Written by Jos van Schaik
SaaS providers often still have a lot of work to do to get a better picture of the financial dynamics of their business model and the value drivers behind it and to put them in the spotlight of financiers and investors. On traditional financial ratios, SaaS providers score much less than transaction-oriented companies. The fact is that the profit on a SaaS service will only be realized over a number of years in the future. The costs of investing in a long-term customer relationship (marketing and sales) weigh heavily in the first year and the margin on the service is only realized in the years thereafter. This has a negative effect on balance sheet ratios and short-term results. In addition, the faster the SaaS provider grows, the more negatively this affects these ratios. The focus on this leads – in my view often wrongly – to a higher risk perception.
A good SaaS business case
A good SaaS business case is built from the financial flows related to the customers over their lifetime. Growth in the number of customers fuels growth in annual recurring revenue (“Annual Recurring Revenues“). This is the #1 metric that every SaaS provider should focus on. Profitability per SaaS customer over the years is determined by the following three “key value drivers” in the customer relationship:
- The annual recurring margin per customer
This value driver indicates how much annual recurring margin is earned on the customer. This is the difference between the annual recurring revenue per customer and all the annual costs of running the service per customer.
The SaaS provider can influence these from two sides. From the revenue side, it is with the price of the service and with up- and cross-selling on the existing customer base. From the cost side, it is through scalability benefits and efficiency of the service (flexible infrastructure, standardization and automation of processes). As volume grows, scalability will lead to increasing margins per customer.
- Acquisition cost payback time
This value driver indicates how efficiently the SaaS provider can grow. The ratio is calculated as the marketing & sales cost per customer divided by the annual recurring margin per customer (value driver 1 above). The faster the payback, the less funding is required for growth or the faster growth can be with given funding.
Ideally, this ratio should be 2 years or less. The lower the ratio, i.e. the more efficiently the company can grow, the more this justifies financing and accelerating growth. If the payback period is (still) above the 2-year level, it is wise to first look at possible reduction of acquisition costs per customer (improvement of marketing and sales mix, online lead generation, marketing automation) and/or improvement of the annual recurring margin per customer.
- The Retention Rate
The retention rate indicates the percentage of customers who remain customers when contracts are renewed. This is the opposite of the churn ratio, which indicates the percentage of customers who cancel the contract. The retention rate is measured both in numbers of customers and in absolute annual recurring revenues (relevant for different turnover categories). The longer the customers stay and generate margin, the higher the customer value. Customer loss at a SaaS provider is a huge and dangerous value killer. After all, most of the costs for the customer have already been incurred and the loss is then irreversible. The cause of the customer loss must be sharply analyzed. The business case will have to show how the SaaS provider ensures that the customers are satisfied and remain so in order to substantiate the retention rates used.
The financial projections in the SaaS business case are all fed from customer growth (in numbers and in Annual Recurring Revenues) and the values of the key value drivers. If the value drivers have a favorable value the SaaS provider is doing well. If the market is there, investing in growth is justified.
Then, accounting rules regarding revenue recognition and customer payment patterns (annual/monthly fee rather than one-time purchase price), in relation to the as-a-service business model, determine the outcome of the financial projections in the business case.
So to get to the bottom of those, you have to go back to the basics of the SaaS business case: the growth rate and the key value drivers. You can positively influence the short-term financial projections of P&L, Balance Sheet and cash flow by reducing the growth rate. Less funding is then needed as well. But in a successful SaaS proposition, this would lead to a lower enterprise value.