Posted: November 19, 2012
Six tips for being SaaS-y
A guide to operating the Software-as-a-Service business modelDan King
Software-as-a-Service (“SaaS”) business models are gaining popularity for good reason. Market research firm IDC says that by 2015, SaaS solutions will account for $1 of every $6 spent on software. Additionally, Forbes recently recognized five reasons why Denver is a great place for startups, including SaaS companies.
Currently in the software marketplace, publicly traded SaaS companies are being valued at a premium. Recently acquired companies include Taleo, SuccessFactors and RightNow Technologies. Others have launched successful IPO’s such as Workday and Eloqua.
What makes SaaS companies so attractive? Much of the answer lies in the unique nature of how this low cost; no waste business model is executed in terms of sales, service and technology.
SaaS models allow businesses increased flexibility when using software applications. The software and service models are single-instance, multi-tenant, highly available, with a single version of code for all customers. The offering includes the infrastructure, platform and software.
This flexibility usually prices as a “pay per usage” or “subscription." Customers have the ability to elect a variable cost model, with little to no up-front cash requirements. This flexibility allows for both a predictable cost to the customer and revenue to the vendor. This leaves the question of how do SaaS vendors know if they are optimizing their financial operations and how can finance play a key role in a company’s success?
Newer concepts and metrics have been implemented by thought leaders. These concepts are evolving. The following will outline 6 key concepts a SaaS company should consider when developing operational strategy:
1. CAC – Customer Acquisition Costs – This is a great indicator of long term value creation. This concept measures how quickly your company obtains a return invested to acquire a customer. Ideally, your CAC ratio should be < 1. This means the investment to acquire the customer will obtain a return within one year. Multi-year agreements are useful in this situation, but can create friction. To reduce this friction, many SaaS agreements are month to month.
2. Customer Lifetime Value – This concept measures the net present value (NPV) of recurring profit streams of a customer, less the acquisition costs. The key is to measure profit streams, not just revenue. Ideally, the NPV is positive indicating the customer may be profitable. This can be difficult to track in early stage companies with little history. Generally, SMB customers have a shorter lifetime then enterprise customers.
3. Service – The service provided to customers can be the differentiator between failure and success. Many times the “service” part of SaaS is either ignored or underappreciated. SaaS companies live and die by the quality of services provided. This expectation of service holds the software provider accountable over time. Expect margins to be lower than traditional software models primarily for this reason.
4. Cash Management – Initial working capital requirements for SaaS companies can be demanding. Cash investments made to acquire the customer include: sales, marketing, legal, capital and implementation costs. Managing cash around these investments is critical because customer payment terms are often stretched out over the term of the contract.
5. Churn and Client Retention – Implementation disasters are unacceptable for SaaS businesses because the customer has the ability to stop using the software entirely, regardless of contract terms. Keeping customers happy and engaged is key to successful contract renewals. The cost to renew a customer is substantially lower than the cost to acquire them due to the fact you are renewing existing implemented business. What is the magic retention rate number? Industry norm is typically >= 90 percent - with most of the churn due to death (bankruptcies) or marriage (acquisitions). Measure the company’s retention rate frequently and look ahead to manage the renewal process.
6. Finance – Your finance team can support you through the nuances of how SaaS customer transactions ultimately manifest into revenue and earnings. Software revenue recognition has undergone significant changes beginning in 2011 and is still a mind numbing science to manage. Lean on your finance resources to help you understand the underlying economics of deals, including the mystery of how closing deals (bookings) translates into revenue.
The concepts discussed above are not exhaustive. There are many other important concepts that should be discussed such as committed monthly recurring revenue, internal controls, security, etc. Each concept will be important for different reasons.
The key takeaway is to incorporate financial leadership early. The finance team can help build a best in class organization with SaaS metrics, operations and leadership. Issues can compound over time and are very difficult and embarrassing to unwind. Incorporating financial leadership early can provide your organization the greatest likelihood of success.
Dan King is a financial operations leader with significant experience in venture capital and private equity-backed technology companies in software, SaaS, Cloud and ecommerce business models. He began his career as a CPA with KPMG in the Silicon Valley and is active throughout the Colorado technology and small business community. Dan can be reached at firstname.lastname@example.org