Categories Articles, Sales and Marketing

Much of this post is excerpted from a new eBook co-written by the CEOs of InsightSquared and Gainsight about how the tech downturn affects the way SaaS CEOs think about revenue growth. You can get the full eBook here.

If you were to zoom in on the finances of a single month in the life of a young, growth-stage SaaS company, the numbers probably wouldn’t make much sense.

You would see a lot of cash leaving the company — to keep the lights on, to pay the people building and selling the software, to market to potential customers, etc. — and a much smaller amount of cash coming in. You don’t have to be a finance expert to realize that this setup doesn’t scream “healthy business model.”

Of course, this isn’t news to the people running (and investing in) SaaS companies. They know full well that the math of a single month in the life of a young SaaS company doesn’t add up.

So what gives? How can SaaS companies turn an overall profit if the single-month economics don’t make sense?

The answer lies in the fact that SaaS companies bring in two types of revenue: revenue from new customers and revenue from existing customers. Understanding the difference between (and interplay of) these two revenue types is essential for running a successful SaaS business.  

In this post, we will explore the interplay of the two types of revenue by looking at:

Section 1

Section 2

Section 3

The Power of Lean Revenue

The SaaS Model

SaaS companies don’t become profitable by closing a lot of deals; they become profitable by making their customers happy. This isn’t bromide about the importance of good customer service — it’s a reflection of the fundamentals of how the subscription model functions.

Nearly all SaaS companies incur negative cash flow when they sign a new customer. Not only do they need to finance fixed costs — like R&D and office space — but also, given the subscription model, customer acquisition. As such, SaaS companies act like banks — giving their customers access to a valuable product and allowing them to pay for it over time.

Here’s a representative example of what it looks like for a SaaS company to acquire a new customer. As you can see, that customer only pays back its acquisition cost several months after the deal is closed.

trough-06

Of course, the average SaaS company doesn’t just add one customer — they add many. Because of this, SaaS companies end up going pretty deep into negative cash flow as they wait for their customer base to stick around long enough to become profitable. This helps explain why SaaS growth can be so expensive — SaaS companies must finance customer growth with the hope (and plan) that the customers they add will one day become unit profitable.

trough-01

The image above shows how each new customer a SaaS company adds plunges that company further into negative cash flow. The more negative cash flow you incur acquiring customers, the larger your eventual profits should be. (The gray bars represent an even more pronounced version of this.)

This concept is so essential to the SaaS model that it even has a name: The SaaS Cash Flow Trough. The whole model is built around the concept that undergirds the SaaS Cash Flow Trough: SaaS companies are designed to be short-term unprofitable but quite profitable in the long-term.

This understanding explains a great deal about the SaaS model ‒ the need for outside capital, the importance of customer retention ‒ but it also highlights something a little less obvious about the SaaS model: the existence of two types of revenue.

The Two Types of SaaS Revenue

The last section showed how SaaS companies typically lose money the day a contract is signed, and (hopefully) make that difference (and more) up as customers renew and upgrade their licenses.

This setup makes it useful to think about these two revenue sources — the revenue recognized on the day of the initial contract and the revenue that comes in on a monthly (or quarterly or yearly) basis — as separate.

(I recently got a crash course on the ins and outs of this from a great webinar co-hosted by InsightSquared and Gainsight.)

The first we can call ‘expensive revenue’ because it costs a relatively large amount of capital to secure — the marketing campaigns that brought in the lead, the salary of the sales rep who worked the opportunity, etc.

The revenue coming in from the customer’s subscription payments can be seen as ‘lean revenue’ because it doesn’t include those costs.

Lean revenue comes in a few flavors.

  • Deferred Revenue Recognition: SaaS companies typically bill customers upfront for a period of time, but then recognize that revenue evenly over the duration of the contract. Because most of the cost is incurred upfront, the ongoing revenue that was deferred upfront and recognized over time is very profitable.
  • Unbilled Deferred Revenue Recognition: Furthermore, SaaS companies with multi-year contracts often bill one year at a time, meaning profitable revenue will “automatically” show up in future periods that isn’t even on the balance sheet today.
  • Renewal of Existing Customer Agreements: Typically, customer purchase SaaS offerings with the intention to use them for a long period of time. If a SaaS vendor has a strong Customer Success program, they can drive high renewal rates on those contracts with a significantly lower cost of renewal than the cost of the initial sale.
  • Expansion Revenue: Finally, those customer agreements can grow over time with limited incremental Sales and Marketing expense. 

Without having to bear the cost of expensive sales and marketing teams, revenue generated from existing customers is some of the most fruitful earnings a company can earn. To help you visualize the difference between lean and expensive revenue, here’s a visual showing the cost of acquiring $100 of each.

NickGraph_REVENUE-COSTS_NEW-(1)-rgb

Now, you might be thinking to yourself “I get that revenue from existing customers has better returns than revenue from new customers — but so what? I need both, right? How is this useful for thinking about the way I run my business?”

All of that is true. You need expensive revenue. Without it you won’t get any lean revenue down the line. Even perfect customer retention won’t help you if you have no customers. So what’s the point?

The answer is that it’s important to think about the balance between these two types of revenue. How can you organize your business to get more lean revenue and to need less expensive revenue? What can you do to gradually increase your ratio of lean revenue to expensive revenue? Finding this balance is especially important in 2016, given the current fundraising climate and increasing cost of capital.

Download the Guide to the Downturn

The Power of Lean Revenue

Lean Revenue and the Downturn

If you’re in the SaaS world, you probably know that the industry is in the middle of a downturn. Over the last few months, several publicly traded SaaS companies have experienced share-price drops, and the venture capital market has gotten much tighter and more conservative as a result. Capital is more expensive and elusive.

Because of this, venture-backed SaaS companies have had to shift their mindsets from “growth at any cost” to a much more efficient form of growth. They can no longer rely on the traditional playbook: use as much capital as possible to finance new customer acquisition.

Instead, growing SaaS companies need to achieve more efficient (i.e. less capital-intensive) growth by shifting the balance of their revenue from expensive to lean. De-emphasize new customer acquisition in favor of extracting more revenue from existing customers via upsells, cross-sells and renewals.

Strategies for undertaking this balance shift could easily fill a distinct blog post (a book, really), but here’s a quick rundown of some options:

  • Decrease sales force and increase customer success reps
  • Move some of marketing’s budget from customer acquisition to customer marketing
  • Survey existing customers to learn what new features or fixes they’d like for your product or service

These options are, of course, just a starting point. The SaaS structure is unique in many ways, and understanding its levers and mechanics is essential for creating a healthy, durable business.

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Mike Baker
Mike Baker is the Content Strategy Manager at InsightSquared, where he helps distribute original eBooks, articles and guides about data-driven sales and marketing. He has a BA in English and Journalism from Oberlin College.
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Comments
  • Jamie Lee

    Great post. I’m curious to know how Insight Squared helps SAAS companies do the following:
    -Deferred Revenue Recognition
    -Unbilled Deferred Revenue Recognition
    -Renewal of Existing Customer Agreements Tracking
    -Expansion Revenue Tracking

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