Understanding Business - SaaS Edition
Understanding Business - SaaS Edition
53: Bigger picture.
Hello ladies, gents, cartoon animals, and others.
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Based on the great conversation we had with fellow anon on the X app (ex-bird app) we have decided to drop something we are not sure how the majority will react. It’s a heavy topic. One that most SDRs and SaaS employees will need to understand.
Anyone involved in the industry will benefit from understanding what happens behind the scenes. For a few, it will perform better and assist you if you have yet to break into the industry. Knowing how to choose the right place to be.
The goal was to keep it as light as possible for the average reader who is not part of the industry. While at the go deep enough to explain the complex topics.
If you are already in a well-established company (congrats) most of these will seem like a sci-fi movie. We would still recommend reading and getting a deeper understanding of certain topics. For SaaS builders and curious ones - mandatory read.
There is a potential that you will have an “aha” moment.
SaaS 101
We feel obliged to start the article this way since not all of the readers are 100% down with the SaaS (Software as a Service) basics. First of all, if we had to describe what SaaS is without getting too technical, we would stick to:
“Application that has certain functionality with a recurring subscription to use.”
So what’s so special and why everyone is talking about it?
The biggest difference between regular software and SaaS is that the end user does not own it. Instead, it’s a service to the end user. If we want to dumb it down even further SaaS is a delivery model. We won't deeper into this. But there are different delivery models, such as Infrastructure as a Service (IaaS) and Platform as a Service (PaaS), which you can explore if you're curious.
So why SaaS and not “regular software”?
With the increase in popularity, it's hard to find companies that are still developing 'regular software' and not moving towards SaaS or cloud-based solutions. We are talking about solutions that are even hardware-heavy. Something that is not stopping big players from taking things to a new level.
A great example that comes to mind is Adobe. Back in 2012-2013, they took a whole new direction by switching from 'regular software' to a SaaS delivery model. Most of you will not remember, but things were looking BAD for Adobe during that period. Straight-up hate across the forum boards.
The real reason behind this?
SaaS as a model was still quite a “new thing”. Better said not the standard it is today. Before anyone drops the comment “Salesforce did it in 1999 which was 14 years earlier”. We all know.
When it comes to the SaaS market in 2013 when Adobe (we could argue it’s not a 100% SaaS solution) did switch the whole market was roughly 7x smaller when it comes to total revenue in $ (rough numbers from our heads). Think about it for a moment. It was not 30 years ago. It was 10 years ago.
Those are huge numbers when you take into comparison that the whole US retail industry did grow 2x in the same time frame and US e-commerce roughly around 6x. Guess how many products were being ordered online in 2013 when compared with now? Not much. Still didn’t manage to catch up with SaaS growth when it comes to revenue numbers.
Random two examples we have decided to pull up.
“We still don't have answers as to why everything shifted to SaaS?”
Simplicity is one of the reasons for both sides. What most rookies get wrong is mixing subscription-based offers with SaaS. That's not fully true. Why? Because before SaaS became a 'modern thing,' there were still subscription-based offers, but they were not provided over the cloud.
Meaning you had to have your local machine capable of running the service you wanted.
The great thing about the introduction of the cloud was how everything seemed to move in a new direction. Giving you more freedom as an end user and eliminating the need to worry about the machines and responsibilities that come with it. Now consider how things used to be back in the day with “regular licenses” where for each new update you would have to pay 20 - 30% more. Fun times.
With SaaS the first thing you will not have to worry about local machines and infrastructure. As mentioned already paying for updates is still possible. Not the norm where the market is heading. It’s an unwritten rule to receive the new updates as long as you are paying the monthly subscription.
Throw into the mix small businesses/startups. You will realize what kind of flexibility SaaS as a service provides. If the cash flow is your concern don’t worry there are 1-3 months licenses that will show if you are capable of making business work or not.
At the same time, you don’t need any experts to run most of the solutions off the ground. “Regular software” has to be manually implanted and deployed. Not always the cheapest thing to do since you will be paying FTE to do it for you.
Worth Mentioning - Big Players And SaaS
Another key point when it comes to SaaS and why Big Players (investors) are loving it. Because of the predictable aspects it brings to the table. It’s not hard to predict how much $ you expect to have in the same month next year.
