In the summer of 2014, South Carolina–based BenefitFocus was preparing its Initial Public Offering. The IPO would deliver an infusion of cash to fuel the company’s growth.
High anxiety accompanies IPO preparations. For the first time in its life, a company must publish its operational and financial results to the world. Its strategy, leadership, and financials all come under a high-powered microscope from investors and analysts.
Fortunately, BenefitFocus could tell a story of success. Founded in 1997 by Mason Holland and Shawn Jenkins, the company had grown steadily since acquiring its first customer in 2001.
There was just one problem. Despite its consistent leadership and continued growth, the company had been losing money for years. And its losses showed no sign of stopping anytime soon. In fact, the company warned investors that it would continue to be unprofitable for the next few years.
Some analysts accepted those losses. Others were not so sanguine, warning investors to beware a company with a high valuation that could not seem to turn a profit.
Rapid Growth Requires Significant Investments
Like many Software as a Service (SaaS) companies, BenefitFocus competes in a winner-take-all market. As David Skok explains, in these markets “it is therefore important to grab market share as fast as possible to make sure you are the winner in your space.”
BenefitFocus software streamlines the administration of corporate benefits, selling its software to both large employers and insurance carriers. The software makes it possible for more than 20 million consumers to “efficiently shop, enroll, manage, and exchange benefits information.” Its position at the “center of the benefits ecosystem” creates high switching costs for customers and barriers to entry for competitors.
Since 2009, BenefitFocus has expanded from 28 to 40 Exchanges and from 121 to 393 Employers. In order to be the winner in its market, BenefitFocus must continue to rapidly win new customers.
However, growth at BenefitFocus requires significant investment. To stay ahead of better-established competitors that are entering the market, it has to move quickly to sign up both Employers and Exchanges.
Can a company that loses money every year become the dominant player in its market? To answer that question, let’s look at the causes of BenefitFocus’s losses.
Sales, Marketing, and Customer Support Cause Losses at BenefitFocus
Let’s start with overhead costs, which include those for Research and Development (R&D) and General and Administrative (G&A). Overhead costs at BenefitFocus match expectations for a growing SaaS company. In 2013, it invested approximately 22% of its revenue in R&D and 10% in G&A.
So far, so good.
Next let’s look at the cost of revenue. Typically, SaaS companies yield 80% gross margins. Their costs of revenue usually include serving and hosting costs, software licenses, and customer support.
Unlike the typical SaaS company, BenefitFocus delivers only 40% gross margins. This surprisingly low number caused analysts like Don Dion at Seeking Alpha to raise the alarm.
It seems unlikely that BenefitFocus’s data center costs significantly exceed those of other SaaS companies.
The high cost of revenue probably arises from Customer Support activities. BenefitFocus states in its prospectus that “our cost associated with providing implementation services has been significantly higher as a percentage of revenue…due to the labor associated with providing implementation services.”
Here’s a likely explanation. The company has been growing rapidly, and it deploys complicated software. It has simply been more difficult and expensive to implement software at customer sites than BenefitFocus had expected. The high costs of implementation has put significant pressure on gross margins.
Now that we know that implementation costs contribute to the losses at BenefitFocus, what about the cost of Sales and Marketing?
To solidify its position in the market, BenefitFocus must invest in rapid growth. In 2013, it added 113 customers, a 35% increase over the previous year. However, BenefitFocus currently owns only a small percentage of the 18,000 large employers in its target market. It must grab market share quickly if it wants to be the dominant player.
BenefitFocus software is complex and expensive. Employers pay about $100K per year in subscription fees for the software; Exchanges pay over $1M. A new customer requires months to implement the software and to train its employees.
Consequently, buyers require time to make a purchase decision. Multiple people at high levels become involved in that decision. From the time they engage with a BenefitFocus sales team, Employers need about 4 months to complete a purchase, and Exchanges need 15 months.
This makes customer acquisition expensive. BenefitFocus invests heavily in the sales function, allocating 34% of its revenue to customer acquisition. The direct sales force makes possible the growth that is essential in this winner-take-all market.
