Huge thanks to Kevin Salimian and Lone Pine Capital for their data contributions for this series, and to Nick Mehta (CEO, Gainsight) for sharing his wisdom and reviewing this piece.
Most software startups are single-product, linear businesses. They find product market fit, scale sales and marketing to grow the business, and are off to the races. While these businesses worked great for the last ten years, powered by the twin tailwinds of cloud transition and low-interest rates, the inherent weakness in the model is becoming painfully and rapidly apparent. Multiples are being crushed, and companies are struggling to grow as they once did.
In our opinion, there are three things limiting most software businesses that our new environment makes apparent. By understanding these, we can see hints of what will solve the current problems.
1. Sales S-Curve
Software distribution models have historically been direct-selling models. In practice, this looks like sales bullpens lined wall-to-wall with 20-year-olds pleading into Zoom calls for signed contracts. So “scaling sales and marketing” just means hiring and training a ton of quota-motivated killers. As with all jobs, individual salespeople have a learning curve, so there is a natural “S-curve” to scaling sales organizations—a large investment upfront, then growth, and then plateau. Once an upper limit is reached, the only way to grow new bookings is to add more staff.
2. Ideal Customer Profile (“ICP”) & Diminishing Returns to Sales and Marketing
A company typically starts to scale with its best customers. The product market fit is so strong that a customer will trust its business to a small, raggedy startup. Selling into this ideal customer is, well, ideal. They are acquired and retained cheaply because the product solves such a painful problem for them.
As a company seeks to scale, it often needs to sell outside of its ICP. There’s a learning curve and lots of execution that goes along with this expansion—but when a company finally achieves this Herculean task, they will discover, to their horror, ever-diminishing returns to scale in sales and marketing spend. The further they expand, the less ROIC each customer will bring.
However, they can’t stop! As they keep growing, they find that they need to drift further and further and further away from their ICP and see diminishing returns to scale. This phenomenon is why investors are maniacal about the three holy acronyms: TAM, SAM, and ICP (Total Addressable Market, Serviceable Available Market, and Ideal Customer Profile). The bigger each of these categories, the more room a company has to run before the Law of Diminishing Returns rears its ugly head. With low-interest rates diminishing the hurdles for ROIC, SaaS companies had ideal soil to grow in.
3. Operating Leverage
Investors like when revenues grow faster than expenses. (Yay!) There are four types of expenses in a software company:
- Cost of goods sold (COGS): direct costs associated with making the product—like hosting costs or payment processing
- Research & Development (R&D): indirect costs from building the product, like engineers and PMs
- Sales & Marketing (S&M): the people and resources used for selling the product, like sales staff or buying ads
- General & Administrative (G&A): all the expenses—rent, finance, HR teams, and so on, to support the other functions
The story always ends up being told to boards the exact same way: COGS will scale in line with revenues. R&D and G&A stay semi-fixed and grow less quickly than revenue. But, as discussed above in concepts 1 and 2, S&M expenses can easily grow faster than revenues.
Maybe product-led growth companies like Slack have hinted that you can have some potential relief from the Sales S-Curve. However, looking at incremental paid marketing payback tells us it doesn’t solve diminishing returns. As soon as you saturate your ICP, incremental costs skyrocket; you no longer are fulfilling demand, but have to start creating it—a much more expensive proposition. Even the darlings of developers and PLG, like Notion, Stripe, and Atlassian, have had to add enterprise sales teams to retain compound annual growth rates. The S Curve comes for us all.
Resulting Business Model
The point solution’s business model is the net effect of two countervailing forces: 1) operating leverage as revenues grow faster than R&D and G&A expenses, and 2) diminishing productivity from sales and marketing as the company seeks to grow outside of its initial ICP. A point solution’s profit margins are relatively capped. Managing these P&Ls is a delicate balance between the need to grow and the need to expand profit margins; as a result, a “Rule of 40” is typically well below 40.
The Single Product Ceiling
In the last few years, we have also seen growth come at the expense of margins. And to be fair to these companies, in a low interest rate environment is exactly what the market has been cheering for! Companies walking this path were given high multiples in the public markets.
However, with negative margins and free cash flow, a company also needs cash—and lots of it. Single-product software companies require more capital to build and, as our data shows, are less profitable at scale, making them meaningfully more reliant on the capital markets.
Now though, companies are still expected to grow and be profitable. The only way to solve the problems of the S curve, ICP, and operating leverage is through multi-product.
Long live Multi-Product SaaS!
Look, we aren’t Chicken Little. This is not us running around screaming the world is ending. Instead, it is an acknowledgment of the new SaaS reality and the incredible opportunity ahead for the companies that are able to adapt. Multi-product SaaS shows the financial outcomes that are needed in today’s macro environment.
They can do this in 3 ways:
- S Curve: Multi-product means that after you sell your initial product (assuming it is a control point), you can then far more easily attach additional products over time. This means that your staff with sales responsibilities can scale a lot further than before. It could mean that an AE keeps selling to the same customer or, alternatively, a customer success team with quota is spun up.
- ICP: If the issue is expanding beyond your ICP, the simplest answer is to never need to expand beyond your ICP. Continue to solve more and more problems for your selected vertical/horizontal market. Acquisition costs spiraling out of control is never a bother because the acquisition is mostly done already.
- Operating leverage: Solving the S curve and ICP issues then increases the operating leverage you are able to get out of your organization. Rather than being forced to stretch a product beyond its natural limit, you can add to accretive products that, hopefully, extend the product’s strength naturally.
This essay is the second in a series on becoming a PCG. If you want to come explore with us, make sure to subscribe below.
Are you building a platform of compounding greatness? If so, we’d love to talk. We can share more detailed proprietary research and benchmarks and geek out on the power of this approach to SaaS. You can reach us at knowledge@tidemarkcap.com.
