How To Develop a SaaS Financial Model
There are approximately 16,000 SaaS companies in the world but how many do make the cut? A few.
Do you wonder how HubSpot, Dropbox, and Salesforce continue to be the most successful software-as-a-service (SaaS) platforms? Do you aspire to make your company as big as these giants? It is not just their unique business ideas, but the driving of their financials smartly.
Let’s talk about SaaS. There are approximately 16,000 SaaS companies in the world but how many do make the cut? A few only. How do you create a sound business model which is financially viable?
Create your revenue model
There are two major revenue streams. First is the subscription fee which is calculated as the paying user base multiplied by the average plan price. The drivers of revenue are traffic (it is the total number of visits recorded on a platform/website) and the conversion rate (it can either be the number of users who visited the platform and converted to paying users or the number of users who have opted for a trial or the number of users who have converted from trial to paying customers).
For free trials that don’t require a credit card, the average conversion rate (trial to paying user) stands at 8-10 per cent compared with around 25 per cent for free trials that require a credit card.
The paying user base is the number of paying users and is calculated as baseline users plus users added and minus the users lost in a period. Baseline users refer to the paying user base in the previous period.
Pricing plan refers to the price of the services being offered and there are three main types of pricing plans—flat rate pricing, tiered pricing strategy and usage-based or pay as you go plan.
Price optimization can be two times as efficient as improving retention and four times as efficient in improving acquisition.
The second revenue stream is professional services. Professional services and other revenues include the income earned from offering services such as training and installation, among others, to users.
The revenue from professional services can be computed in two ways
As a percentage of sales, wherein the revenue can be calculated by estimating a percentage of monthly subscription fees, and incremental revenue per user, a method that involves assuming an absolute average amount earned per user.
Budget your expenses
Classify expenses into one-time, fixed costs (such as office, admin) and variable costs (such as server expenses).
Track your performance
Now that you’re ready with your financial projections, let’s discuss the measures to track the performance. Here are the key performance indicators.
Average revenue per user refers to the revenue earned from each paid subscription over a period wherein ARPU is equal to the total revenue dvided by the number of users.
SaaS firms have grown rapidly in the early stages as revenue growth slows down as firms reach $10 million in annual recurring revenue.
Churn rate is the rate at which you are losing your existing users in a period which is calculated as users lost divided by baseline user base.
The average churn rate for SaaS firms, targeting small-sized businesses, stands at 3-5 per cent per month. For big-sized firms, churn has to be lower as the market is smaller.
The customer acquisition cost is the total amount spent on acquiring a new paying user. It is calculated by dividing the sales and marketing cost by the number of new users.
SaaS companies that have raised less than $10 million spend between $0.56 in early stages and scale up to spending $0.77 to get $1 in new annual recurring revenue (ARR) to grow north of $50 million in ARR.
The customer lifetime value is the revenue a user generates before he stops being a user, and is calculated by dividing ARPU by the churn rate.
Operating expense ratio is an efficiency ratio reflecting the portion of operating cost out of total revenue generated, and can be gauged by dividing the operating expense by sales.
Sales and marketing cost are a SaaS firm’s major expense head after they reach $2.5 million annual recurring revenue. Before that, it’s research and development.
Finally, the relationship between LTV and CAC reveals whether a business will be able to grow or not. Successful SaaS firms have benchmarked this ratio to at least three times to run a sustainable business. Highly profitable SaaS firms have achieved a ratio of 11 times with continual price optimization.
Get down to business ‘smartly’ and don’t go easy on your financials. If you want your SaaS platform or website to be alive and kicking, you should have a perfect business strategy and a viable financial model.