The Basic Equation Behind all Successful SaaS Business Models

Simply put, SaaS finance is different. The SaaS business model is just fundamentally different from the business model of traditional product companies, with different priorities, concerns, metrics, reporting, etc.

The most meaningful metrics for SaaS businesses are not addressed by GAAP standards, because what SaaS companies need is to:

• Value one-time revenue very differently than recurring revenue.
• Measure business across multiple dimensions of time – not just the past, but the future as well.
• Manage complex changes that can create chaos in downstream processes, such as mid-month subscription cancellations that can result in credits or refunds thereby impacting revenue recognition.

GAAP vs non-GAAP

CFOs and their teams are in pain because it takes longer for them to close the books. My revenue team, like many, was drowning in spreadsheets with a row for every customer – spreading revenue across a multitude of columns. I know this has forced some SaaS CFOs to maintain one set of GAAP books to please auditors and another to run their business.

On the executive side, CEO and board members demand insights into more than just balance sheets and income statements; they need insights into forward-looking metrics, like ARR, Churn, and ACV.

I don’t know about you, but at Zuora we have to rely more and more on non-GAAP off-balance sheet accounts to explain our success. In addition, despite a growing awareness of these recurring revenue models many Wall Street investors don’t fully understand the subscription business model and often fail to value subscription businesses correctly.

I know what it’s like to go through this, and you’ve just got to get it done right.

New Model, New Equation: The Basic Equation Behind All SaaS Businesses

For SaaS companies, your business strategy must be focused around offering innovative services that breed long-term relationships. So instead of being about single, discrete sales, the Subscription Economy nets down to monetizing and retaining relationships for a predictable recurring revenue.

Here is the basic equation behind all SaaS businesses:

ARR

Annual Recurring Revenue, or ARR, is the amount of revenue you expect to repeat. It’s that simple. Note that, this does not include one-time revenue, it only includes revenues that recur. And with that said, ARR is different than revenue. Revenue is a backwards looking number while ARR is a forward-looking number — emphasis on “Recurring” in ARR.

The Problem? Well, your traditional financial statements only show revenue for a past period and have no concept of forward-looking, recurring revenue. But for SaaS companies, because of ARR, they can actually start each fiscal year knowing what their revenues are going to be for that year. In the formula above, we call this Starting ARRn.

Churn

In its simplest sense, churn is the number (often noted in revenue) of subscribers who will not renew. Typically, downsells are also factored into your churn number.

It’s a hard reality to swallow, but even if you’ve got the best SaaS offering in the market, you’ll still have customers that will leave you. So, in the formula you’ll need to subtract your churn from your ARR for the year.

ACV

Annual Contract Value (or ACV) is your new revenue brought in by new customers or customers upgrading or renewing their existing contract. You invest in sales and marketing to drive new revenue, because ultimately this increases your ARR. And we like that.

If you add up all of these metrics, you not only have a complete financial picture of your SaaS business, but you also have your recurring revenue for next year, or your Ending ARR.

Where ERPs Fail SaaS Businesses

When it comes to tracking metrics for subscription businesses, traditional systems just can’t account for the whole picture.

So, by now you get the subscription business model on which SaaS is built: ARRn – Churn + ACV = ARRn+1. But how do the ERP financial systems you have in place today support a new model based on fostering and monetizing relationships?

Tracking recurring revenue is a forward-looking process. So, when it comes to tracking metrics for subscription businesses, traditional systems just can’t account for the whole picture.

Sure, financial metrics like bookings, billings, cash and revenue were tracked in the old world of commerce, but they were backwards-looking and focused on one-time transactions.

Let’s look into some ERP limitations when it comes to SaaS:

SaaS relationships are committed relationships, not one-night stands.

Recurring revenue is the output of a committed long-term customer relationship, where both the customer and the vendor hold up their part of the bargain. A committed relationship needs constant attention, whereas a one-time purchase is casual, transactional.

Thus, businesses need to account for recurring revenue differently from one-time revenue. But traditional financial systems don’t know how to differentiate between a one-time transaction and a recurring customer relationship, and so they tend to just lump the two together and treat them the same.

With SaaS, relationships evolve over time.

People, customers and businesses — the only thing constant is change. Their needs and their wants will indefinitely constantly change as they mature and as their environments change. Your relationship will have to evolve to service the needs and wants of your customer.

