Why so many SaaS startups fail due to lack of startup capital

SaaS is sexy

Selling software as a service instead of a license sounds pretty tempting. Customers like the concept, because “service” suggests that the customer is not left on his own after the purchase but also receives a “carefree package”. In addition, the risk decreases in the case of a wrong decision. After all, you don’t need to spend a lot of money at the beginning and, assuming that cancellation notice periods are reasonable, you will not be left with high initial costs if you don’t like the software.

For providers, SaaS has its charms as well. The lower costs at the start promise easier sales and quicker customer decisions. In case of success, the company’s value can be easily predicted, since in the end, money in the form of subscription fees will come in continuously.

Is it all really so blissful?

So, a win-win situation, right? Business models based on up-front license sales are a thing of the past. Long live SaaS! There’s only one catch: cash flow. If high, up-front license income is replaced by cheap, monthly subscription rates, a gaping hole will quickly appear in the company’s wallet. After all, salaries and suppliers want to be paid immediately, not years later, when a large customer base ensures high monthly revenues.

A brief, rough estimate

Let me illustrate the problem with a brief, rough estimate. Let’s start with an IT entrepreneur who has a great idea for a SaaS product. It is not a trivial app written over a weekend but requires serious planning and development work. Let’s assume that our fictitious founder needs three more team members in addition to his own time commitment. According to relevant industry surveys, estimated annual costs of € 48,000 for software developers in Western Europe are by no means excessive. For three people, this results in around € 150,000 salary costs per year. For the sake of simplicity, we will ignore other, non-negligible costs (e.g., computer, software, cloud framework agreement, rent, marketing material, online advertising, etc.) in our rough estimate. They would only darken the picture.

Next let’s assume a development time of six months. For a medium-sized project such a time span for planning, implementation and stabilization may seem rather short. But let’s be optimistic for our calculation.

As a third assumption, we need the sales or subscription price. What value can a four-member team produce in six months? A product with a license price of € 5,000 plus 20% annual maintenance costs seems realistic to me. As a result, a customer would pay € 9,000 in four years. From this we can also derive a rough estimate of the subscription price: € 250 per month appears feasible.

In terms of sales, our startup runs like clockwork once development is done. The first customers are already buying three months after the first version has gone online. Over time, sales are becoming more effective, and the number of new customers increases quarter by quarter. 

The SaaS cashflow gap

Figure 1 compares sales and financing needs over the first 24 months of our fictitious startup. Well, 125,000 € would have our company on its feet if the business plan holds true.

Figure 1: Development of financing required for license sales

And how do things look with SaaS? Figure 2 shows the difference. Since I am well-disposed towards SaaS, this calculation assumes that our startup can win twice as many customers can as with license sales. And yet, our startup needs more than twice as much starting capital and can show no positive cash flow even after 24 months.

Figure 2: Development of financing required for SaaS

What now? Is the SaaS model unaffordable?

Is SaaS approaching a suicide mission for young companies or product teams? Not if one plans for the high capital requirement from the beginning and appropriate measures are found in the business plan. Here are some examples of strategies to deal with the SaaS cash flow gap:

• Sufficient starting capital: This strategy is obvious – you just have to get enough cash for the start phase. As if it were that easy.
• Complementary service products: The slow increase cash flow from subscriptions is compensated by other product segments (e.g., training, implementation projects) with faster cash flow.
• Calculated compensation: Established companies with well-performing cash cows often find it easier to start a SaaS business, as SaaS development can be cross-financed by other products.
• Attractive prepaid offers: Especially in the beginning when cash is scarce, one can try to persuade customers to pay in advance for subscriptions at particularly attractive prices. Longer minimum commitment periods do not put euros in your pocket right away, but they can serve as collateral for funding rounds with lenders.
• Reduction of time-to-market: The faster the product is ready for the market, the sooner the sales process can start.
• Reduction of initial development costs: Profit-sharing models can attract developers who would otherwise be too expensive. Public cloud services ensure that operating costs increase with sales and that no huge sums need to be invested in IT infrastructure.
• Near- and offshoring: People in western economies don’t like hearing this, but it is a fact that you can consider: In other regions of the world, well-educated developers are much cheaper than they are here.
• Funding: Especially in Europe, subsidies from the state or from the EU are often available for the technology sector. Even the big cloud providers attract startups with attractive start offers (e.g., the BizSpark program from Microsoft).
• Crowdfunding: Banks see SaaS startups as a high-risk investment. Crowdfunding, i.e., the financing of product development by large numbers of future users, can be an option, especially for B2C products.

Motivation and time instead of venture capital

Especially young entrepreneurs who want to get started with SaaS often find it difficult to get the funds they need to realize their product idea. In this case, one way to enable your startup is to minimize your own living costs and put every spare minute in product development. It’s always amazing what a committed, motivated team in the proverbial “garage” can put on its feet.

However, one fact should not be overlooked: at some point, every serious project has to face the market and prove that it is financially viable in the long term – otherwise it is a hobby and not a SaaS company.

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