn. It’s informed decision making with constant perspective checks across the organization. It’s too easy to get so caught up in the numbers that you forget what they really mean.