You will only need a few things such as MRR and churn rate. Yes, we know there are a few more factors that should be taken into consideration. But you get the point. Now add into the mix margins that are above 70% and revenue that scales with it.
Final Result?
Imagine a full boardroom of investors happily rubbing their hands together. Bonus points if we're talking about early-stage SaaS or VC-backed solutions. Where the goal of the operation is to keep it as lean as possible while getting the most output. Fewer people = less expenses.
As a result, the company ends up having more $ left. Primarily because people are one of the biggest expenses when it comes to SaaS. On the other hand, every salesperson looking to position themselves for success should aim for what we just mentioned.
The formula for success:
“Predictable revenue” + high margins + slim operation = $$$
As a sales individual make sure to evaluate the SaaS product-market fit and whether the product category is nice to have or a must-have. They often determine someone's success.
There are millions of other small details such as security concerns and customization. The idea was to raise awareness of how SaaS as a business has changed things. Especially for smaller players.
The big players in general would still pay anything they want to get the solutions they need. That’s not the case when we are talking about small and flexible businesses that are just starting or having liquidity problems.
Customers are more interested in buying relationships with SaaS providers than anything else. Customer retention is playing a bigger role each year as everyone at this point is having at least a few solid competitors breathing down their neck. Readers selling solutions already know the feeling. Better said some of them don’t have to sell but take orders. Best way to hit their quota.
It’s all about customers getting themselves the flexibility and cost optimization they are looking for. SaaS in the end comes down to efficiency and increased convenience for buyers - good enough reasons why the whole industry is growing Y/Y.
Before moving forward we recommend getting the basics down.
Basics Average SDR Will Not Understand
Let’s make things more complicated. What is something that most recent college grads who get into SDR roles do not understand? Numbers and reasoning behind those.
Understanding this will not have a direct impact on your sales skills. Neither will it directly help you hit your quota. But it will provide you with a deeper knowledge. If done correctly it could also assist you in selecting your next employer.
Unfortunately, it’s not possible to cover all the industries so we are sticking to a general overview. One that should fit most cases. Each industry solution you are reading about will have something different and special.
Financials First (Accounting)
The article itself will not turn into a financial one. Since that’s exactly what we have managed to escape from successfully. While writing this we had some pitch-deck flashbacks we tried to push and not think about.
But at the same time, every individual over the age of 20 should understand terms such as Gross Margin, Cost of Goods Sold (COGS), and general classification between assets and liabilities.
They are part of every business.
Since we are talking about Financials and SaaS let’s go through the Salesforce (SF) 2023 10-K. We are not turning this into an accounting 101 class. But let’s mention a few general principles when it comes to SaaS and compare the Salesforce result vs. PY. Leaving you to conclude.
Balance Sheet (BS)
Assets:
Solid increase in Cash position vs. PY.
Accounts Receivable (AR) - Depending on the SaaS invoicing (yearly for example) - the whole amount is being registered underline. Meaning SF got around 10% more vs. PY “waiting to receive from customers”.
Cost capitalized to obtain revenue - Similar to deferred commission (not the same). Talking about various expenses that are directly related to obtaining or fulfilling contracts. Recognized as an asset on the balance sheet and later amortized.
Prepaid expenses and other current assets - In SaaS most often the line is reserved for ongoing subscriptions.
Property and equipment - Internal software and office equipment go here. There must be an investment going on since we see around a 30% increase in assets vs. PY. Often you will find costs that are related to development.
No reason to mention other lines such as Goodwill and operating lease since it’s almost the same concept for every business. Trying to keep it light.
Not going into stockholder equity and what’s behind.
Liabilities:
Accounts Payable (AP) - Easiest way to describe in SaaS terms would be vendor bills.
Unearned revenue - Another way to call Deferred revenue. Each time you send the invoice to the customer and they pay → unearned revenue is decreased. An increase in unearned revenues is a positive sign. Number growing = having more deals.
We hope you understand that each side has to balance itself (again repeating this is not accounting 101). On both sides first, you will find current assets/liabilities (under 1 year). While further you will see non-current items (over 1 year). Repeating for those that don’t know it.
