For one day in 2016, it looked like the bottom fell out of the SaaS market. On the exact date, Feb. 5 2016, LinkedIn and Tableau’s stock prices fell 43% and 49%, respectively. Salesforce, the standard bearer for SaaS, also fell 10% that day. Atlassian, which had just gone public in December 2015 and hadn’t reported earnings yet, saw its stock fall more than 20% even though it was profitable and growing. And all of this was happening as luminaries in the SaaS industry were all gathered for SaaStr Annual 2016.  

At that time, it felt like the industry was bracing itself for an apocalypse. Everything happening in the SaaS market seemed to come back to this discussion around the tech bubble, and whether it had burst, or if we’re still in it.

Now, about a year later, as we prepare for SaaStr 2017, we thought it would be a good time to look back and reflect on the past year in SaaS. Ultimately, what looked like an inflection point at the time now looks more like investor overreaction. Though both companies’ stock prices are still down in double digits versus a year ago, the SaaS market as a whole continued to grow. An analysis that InsightSquared has prepared based on data from dozens of SaaS companies, however, shows some potentially worrying signs for the segment, including greater churn and a longer average sales cycle.

Overall, the space is much more competitive than a few years ago and investors are much more discriminating, valuing low burn rates along with strong growth. New entrants are likely to find more success in under-penetrated segments like accounting, or no longer seek to be a “system of record” for data but rather a “system of engagement” that employees use to get work done.

Evolution of the market

The SaaS market has been around in one form or another since the birth of computing, but modern SaaS as we know it closely mirrors the rise of Salesforce.

When Salesforce launched, the CRM market was dominated by Siebel Systems, whose software platform was both unwieldy and expensive. (A stat from 2003 claimed that 43% of salespeople never used the CRM software they had installed.) In addition, Siebel’s software could cost hundreds of thousands of dollars and take months to install. In contrast, Salesforce’s web-based CRM platform was relatively cheap (starting at $65 a month per user), which convinced a whole new base of customers to give CRM a shot.

Led by Salesforce, by 2005, SaaS controlled about 5% of the market, according to Gartner and penetration in CRM was 8%. As Robert DeSisto, research VP for Gartner noted at the time, SaaS underwent a transformation from 2000 to 2003 in which “most providers supplied ‘good enough’ functionality with core configuration capabilities. SaaS and solving business complexity were two phrases not associated with each other.”

That perception endured. Even in 2008, another Gartner analyst, Denise Ganly, dubbed SaaS offerings in ERP “immature.”

By 2015, the changeover was complete. Gartner predicted that in 2016 more than half of all CRM systems would be SaaS-based and a survey of human resources execs found that the number of firms planning to use a SaaS solution for HR were neck-and-neck with those planning to employ an in-house solution. A 2013 Forrester report also found that the median number of SaaS apps used in an enterprise was 11, but respondents expected that figure to rise more than 30% every year through 2015.

But just as SaaS had reached a tipping point for acceptance in the enterprise, the market showed signs of peaking. In 2014 for instance, valuations for SaaS firms were based on an 8X multiple, an all-time high. By 2015, the figure had fallen to 5X. (The average from 2005 to 2015 was 4X to 6X.) At the same time, the average growth rate for SaaS firms fell from a zenith of over 50% in 2007 to a still-impressive 30%.

In early 2016, investors got more bearish on the market, driving the average multiple down to 3.7X. As Sapphire Ventures’ Phil Orr wrote in a blog post around that time, “sloppy growth” was out. Investors were looking for companies that were fast-growing and profitable at the same time.

The dour mood was reflected in SaaS valuations, which fell 57% according to one estimate while

That set the stage for Feb. 5. Both LinkedIn and Tableau beat their earnings but offered lowered their guidance for future quarters. It should be noted though that SaaS stocks weren’t the only ones hammered that day. FANG stocks all fell and the Nasdaq closed the day down 3.2%. That gloom was short-lived. Nasdaq closed 2016 up 7.5% for the year.

Crowded Cloud

We recently polled some SaaS clients and found a somewhat challenging market. In particular, churn was up 5% year over year and the sales cycle had extended by 8%. Translated, that means that more people are bailing on existing SaaS apps than in the past and it takes longer to sell the products.

This is a reflection of two changing variables in the market: Saas fatigue among customers and increased competition.

At this writing, AngelList claimed there were about 11,000 SaaS startups in the market with an average valuation of $4.3 million. That compares to around 7,000 in 2015.

What’s driving overall growth is that SaaS has evolved beyond basic business functions like CRM, ERP and HR toward specialized industries like healthcare, energy/utilities and retail a.k.a. the “industry cloud.” At the same time, the category growth has prompted many me-too products that offer narrow functionality but drew venture capital. The result is that the SaaS market is either overcrowded or underserved, depending where you’re looking.