Unit Economics Alter Your Perspective on Costs
Now we understand the source of losses at BenefitFocus. They arise from Sales, Marketing, and Customer Support. The cost to acquire and train new customers absorbs nearly 75% of the company’s revenue.
When financial analysts see high customer costs, they question the viability of the business. Why is it so expensive for BenefitFocus to acquire and train customers? Will the company ever be profitable?
Investors cannot extract answers to these questions when they study the published financial statements. Why not? Because income statements obscure the timing of revenue and expenses in a SaaS business.
In the chart above, the orange bars show that revenue in a SaaS business accrues over time as customers pay recurring monthly or annual fees. Even when the company grows quickly, new customers do not add enough revenue immediately to offset the money spent to acquire them.
However, the green bar shows that investment to acquire customers is expensed immediately as sales and support staff are paid for their work. These investments cause the company to lose money. The faster the company grows, the greater the losses from customer acquisition.
Instead of using financial statements to look at all customers in the aggregate, David Skok recommends asking this simple question:
Can I make more profit from my customers than it costs me to acquire them?
The answer to the question lies in the unit economics of each customer. You need two customer metrics to study unit economics:
LTV: the Lifetime Value of a typical customer
CAC: the Customer Acquisition Cost of a typical customer
Calculate Lifetime Value
The lifetime of a customer is simply the inverse of the churn rate. If you churn 33% of your customers each year, that means the average lifetime of a customer is three years (1/.33 = 3).
To estimate the lifetime value of a customer, multiply the years of lifetime and the annual customer revenue.
Calculate Customer Acquisition Cost
Customer acquisition cost is the total sales and marketing annual expense divided by the number of customers you acquire that year.
Once you know the LTV and the CAC, two ratios will give you important insights into the unit economics of a SaaS customer:
LTV > 3 times CAC
Months to Recover CAC < 12 Months
The LTV:CAC ratio tells you whether you will be profitable in the long run—that is, once you have paid to acquire a customer. In a healthy SaaS company, the lifetime value is more than three times the customer acquisition cost.
The months-to-recover CAC tells you how long it takes for each customer to become profitable. SaaS companies try to recover their customer acquisition cost in less than one year, so they can use those funds sooner to acquire another customer.
You Have to Spend Money to Make Money
Now that we know how to use unit economics to evaluate a company, let’s apply those ratios to BenefitFocus to see if the results give us any insight into its losses.
First, let’s calculate lifetime value, which is the product of lifetime and revenue. BenefitFocus churns only about 5% of its customers a year, which is a very low rate. Customers remain with the company for an astounding lifetime of 20 years (1/.05 = 20). Average annual revenue per customer at BenefitFocus is $242K.
LTV = 20 years times $242K/year = $4.9M
Next, let’s calculate customer acquisition costs. In 2013, BenefitFocus spent about $36M on Sales and Marketing to acquire 113 customers.
CAC = $36M Sales & Marketing cost / 113 Customers = $319K
Finally, we have the metrics to evaluate the health of BenefitFocus, whose two unit economics ratios are:
LTV:CAC = 15
Months to recover CAC = 16
The LTV:CAC ratio should be greater than three. A ratio of 15 tells us that each BenefitFocus customer delivers a revenue stream long after the customer acquisition costs have been paid. Following the first year, the economics go from an operating loss of 27% to an operating profit of 47% on each BenefitFocus customer. These operating profits continue for the life of the customer—in the case of BenefitFocus, for 20 years!
BenefitFocus has fostered a solid customer acquisition model. Customer acquisition costs are high, but not unexpected, for a complex software product. In order to acquire market share as quickly as possible, the company must invest heavily in customer acquisition.
The real value of this company resides in the high price it charges each customer and in the long lifetime of those customers.
The unit economics of customers sheds light on the business model and on financial results that traditional financial statements cannot accomplish. Despite the cost of customer acquisition, the unit economics of BenefitFocus show that the high software price and long customer lifetimes make for a solid SaaS business that will return profits long into the future.