The main difference between traditional businesses and SaaS businesses: the cost of growth.
In the traditional world of software, companies like Oracle or SAP base their business on the marketing of licenses for their solutions. This is followed by the installation of new versions. Customers pay for the licenses before using them. They also pay an annual maintenance cost calculated on the cost of acquiring these licenses (typically 15%).
This is great for these software vendors and even better for their income statement because the revenue schedule and the expense schedules are perfectly aligned. The sale of a license of $100K in the 3rd quarter will result in the recording of an income of $100K for this same quarter. This is how these companies can show profitability earlier in their life cycle.
The SaaS Business Model
SaaS vendors do not play on the same court. Their customers don’t buy a license once and for all. They subscribe to a service that is billed to them, usually monthly, for as long as they are in use. This is referred to as “Software as a Service”. Imagine that a customer signs for a 24-month subscription, the SaaS vendor will not be able to recognize the revenue of these 24 months when the subscription starts. Current accounting rules only recognize the service when it is provided. In our case, recorded revenue accounting each month equals 1/24th of the total value of the contract.
On the other hand, the cost of acquiring this customer is to be recorded as soon as the subscription starts. This cost includes sales, marketing, development, maintenance, and the hosting of the infrastructure. And this is where the shoe pinches: revenue and expense schedules are not aligned with each other! It thus appears that the analysis of the revenue statements alone is not sufficient to evaluate a SaaS business.
Even more significant, cash flow timing is all over the place. The customer pays his bill once a year, quarter, or month. But the SaaS vendor must pay all its expenses on acquisition right away. In the case of SaaS vendors, as with many new activities, cash flow is not the most relevant indicator.
To illustrate this point, let’s take the example of a SaaS vendor who spent $6,000 to acquire a customer. And the customer pays $500 for the services every month. The reported theoretical cash flow with this customer will reach its equilibrium in the 13th month of the subscription.
Meanwhile, The SaaS vendor will continue to acquire new customers and its cash flow situation will deteriorate. The faster it will convert new customers, the larger its installed base will be and the better the evolution of its cash flow after the break-even.
Why SaaS Business Model works?
SaaS is magic! Provided that the SaaS vendors offer is competitive and delivers value,the customers will tend to remain loyal to it.. Since the cost of acquiring was paid upfront, all the incoming cash is profit. And at this moment, the “cash machine” starts.
Another interesting and sometimes neglected aspect: Research & Development. A traditional software vendor is forced to maintain multiple versions of the software. Even Microsoft has been forced to drop support for Windows XP, to the desperation of many customers.
Here is a technical, commercial, marketing, and financial constraint that a SaaS vendor does not have to suffer from. All of its customers use the same hosted version of its software. This means a single version to maintain, update, debug, a single physical environment (servers, storage, network, etc.) to administer. This can represent a very substantial economy of scale and further improve the long-term profitability of the SaaS vendor.
How do we know the model is working if there is a huge negative cash flow?
CAC or Customer Acquisition Cost is the first parameter of interest to master. This consists of calculating the total sales and marketing expenses over a given period (quarter for example) incurred by the SaaS vendor, then dividing it by the number of new customers acquired during the same period. Then it is necessary to assess whether the value of this CAC is acceptable or if it shows that the acquisition of new customers is too expensive for the company to be able to generate profits within a reasonable time.
For this, we need a second parameter that is: the “LifeTime Value (LTV)” or “customer lifetime value” which is calculated by (Annual Recurring Revenue x Gross Margin) ÷ (% Churn + Discount Rate). It should also be noted that the LTV can also make it possible to enhance a business through the value of its customer portfolio.
The important thing is to retain as a commonly accepted rule that the LTV must be equal to or greater than 3 times the CAC. This is the benchmark of a successful SaaS model even with negative cash flow. On the other hand, if the LTV is close to or lower than the CAC, the SaaS vendor must seriously worry since the amount spent to acquire a new customer is higher than what this customer is likely to bring him in the margin. Several explanations are possible:
- The vendor does not sell its solutions at a sufficiently high price;
- Customers are not retaining (churn too high) and leave very early
- The acquisition costs are too high.
Churn Rate Plays a key role
Small churn reflects an excellent level of customer satisfaction and their propensity to remain loyal to the vendor. It is interesting to relate the churn to the rate of new customers. A small hole in a bucket and you can still fill it up with water.
There are two types of churn: the “customer” churn and the “revenue” churn. Each of them provides a different parameter on the health of the SaaS vendorr’s business. Customer churn is the total percentage of customers who terminated their subscription at the end of a given period. The revenue churn represents the share of revenue lost due to customer churns compared to the total recurring revenue.
Learn about the different ways to calculate churn.
If the customer churn equals the acquisition rate, then the number of new customers exactly compensates for the number of departures. Growth will slow down and then stop. Churn is an incredibly complex metric to look at for future growth. The need to compensate for the business loss will always increase along the path.
To control or reduce its churn, a company can:
- Bring in new customers at a faster rate
- Have negative churn (happens when expansion revenue is larger than churned revenue)
- and of course, retain the customers.
It is here Customer retention software like CustomerSuccessBox plays an important role. As per McKinsey report, companies that use customer analytics across all business decisions tend to see 126% jump in profit over companies who don’t. Customer retention/success platforms can help you get a grip on churn by optimizing customer retention.
Remember, keeping and growing orders from existing customers costs less than finding new customers. This explains the importance of sales, marketing, and customer support functions within SaaS publishers and their tendency to devote more and more resources to them.
What are the advantages of SaaS?
A software solution marketed as SaaS will have these advantages:
- Cost reduction: heavy investment in IT infrastructure is not necessary. In a SaaS model, companies no longer need to install and launch applications on their computers or in their data centers. You don’t need to acquire any hardware nor bear the costs of procurement and maintenance, software licensing, installation, and support.
- Security: The applications and data are hosted on secure servers.
- The ability to upgrade: The hardware and software updates are carried out automatically Rather than having to purchase new software regularly, users can rely on the SaaS provider to perform updates and add hotfixes.
- Access to your applications from anywhere. SaaS applications are on cloud and doesnot require onpremise installations. The users can access it from anywhere.
A SaaS solution’s high scalability or high capacity stems from adapting to an order of magnitude change in demand. Depending on their needs, the user can access more or fewer services and functionalities on demand.
The diversity in a SaaS business is incomparable and as the means of securing funds is constantly expanding, there is no better time to get into this field. One of the keys to success is to be data-driven as early as possible for a SaaS company. The tools you use to achieve that do not matter. Build towards sustainability and measure key metrics at every point of your journey.
You can learn more essentials on the SaaS business model on our blog.