You are an experienced businessperson connected with your business and the trends around you. You have begun the process of financial modeling and business planning. All of this talk about structural change has no doubt got you thinking about how the involvement in a recurring revenue driven cloud or SaaS business might impact your company’s income statement and therefore profitability and valuation. The cloud or SaaS business requires most business people to think about their income statements differently then they did when they were predominately transaction driven, on premise focused. The revenue, expense and therefore profit drivers in this new arena are different then the drivers in your traditional business.
In a classic on premise software reselling focused business revenues are driven by few large transactions that are front ended loaded with revenues (and therefore gross margin) with the majority of the lifetime value of the customer obtained in the first 12 to 24 months after the transaction is closed. Service is “dragged” by software license sales. This pattern and structure of revenue acquisition drives sales force compensation systems, allowable marketing spend per revenue dollar and the cash flow requirement patterns of the business. Large customer acquisition investments are made in few big clients. This results in lumpy sales revenue flow, lumpy cash flow over time and business valuations that bounce up and down with transitory results.
The revenue drivers and relevant revenue metrics in the cloud and SaaS business are more like the drivers and metrics in the life insurance business. Cloud and SaaS accounts can contain multiple clients that can generate multiple transactions. Accounts are identified by the amount of recurring revenue that remains payable on the total portfolio of contracts in the account. The rate at which accounts, clients or transactions are lost or churned is a huge driver of the revenue side of a cloud or SaaS focused business. When a cloud or SaaS business loses an account that is going to be generating revenue for a 3-5 year period the net present value of a lost account at a 10 per cent discount rate is easily 30 to 40 times the monthly value of the fees being paid at the time of loss.
The average or median size of transactions in accounts is crucial due to the relationship between the initial size of the cloud or SaaS contract and the likelihood that the stream of recurring revenue will grow organically over time. We are beginning to learn that larger initial contract engagement leads to larger subsequent engagements and multiplied growth.
The rate of new account acquisition has a dramatic impact on revenue and revenue growth. Driven by the marketing and sales infrastructure you have put in place, as well as the compensation system you have implemented, this metric has a compounding effect on growth due to the mathematics of layered annuities growing on top of each other.
The combination of high initial average or median transaction sizes combined with low rates of customer loss or churn, coupled with high rates of new account acquisition creates a revenue generation dynamic not seen in an on premise business.
As you build out the financial model of your cloud or SaaS business make sure you experiment with the variables outlined in this installment. If you do not yet have a financial model for your cloud or SaaS business our advice is very direct-trial LivePlan.
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Margaret and Bruce Stuart founded Channelcorp in 1989. The firm is a global leader in the assistance of reseller, distributor and vendor clients. Channelcorp specializes in the business model transformation that is required in the face of the structural changes to recurring revenue driven business models in the worldwide IT business (www.channelcorp.com/services.php). Channelcorp publishes and sells four industry- leading books and 12 white papers (www.channelcorp.com/publications.php). This independent firm has delivered consulting and executive education to vendor, reseller and distribution clients in more then 40 emerging, developing and mature m