Income statement (P&L)
Revenue:
Subscription and Support - Only the Subscription part without support. No surprise. We are talking about Salesforce and they are offering x additional services + software. GAAP revenue → meaning it has to be spread across. Worth mentioning that there are a few types of revenue and how it’s being calculated - Subscription base and consumption base.
Salesforce is reporting 18% growth vs. PY in total revenue. You might be thinking that looks solid. But we know quite a few sales reps who would disagree with how things are working out.
Professional service is not a positive indicator - the norm is the leaner you run the operation the less you will have to report. Often connected with how many FTEs you need to run your service.
Cost of revenue:
Splitting costs between Subscription and Professional service.
Subscription COGS - All the expenses such as hosting, Dev teams, and help teams (support teams) are allocated when it comes to SaaS business. CS can also be located underline here. Depending on how they choose to place it.
Professional service COGS - Costs related to delivering the service. Better said people generated costs related to SaaS. Look at the example above. SF is having “cost” over 100% of revenue. Often the case when we are talking about professional services.
Gross Profit And Gross Margin
Gross Profit (GP) = Revenue - COGS
Gross Margin % = GP / Revenue
80% Margin coming from the main revenue source subscription services.
73% Margin when it comes to Salesforce for FY22.
OpEX (Operating Expenses)
Same as with the other SaaS companies OpEX is split into:
Research and development (R&D)
Sales and marketing (S&M) (SF calls it Marketing and Sales)
General and administrative (G&A)
Additionally, we have the line “Restructuring” - we didn’t go into details.
Payrolls certain types of hosting costs, quality assurance, audit, insurance, HR, legal teams, and CEO bonuses. They all go into OpEX. What we can see is that there was a solid change Y/Y in S&M. Was salary increase across all of the departments under this line?
Other expenses:
We are not diving deep. But something must went wrong or it was planned based on the SF example we are using.
Other expenses are fairly simple - All the interest expenses/income, investments gains/lost + foreign exchange gains/lost.
Taxes part:
Not going to cover it. Mostly it comes to games on how to trick the system and pay less tax. There are many rules on taxable income - change every few years.
Cash Flow (CF)
Operating activities:
Almost everyone in SaaS uses an indirect method of preparing CF.
Shows all the cash flows (in or out).
You can see an easy example of how CF and P&L are connected - Net income line.
Amortization of costs capitalized to obtain revenue - Something you didn’t know is that the sales reps’ commissions are expensed over a year period.
Investing activities:
Section showing how much cash has been made or spent on investments.
Business combinations net of cash acquired - Huge delta vs. PY. Not 100% on this but seems like Slack M&A they had in 2021 reason why it was such a high number last year.
Looking at the purchasing of strategic investment - SF is experiencing a slowdown in investing to acquire new companies or percent of those.
In general, here you can find Purchases of property and equipment, capitalization, and other investing activities. Nothing much to expand when talking about investing activities.
Financing activities:
Favorite one for the investors. Showing everything that has been done with their money.
You can find all the info when it comes to investments (VCs, IPO).
Debt will be shown in this part of the CF.
Nothing much worth mentioning when we are talking about our example SF except the repurchase of its shares. Are we playing defensive mode?
Want to dive deeper yourself? Link to Salesforce 2023 10-K report.
Since you don’t want to be average. Accounting and metrics (KPIs) info you are going to read and memorize as much as possible. As we said earlier it’s not going to have a direct impact on your performance or quota.
You are not going to look like a dumbass once you find yourself in the company of people that do talk about this. Getting an understanding of all three financial statements when it comes to SaaS and the industry in general is nice to know.
Few things worth mentioning:
FCF (Free Cash Flow) is all that matters when it comes to the value of the business.
Profit Margins > Growth (you need to be careful with “Growth” when it comes to SaaS)
Read more on “Rule of 40”
When it comes to FCF:
High FCF = slow growth
Negative FCF = rapid growth
Be aware if the company is reporting the CS team under OPEX and not COGS → they are manipulating Gross Margin and a few more things.
Small companies will not have accurate financial data.
GAAP rules are not the most optimal for SaaS businesses.
Not sure if the images are going to be visible on mobile devices. Because of that, we are attaching a file for you to download. This is the top material when it comes to understanding how accounting in general works when it comes to software companies.
