Finance for SaaS companies: 3+1 most common missteps and their solutions
You think managing a SaaS company is a demanding endeavor? Well, managing the financials of a SaaS business is even more challenging!
Multiple business specifics complicate financial management and reporting of a SaaS venture. Yet, it is exactly financial management that often makes the difference between a successful business, attracting investments and a failing venture, burning cash on unsustainable actions.
In this article, we have summarized 3+1 most common missteps in terms of financial management and their respective solutions.
1. Revenue recognition
Revenue recognition is one of the primary building blocks of SaaS metrics. Revenue recognition means matching revenue with the period in which it was earned. This is difficult in SaaS because the company usually has customers paying for services before they are delivered (i.e. by pre-paying bi-annual/annual subscription). The different billing cycles pose a challenge to revenue bookings. According to financial reporting standards, you should only report revenues when earned. This means that even though you receive payment from the customer for 12 months, you should only book revenue for 1 month, including the set up and onboarding fees and recognize the rest over time. Many companies recognize the whole customer payment as revenue, regardless of the period of service provision (i.e. 1, 3, 6, 12, 24 months). This practice has the effect to artificially increase the revenue of the current period at the expense of the next period and distort analysis of company’s performance. What is more, it leads to misrepresentation of ARR and MRR.
Revenue recognition normalizes bookings across a period. Properly recognized revenue provides visibility into your revenue composition which is required if you want to know where to focus to optimize it. What is more, it is exactly the Annual Recurring Revenue (ARR) that is one of the biggest drivers of valuation. Well-managed recurring revenue businesses tend to attract higher valuations.
So, before reporting and analyzing revenues, make sure you recognize payments for future services over time and your calculations align with the applicable financial reporting standards (i.e. IFRS, BG NAS, Spanish GAAP, etc.). Second, always cross check that the revenues reported substantiate your ARR. Even though cumbersome at first, this process could be easily streamlined and optimized with the right structure of management reporting, data input and analysis.
2. Accounting data vs. Management data
Company’s financial statements are important to drive data-based decision making and help investors, company owners, and other stakeholders better understand business performance. Yet, accounting and management reporting often mismatch and follow two separate parallel processes. So, which numbers do you track? Most managers base their decisions on management reporting data, extracted from platforms such as SaaSoptics, Recurly, Zuora, Salesforce. Even though great at tracking operating KPIs, these platforms do not by default provide the right metrics from financial perspective. You track customer acquisition, ARR, MRR, churn. What about revenue, gross profit, EBITDA, cash flows? In the end, SaaS business have to deal with official accounting reports considerably differentiating from the management data. Here, always keep in mind that before external stakeholders (investors, banks, and lawyers) the official reports have priority over internally generated reports. Provided misalignment occurs, analysis of internal stakeholders (founders and management) and external stakeholders (Investors, Banks, Audit firms) may differ. This might result in diverting conclusions on а) valuation, b) company performance and c) quality of general reporting processes.
So, you would like to couple your management data SaaS metrics with the traditional reporting to get an accurate view of your business’s past, present and future financial position. Even though traditional IFRS/GAAP fall short in understanding SaaS metrics, there are accepted industry standards, that will allow you to integrate the accounting reports with your management reports and come to a bullet-proof and justifiable financial data that you will use both to run and improve your business, and present it to potential investors.
3. Cash burn and runway
Let’s start with Target #1 – Do not run out of cash. Regardless of all the great achievements of the business, an empty bank account means your lifespan is limited.
The industry and business specifics of SaaS models complicate regular compilation of a truthful cash flow statement and usually lead to a mixture of elements cash and non-cash based that could misguide management decisions. The Cash flow statement format should give the user a great deal of information where receipts are coming from and where payments are going to. Split by departments, sources, suppliers etc. is a prerequisite.
Usually in SaaS businesses, cash inflows are up to 4x higher than revenues, so don’t be fast to judge company’s performance based on its cash inflows. This is due to the fact that depending on the subscription and billing plan, a customer may prepay up to 3 years of services in advance. Even though, this is great from cash perspective, since you can rely on this cash to support growth, make no mistake. This cash is required to support services of the respective account for 3 years ahead, so you should be well prepared to forecast and manage you cash balance, taking into account all future cash outflows, related to the service, while also keeping a buffer for unexpected business disruptions. Keep in mind that traditional SaaS businesses operate at c.70% fixed costs, so a sharp decline in customer acquisitions does not have an equal effect on costs.
Be aware that it is never a good idea to support growth with cash from pre-paid customer acquisitions, without making reasonable forecasts for your future cash outflows.
If you have a clear cash picture, you will know with details what is your cash position and runway and you will have available the tools to organize a fundraising process or internal reorganization in a timely manner, when you need it.
4. Pricing and Unit costs
Many SaaS businesses rely on competition-based pricing to guide them in setting prices for their services. Even though, this might be a good starting point, relying solely on competition may put you in an unfavorable position in terms of profits.
Without a view into a firm's unit economics (the cost to acquire and service a single customer and what profit that customer is expected to bring in over time), you wouldn't know if or when the company has the ingredients required to become profitable.
Every SaaS company has two main cost categories: Direct costs (Cost of Sales) and Indirect costs (Overhead, SG&A).
- Price – Direct costs = Gross profit margin.
This is the first cornerstone of your company’s performance. You should always aim to sell your service at prices higher than the direct cost you incur to provide it.
- Price – Direct costs – Indirect costs = Net profit margin
This is the second cornerstone. Keep in mind that only if this second equation generates a positive number, you can deem your business profitable.
However, any sale that generates a positive gross profit should be pursued, in case your company is still in pre-breakeven stage (i.e. not yet generating profits).
So, make sure you track your unit cost and know the actual profits you are making. Even if you are not yet generatig profits, this information will provide you with the right numbers to make a plausible plan on how to achieve them over the coming periods.
As a guiding point you can start by calculating your costs per unit using the following categories:
So, why do it?
Being able to compare the direct and full cost for the service with the actual price of the service and incorporating these calculations in the operating processes has the following benefits for a SaaS business:
- Allows differentiation of service packages based on profit margins of different subscription plans.
- Prioritizing sales and marketing efforts towards higher profit service types and acquisition channels.
- Taking timely measures in case of identified subscribers serviced at a loss for the company.
- Custom pricing of corporate plans reflecting full cost of service provision and target profit margins.
All in all, good financial management lets you get ahead of the data instead of reacting to it. This is where financial metrics come in. Instead of relying on your gut feeling to let you know if your business is thriving or surviving, let the numbers show you! This is how you make sure you will always be in the first category: THRIVING!
We, at CFO Insights, have worked with a number of SaaS business in the CEE region, supporting the founders and management in overcoming the challenges presented by financial management. If you think, we could be a right fit, do not hesitate to contact us and schedule your free consultation: