One of our Friends and Family in the SaaS Benchmarking Community, Tom Huntington (CFO of Qstream, Vela Systems) has been talking to his network about product investment.
Here are his thoughts after looking at some of our blinded data. Let me know what you think, too, and what you’d like to see us benchmark. Sales & Marketing ROI gets plenty of attention but R&D is a blackbox for most financial analysis. We plan to focus more in this area, after we complete our annual 2017 benchmarking in the next month (participate now to get results!).
Are we any good at product investment?
by Tom Huntington
No, not really.
I looked at 145 public and private SaaS companies with revenue of $5 million and greater in conjunction with the team at OPEXEngine. Our goal was to find a relationship between product spending and payback once companies achieved product market fit. What happens when SaaS companies step on the gas in product? What happens when they throttle back? The answer is that results may vary – a lot.
As SaaS companies build on their product market fit, product payback should become more predictable. In most situations, it should show up through revenue growth, whether from priced features, more users, or lower churn. However, as the graphs illustrate below, the relationship between product spending and revenue growth is embarrassingly weak. I looked at time lags, cohorts by size, and cohorts by sales and marketing spend. No pattern emerged. We are categorically inefficient. We need to talk.
Several growth equity investors told me they don’t invest heavily in product. (This defensive strategy is reflected by the clusters in the lower left of both graphs.) Investors have been burned by markets that failed to materialize, and by products that took too long to develop.
One firm benchmarked its 34 portfolio companies to show how its fast growers compared to the rest. Their fast cohort spent 40% on R&D compared to a median of 24%. Nonetheless, the investor advises its companies to spend 15-25% since spending more doesn’t guarantee fast growth. Risk is high. Don’t risk it. This may reflect a more conservative approach than a venture approach where it is okay to swing for the fences with a few investments, and win big once in a while.
Here are a few offensive strategies for to help track whether your product investment is paying off:
Track return on R&D Capital (RORC): This metric is the current year gross profit divided by the prior year R&D expense. It’s a popular metric among CFOs who focus on product ROI. You can calculate it immediately because it uses existing GAAP data. For further details, check out Lauren Kelley’s blog on the topic.
this year’s gross profit / prior year’s R&D expense
Track % of revenue from new products: This is another popular metric among CFOs who focus on product. The metric is the percent of revenue from products released within the last one or two years, with 10% as a common target.
Track payback to product decisions. This requires two key events. The first is basing product decisions, in part or whole, on expected payback. The second is evaluating payback after the fact. Product managers should keep a running list of open business cases and review it quarterly. Executives and board members should ask for these reviews.
Strengthen the product management function. In product decisions, strategic rationale, ego, and excuses too often dilute financial criteria. Vaibhav Nalwaya, founding partner of Wavecrest Growth Partners, traces the problem to a lack of rigor in training product managers.
“Product managers are still trained through apprenticeship. There isn’t the repeatable training model that we have in sales. We need to work harder to train and empower product managers. This should be a board-level topic. Sales-aware boards are self-fulfilling prophecies. Product-aware boards are not. Companies should add product management expertise to their boards.”
This is just a first look at the data. If you’re like me, you have questions about taking calculated risks, adjusting management methods, and accounting for capitalized software, just to name a few. We’ve talked too little about this topic, not too much. Product investment is at the heart of SaaS. We need to get on top of this.
Share this with your colleagues. Discuss it with your board. Contribute data and best practices. Let me know what you think.
Tom Huntington is the Chief Financial Officer of Qstream.