Note: This article, co-written with Jacco van der Kooij, first appeared at Harvard Business Review online here.
Summary. Traditional sales models focus on customer acquisition and the “funnel” or “pipeline” metrics that dominate talk about sales. But this approach falls short when applied to a recurring revenue business, where the customer life cycle looks more like a bowtie, not a funnel: In a subscription model, most revenue takes place outside the marketing funnel. Historically, many B2B markets were built on products with steep upfront costs and a business-development culture focused on buyers with sufficiently large budgets.
For years, subscription Software as a Service (SaaS) was the fastest-growing business model for tech entrepreneurs and investors. The SaaS capital index peaked in 2021, crashed months later, and by year-end 2022 VC firms raised their lowest amount in a decade. But the reasons for that rise and fall have not been appropriately analyzed, and the implications hold lessons for other businesses for which a subscription model is a key part of growth plans.
Subscription businesses grew more than 300% from 2012–2018, about five times faster than revenues of S&P-500 companies. After the Covid-19 pandemic, SaaS offerings are moving up-market as firms encourage enterprises to add subscription offerings to their core product lines. This article discusses why the model grew, why it crashed in the tech sector, and the lessons for growth via that approach.
The History of SaaS
SaaS grew for both supply and demand-side reasons. As cloud technology enabled firms to provide low-priced software subscriptions, often via a “freemium” pricing approach, those firms needed a low-cost customer-acquisition model. The SaaS model, with young and less-experienced sales people, lowered hiring and compensation costs compared to the traditional enterprise software model. With an inside sales force making outbound calls but not in-person visits, the model also lowered travel, entertainment, and administrative expenses. Firms could do this because for some years digital marketing was a cost-effective method of lead generation and their core value proposition simplified the task required of novice salespeople: “You now pay $1–2 million for your tech solution: how about a demo for a product that does the same but costs $1–2 thousand per month?”
On the demand side, customers were increasingly comfortable with remote interactions with vendors, while pre-sale search capabilities and online demos facilitated this purchasing approach. Meanwhile, in a prolonged era of low interest rates and abundant investor capital, the land-and-expand economics inherent in this approach allowed many SaaS firms to grow without regard to near-term profitability. The pandemic necessitated more online interactions, and temporarily inflated growth for many subscription-based firms.
A well-known example is Peloton: in 2020 at the height of the pandemic and growth for its subscription fitness service (and $50 billion valuation), founder and then-CEO John Foley emphasized the “massive opportunity [and] when you say ‘normalize coming out of Covid,’ we don’t see that.” Less than two years later, Foley was replaced as CEO, valuation was less than 1/10th of what it was in 2020, layoffs were a serial occurrence, and the firm needed a $750 million loan in 2022 “to strengthen the balance sheet.” But it wasn’t just Peloton: witness similar declines, layoffs, and revised growth forecasts at Shopify, DocuSign, Salesforce, and others reliant on a subscription model during the pandemic.
One result was the “SaaS crash” of 2022. Another result, accelerated by rising interest rates and higher costs of capital, has been a shift in investor sentiment from “scalable” growth without regard to profitability to “sustainable” growth based on more enduring drivers of a subscription model.
Principles for Sustainable Growth
Recurring revenue delivered as subscription services is not dead. In fact, informed by an understanding of the model’s core dynamics and the lessons of the SaaS crash, its best days are ahead. Begin by noting these principles:
A Bow Tie, not a Funnel
Traditional sales models focus on customer acquisition and the “funnel” or “pipeline.” But this approach falls short when applied to a recurring revenue business, where the customer life cycle looks more like a bow tie, not a funnel.
In a subscription model, most revenue takes place outside the marketing funnel. Historically, many B2B markets were built on products with steep upfront costs and a business-development culture focused on buyers with sufficiently large budgets. It’s no coincidence that BANT (Budget, Authority, Need, Timing), the acronym for the common sales methodology developed by IBM in the 1960s, begins with “B,” usually meaning the buyer’s annual capital budget. But most SaaS services fit within buyers’ operating budgets and are bought on the priority of the impact that service provides. For customers, the big expense is the cost of the people spending time with the service, a cost often many times greater than purchase price. That’s why the life cycle framework indicates “commit,” not “closed/won.”
Conversely, this has pricing implications for the seller, because communicating impact means linking price to the relevant unit(s) of customer value. HubSpot initially charged a flat per-month subscription fee, but then tied pricing to number of contacts in a customer’s database. As a client’s database grew, the value of the service increased and the ability to share in that success via impact pricing. For other subscription businesses, the unit differs. Fintech firms typically charge a fee per transaction: usage tends to be episodic and not, as with HubSpot, part of a marketing or sales cadence at customers. Other subscription firms price based on features that are often part of a bundle with ancillary services. In all cases, however, the relevant value unit affects how you sell and to whom.
