The more ARR, the better
Roger Hurwitz is a founding partner of Volition Capital. His primary focus is on investing in software and technology-enabled business services.
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The global software The as a Service (SaaS) industry continues to grow rapidly, but developing and pricing professional services is often a difficult endeavor for SaaS companies.
Gartner recently forecast that SaaS sales could exceed $ 140 billion worldwide by 2022, up 40% from roughly $ 100 billion in 2019. These are intoxicating numbers for an industry that only gained a foothold 20 years ago.
As someone who has led a lot of investments in SaaS companies, there is a clear consensus among boardrooms that assumes compelling sales efficiency metrics: the more ARR, the better. It is also clear that in the SaaS industry, there is strong consistency in total gross margins for software, which are generally in the 60% to 80% range.
There is a clear consensus in the boardrooms, assuming convincing key figures on sales efficiency: the more ARR, the better.
It is much less obvious how to bill customers for professional services, be it for implementations, consulting services or training.
While in the past, in the days of perpetual software, such offers were billed on a time and material basis or for a fixed fee with a targeted gross margin of, for example, 10 to 30%, today it is quickly becoming a recurring revenue model, and these services can equally well be profitable, but also lead to large losses, as companies charge these services very differently.
If you look at SaaS companies, you can see margin fluctuations of 50 points or more in service revenue from -30% to 20%. Why do we see such margin differences for professional services and what impact do these different approaches have on the strategy of a SaaS company?
Are professional services a profit center or a loss leader?
We can start by asking why a company would accept a single digit or even negative margin for its professional services. For some, one strategy is to speed up their ARR by covering some of these costs, for example by foregoing an implementation fee for a higher annual subscription amount. The view here is to remove some friction from the sales process by lowering all service fees. This will accelerate the speed of the new logo, resulting in a higher ARR and therefore stronger growth, which should translate into a higher share price appreciation.
To implement this strategy, a SaaS company can increase its subscription price, albeit not significantly. While this allows the provider to offer such services without specifying the costs in a separate heading, is this really the right answer? As with so many questions, the answer depends on many variables, such as: does it speed up the sales cycle? Would the charges for such services increase customer responsiveness and result in faster implementations? What are the costs for such services? How does this affect the company’s cash position, profitability and funding needs?
Two pricing strategies for professional services
Let’s compare the three-year impact of two pricing strategies for professional services and the resulting impact on funding needs:
- Company A: Provides professional services with an annual value of $ 10 million with a gross margin of -20% resulting in an annual loss of $ 2 million. The total loss over the three year period is $ 6 million.