Part 3 of 9
When I work with ISVs that are moving from on-premise perpetual licenses to Cloud-based subscriptions, or services companies that want to move from project-based billing to managed services contracts, the most frequently asked question is: “How will this impact my cash flow?”
And it is a perfectly valid concern. The monthly recurring model is fantastic once you hit your cash flow break-even, when you can cover all of your fixed and operating costs from subscriptions, but getting there can be painful. Let’s say you have an infrastructure designed to generate $1,000,000 in revenues, with an EBITDA of 20% – that means that your costs for the year are $800,000. When your revenues come in as license fees or project payments you can cover the costs as you generate those revenues. But if that $1 million is now in the form of subscription payments, you might collect $300-400,000 during the first year, but you will still have costs of $800,000. By the end of year two you will likely hit your cash flow break-even point, but you will be out-of-pocket $600-700K in accumulated negative cash flow before you get there.
I am going to illustrate this point by sharing a “one salesperson” model developed by David Skok, a General Partner at Matrix Ventures, one of the leading VC firms specializing in SaaS companies. The model assumes that a salesperson will bring in $5,000 in new recurring revenues every month, with a three- to four-month ramp-up before they are selling at 100% efficiency:
If you treat that one salesperson as a profit center, they are operating at a loss every month until they start bringing in monthly revenues that are greater than their total cost to the company (fixed and variable, social charges, marketing, overhead allocation). The cumulative impact of those monthly losses is quite dramatic:
This model shows that it takes 23 months to get back the total investment, and when you consider that the average tenure of a SaaS salesperson in the U.S. is 26 months, it starts to look bleak. However, the good news is that you keep generating the recurring revenues from those contracts even after the salesperson leaves. With perpetual licenses, you not only have to replace and train up a replacement, you have to re-create the revenue stream.
As mentioned earlier, the model works great once you get to month 23, but the negative cash flow is difficult for many companies to absorb when they are making the transition.
One solution to overcoming the “cash flow” chasm is a simple one – bill annually up-front instead of monthly. This is quite common in the mid-market and enterprise space, because for the larger companies it is a question of budget, not cash flow, and they would rather make one payment per year than have to set up a monthly payment. Annual payments can be more challenging in the SMB market, which tends to be more sensitive to cash flow.
As you can see from the graph above, annual payments in advance virtually eliminate the cash flow chasm and make the transition to a subscription model much less painful.
Previous blogs in this series
- Every SI should be an IP company
- Repeatable IP – strategic or opportunistic?
- Managing customer acquisition costs
- Minimizing churn
- How marketing changes
- Building the right sales organization
- Sales compensation
- Customer support
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