This means you need to be able to iterate on your pricing and packaging. And do it quickly — before your customer goes elsewhere. But this can result in quite a burden for the finance team. Every tweak to pricing or bundling can complicate matters, or make things real wicked if there are multiple time periods in play.

In fact, because traditional finance systems do not know how to spread a series of changing transactions over time, they limit you to simple debits and credits. And if your “system” is a spreadsheet, well good luck tracking the business impact resulting from these changes — things like bookings, billings, cash and revenue – across multiple dimensions of time.

Decisions in relationships will have downstream effects.

Don’t let yourself think that when a customer decides to cancel their subscription mid-month that it’s as simple as flipping a switch. Complex changes like this can create chaos in downstream processes and will have a direct impact on your revenue recognition. Especially if every notable change the customer makes is managed manually.

You need to be able to quickly adapt to changes in the relationship and automatically calculate how this will impact the account, as well as the business. But the core functions of old world financial systems are around tracking raw goods, not software services. They are not powerful rule engines. They are not smart enough to adapt to subscription changes in real-time, and re-calculate any schedules impacted by those changes.

Limitations can be painful for everyone.

Every department in your company will feel the impacts of the limitations offered by traditional finance systems — and this pain ripples far beyond the CFO’s office.

• The accounting teams struggle to close month-end books on time.
• Revenue managers are drowning in spreadsheets.
• CMOs are prevented from implementing new packaging and pricing because of the burden it places on the finance team.
• CEOs are having a hard time explaining their success to Wall Street.
• And, last but not least, CFOs are forced to maintain one set of GAAP books to please auditors and another to actually run their SaaS business.

Relationships require a new system.

At the heart of any successful SaaS business are the customer relationships. In order to properly manage these relationships, you need a system that will partner in offering a new subscription experience and a new customer journey, and has an integrated approach across not just subscription finance, but commerce and billing, too.

3 Key Strategies for Ongoing SaaS Success

In short, here’s a cheat sheet for the key strategies for SaaS companies:

Strategy 1: Increase Your Customer Value

All companies focused on growth have a goal of acquiring new customers. But for your SaaS business, you’ll also strive to establish valuable, meaningful relationships with your customers to increase their value and to retain them over time to minimize churn.

One strategy for increasing the value of your customers is implementing a pricing framework offering various editions. This means, a customer can easily move to a higher edition as their needs increase.

Alternatively, a customer can move to a lower edition if their needs decrease. Initially, the latter scenario sounds negative. But just think, if you didn’t have that lower edition as an option you risk losing the customer all together, whereas just moving down a tier, means you retain the customer — aka, you hold on to at least some revenue.

Strategy 2: Analyze Data in the New Economy

Traditional finance statements are really only good for the product economy. Why? Because they are backwards looking — anchored on a revenue number for a period of time that already occurred, whereas SaaS businesses need to align themselves and drive growth by maximizing recurring revenue.

Sometimes this is called monthly recurring revenue (MRR), annual recurring revenue (ARR), and sometimes quarterly recurring revenue (QRR). Regardless of which you choose, in order to optimize for forward-looking revenue, aka recurring revenue, you need to be looking at a completely different set of metrics.

Churn: Deducting your churn rate from your ARR is critical for understanding the minimum amount of new business you’ll need to acquire this year in order to keep your company viable.

Recurring Profit Margins: This is simply the difference between your recurring revenues and your recurring costs — things like COGS. Leveraging this metric is critical. Why? The higher the recurring costs, the less money you have to play with. Meaning you have the intel to choose to either book as profits or invest in one-time growth expenses.

Growth Efficiency ratio: This ratio shows how much new recurring revenue the company earns with a given investment in sales and marketing. In other words, if you invest one dollar in sales and marketing, how much does that one dollar get you in recurring revenue.

Strategy 3: Optimize Customer Relationships

Traditional finance systems or ERPs just aren’t built to support the subscription business model. Scenario after scenario of subscription business use cases only validates that running your SaaS business on a legacy system is like attempting to stick a square peg in a round hole. Where at the center of a legacy system is a SKU, it really needs to be the relationship.

In order to build a thriving SaaS business, you need a system that enables you optimize customer relationships, quickly change pricing and packaging to keep up with market needs, and be flexible, scalable, and intelligent enough to calculate recurring revenue, churn and forward-looking metrics.

The subscription model is not only a cost-effective, low-risk model for customers, but it also provides a huge potential for subscription businesses and investors. Seize the opportunity and leverage these strategies to build and maintain valuable relationships with your customers and, ultimately, accelerate your company’s growth.