“What happens in venture-backed categories is that a bunch of companies compete against each other and all raise capital to do the exact same thing,” said Blake Bartlett, partner at OpenView. “And the way that they’re competing against each other is by burning venture dollars.”

That’s one factor driving churn, Bartlett said. “If you’re not satisfied with one system and there are five other systems by five other vendors coming after you, they’ll switch from one to the next.”

Compounding this competition, new venture-backed startups tend to launch in narrow slices of the market. “There start to be narrower applications that get funded and even-narrower applications get funded after that,” he said. “Then you start to see things that are barely applications that you can start calling features. You just have a lot of crowding.” At that point, customers often assess what they’re paying overall and realize that there are some expensive redundancies.

This isn’t indicative of the SaaS market as a whole though. The previously mentioned industry cloud still represents blue-sky territory as does areas like finance that have been relatively untouched by the SaaS revolution.

The good news is that there’s little evidence of “SaaS fatigue” among buyers or of an IT department that’s frustrated with shadow IT in which heads of business purchase SaaS products without their consent. As Gartner has predicted (and reiterated in late 2016), in 2017 the CMO is projected to spend more on IT than the CIO. This switch, which has been occurring for some time, fosters a mindset in which the nuts-and-bolts of the technology is less a factor than the perceived benefit.

While the demand for SaaS appears to be continuing to grow, the real reason for cooling valuations and investor wariness is likely that too many SaaS companies have flamed out because they were hell-bent on pursuing growth at all costs. For instance, shortly after LinkedIn and Tableau’s crash in early February, another SaaS firm, Zenefits, announced it was laying off 17% of its workforce. “It is no secret that Zenefits grew too fast,” Zenefits CEO David Sacks wrote in a memo to staffers, “stretching both our culture and our controls.” That memo came after Sacks also cracked down on a freewheeling culture that included on-the-job alcohol intake and sex in the hallways.

Around the same time, Optimizely, which was once “on pace to grow revenue faster than any other SaaS company in history,” announced layoffs as well.

As the overall SaaS market grew 21.7% in 2016 according to Gartner, the only explanation for this sudden contraction is that some companies were growing too fast.

Despite the perceived carnage of Feb. 5, the sector as a whole did quite well in 2016. The BVP Cloud Index showed that publicly traded SaaS firms handily outperformed the overall market during the year.

“The public markets oftentimes can be fairly volatile or seemingly fickle,” said Bartlett. “I think a lot of times there can be overcorrection. Public investors get spooked.”

The way forward

The SaaS market of 2017 is a lot different than a few years ago. With funding in shorter supply, startups need to assume that they are on their own and make self-sufficiency a priority. Investors are less keen on the idea of chasing unrestricted growth if there’s no feasible path to profitability, which is a reflection of the maturation of the market.

Rather than look to VCs, SaaS startups would be wise to instead focus on new ways to draw more revenues from existing customers. This can be achieved by merely asking your customers what additional products and services they’re craving that you don’t currently provide and how much they’d be willing to pay for it.

Progress in such revenue generation can be measured by setting benchmarks, not the traditional ones like top-line revenue growth, customer-base growth and employee headcount growth but more effective ones like unit economic optimization and per-employee revenue growth.

The latter is easy to figure: Just take your revenues and divide it by your headcount. As for unit economic optimization: In SaaS, the unit is the customer, so optimization depends on the lifetime value of a customer and the cost per acquisition.

The other benchmark to consider is the burn rate. While startups are expected to burn through cash, in the current environment, investors are watching the slowing of the burn rate, which is an indication that the company is heading in the direction of profitability.

Finally, there’s the “SaaS Quick Ratio,” which looks at MRR growth against churn, which gives you an idea of how fast the company is growing and how well it does at retaining current customers. A super-high MRR with strong churn, for instance, is a troubling sign because it means the company is good at getting new customer on board, but bad at keeping them. Pretty soon the word on the street will catch up.

This more responsible growth path is hard work. The days of getting pumped with VC cash without worrying about ever being in the black are long gone. The only possible change to this vision is if some unforeseen technological breakthrough comes along to once again shake up the market.

Looking ahead, that kind of game-changing technological switch isn’t on the horizon, though AI and machine learning could eventually throw everyone a curveball. Coming out of CES, AI was a hot topic, but it’s too soon to know if AI will be a fad like Google Glass or a real game changer like the iPhone. Since AI is growing exponentially, it remains a wild card whose effect could be sudden and dramatic across many tech categories, including SaaS. “If you start to see some applications get really good at AI and are getting real results, that could totally shake things up,” Bartlett said.

Are you attending SaaStr 2017 this year? Make sure to check out the agenda.

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