Quality, not Quantity of Leads
Ask most sales leaders what they need to double revenue and they usually say, “I need twice the amount of leads and twice the number of people to call on those leads.” This assumes a linear relationship between leads and wins. But SaaS works as an interconnected system: lead-gen and qualification affect conversion rates and retention throughout the process in a compound manner. A marginal difference in relevant leads means a big difference in Annual Recurring Revenue (ARR). One lesson of the SaaS crash is that this snowball effect applies to subscription models as they ascend and as they fall. It’s like that character in a Hemingway novel who, when asked how he went bankrupt, replies, “Well, first a little bit at a time, and then all at once.”
With subscriptions, change your lead-generation mindset to quality over quantity. One reason why is that the traditional source for leads in this business model — paid search and other online marketing vehicles — is increasingly cluttered, expensive, and an example of diminishing returns. Average cost per lead via Google Ads, for example, went up about 20% in 2021 and another 19% in 2022, and even more in sectors like entertainment, travel, and household goods. Meanwhile, conversion rates fell by about 14% in 2022, reflecting a multi-year decline as the medium becomes more crowded. Hence, the joke currently circulating among CMOs: “Where is the best place to bury a body? Page two of a search engine, because nobody goes there!”
A more fundamental reason to focus on quality of leads is that risk moves from buyer to seller with a shift from an ownership-based to a subscription model. With a purchase paid for upfront, the buyer takes on the lion’s share of the risk inherent in installation, integration, and extracting usage value. With a subscription, the seller builds the infrastructure, develops the software, and hosts the service. And with fractional revenues generated monthly or quarterly, many subscription businesses take many months to recoup customer acquisition cost and need annual renewals to sustain a profitable business. In this context, identify the right customers early on, because the costs of false positives are enormous.
Automation tools enabled firms to send thousands of templated emails: “Hello <First_Name>, as the <Job_Title> at <Company Name> you must experience <Problem_Statement>.” Not only did this generate many false positives, but the customer problem and solution are dynamic variables, not static. During the pandemic, for instance, Pharma firms purchased online meeting software for their sellers to interact with healthcare practitioners. Now those sellers can again safely visit hospitals and doctors’ offices, and the relevant impact has shifted from doing things remotely to doing things faster: “I have a case I need to discuss: can you put me in touch with your specialist in this area?”
Customer Success, not only Service.
In subscription models, recurring revenue is the result of recurring impact, and service is key throughout the customer life cycle. In response to a content marketing piece, a prospect may be on your website and click for additional information. If the product is sold via trials, the service provided during that period is critical. Most subscription offerings make their impact visible thru relevant usage and, in turn, usage is most influenced by the onboarding process, not a demo or hypothetical ROI during the customer-acquisition phase.
This differs from the order-fulfillment and problem-resolution role of service in traditional sales models. Some SaaS firms correctly refer to their service groups as Customer Success (CS) teams, because they are vital in closing a sale, onboarding customers, business reviews that track on-going product impact, and the expansion phases of the customer lifecycle. CS for apps like Slack provide monthly reports detailing how many one-on-one and team conversations took place, how much content was shared, what kind, and so on. This makes visible to customers the value of a thriving, often distributed community of users, while providing CS with data about usage that support recurring impact and revenue.
Conversely, a contributing factor to the SaaS crash is a misunderstanding of CS in that model. When demand slows and there’s a need to cut costs, firing a CS rep often feels like an “easy” decision to many executives: “After all, we already won the customer.” But CS affects revenue in at least two ways that, when combined, are usually bigger than cost savings from decreasing CS headcount:
- Reducing churn in a business model where customer life-time value (LTV) is highly correlated with subscription length. Increasing customer retention by even a month or two usually has a disproportionate impact on LTV in a subscription model; and
- Increasing usage and expansion via renewals, upsells, and potential cross-sells to others in that company or household, and at less cost compared to that of new customer acquisition.
This has implications for metrics and sales management. In a subscription model, Net Revenue Retention (NRR: Starting Revenue + Expansion Revenue – Contraction Revenue / Starting Revenue) is a better metric than new-customer growth, because NRR reflects the relevant economics including upgrades, additional services, adding more users, but also downgrades, fewer users, and/or churn in the customer base. Similarly, it’s common for sales leaders to talk about their people as either “hunters” (good at new customer acquisition) or “farmers” (installed-base account managers). But those roles are much more nuanced in a subscription model, require cross-functional links with non-sales groups, and sales leaders must rethink their hiring criteria and KPIs to deal with this reality.
Technology and the “Internet of Things” are making subscription services a major opportunity for firms in sectors far removed from software. Despite fashionable talk about “predictable revenue,” no business model manages itself. Learn from the early movers in this area — from both their insights and mistakes.
- Frank V. Cespedes is a senior lecturer at Harvard Business School and the author of Sales Management That Works: How to Sell in a World That Never Stops Changing (Harvard Business Review Press, 2021).
- Jacco van der Kooij is the founder and CEO of Winning By Design, a firm that works with early-stage companies on sales and other go-to-market issues. He is also the co-author, with Fernando Pizarro, of Blueprints for a SaaS Sales Organization.