Thanks to OnlyCFO for giving us the approval to use his work. Make sure to check out his webpage. You will be positively surprised.
Metrics Second (Fun Part)
SaaS (software-as-a-service) metrics are benchmarks that companies measure in order to establish steady growth. Like traditional KPIs, SaaS metrics help businesses gauge the success. - builtin.com
Where to start with this one?
You have to realize that often you will not be able to get the figures you require to make some of these metrics work. Bigger and public companies should not be the problem at all. If you are trying to understand a small SaaS business (or you own one) - there could be problems in obtaining the necessary numbers.
Not to mention that those numbers should not be taken 100% seriously until a third-party audit is included. What you could always try is to email their investor relations and try to get your hands on figures - not saying it’s going to work. Something worth trying.
We are going with abbreviations since you should read our earlier post in the article to understand what each one of them means. Keeping it light and sticking to the most important ones.
Gross Margin
Revenue - COGS
You are looking for at least 70% + when we are talking about this - lower for newer companies that have loads of unnecessary FTEs or poor setup.
MRR → ARR
Golden Standard when it comes to SaaS. Can be either monthly or annually. To dumb it down further - ARR is always 12x MRR. Worth mentioning is that a one-time payment (Professional services) doesn’t go towards it. The payment has to be recurring - a contract.
Most companies are calculating ARR differently → resulting in different valuations when it comes to valuations → look at how it’s being calculated.
Not every MRR is the same. Companies have more retained MRR while some of them have more MRR coming from new customers (meaning new sales were made). Keep track of where is MRR coming from - there are a few different types of MRR.
Pay attention to how much new ARR comes in vs. how much the S&M spent → New ARR should be > S&M expenses.
Accounting revenue and ARR are not the same thing.
NRR (Dollar Retention)
The whole term comes to how much additional cash is being generated in each period on initial $ from the customer base.
Should be above 100% to be considered “positive”.
CAC
Where to start with this one?
How much money does the company spend to get new customers - essential when we are talking about subscription-based business.
Fully loaded CAC is a must if you can choose. Since companies like to manipulate the metric all around.
The solid indicator of the business - lean or not.
CAC Payback → How many months does it take the customer to produce a gross profit to pay back CAC. Lower margins get hit hard by this → takes a longer time for payback.
Logo Retention
% of customers who stay “activate”
Can’t be more than 100%.
Enterprises generally have higher and when compared with SMBs.
LTV
Easy to manipulate metrics.
How much money does the customer spend while using your services.
Shows the health of the company.
CAC is part of it.
Churn directly has an impact on LTV.
Churn Rate
Metric that accurately represents the percentage of customers who discontinue using a particular service in a certain period.
Often internally separated into certain categories (like avoidable / not avoidable churn) → meaning CSM plays a huge role.
Very inconsistent in reporting.
Burn Multiple
How much cash is being burned based on ARR - giving you an overview of how efficient the company is → correlated with AP (Accounts Payable).
There are many SaaS metrics we have not covered. At the same time, the ones provided should give you an overview of how to vet and read what is happening in the end when it comes to financials. SaaS as the industry is a hard one to “measure”.
It’s one of those things that seem easy to read and analyze. Once you try to put it into a full picture it seems hard. Because it is hard to do. We tried our best to mention a few of those that will make you stand out and provide you with the content you need.
There are loads of apples and oranges comparing going on currently in the SaaS world. Our advice? Always read small letter prints in financial statements.
Keep in mind things are different when we are talking about VC-backed businesses as well as most startups. Not planning to cover it in this article since it would become much more technical.
Should you bother with a startup?
Conclusion?
Hopefully, you are mange to gather at least some knowledge of the markets you are selling into as well as a basic understanding of accounting and SaaS metrics to keep an eye on. Nothing to help you sell better. But something to prevent you from looking like a fool if conversions turn in that direction.
SaaS in general is quite different than other businesses. Even the non-trained eye can catch that while looking at the financials for the first time. It’s easy to get wrapped up in the wrong picture.
Does X always mean that it's better for the business than Y? Not really. It depends on many factors as well as the phase your solution currently is in. SaaS in general revolutionized how things are getting done. What about the current state of SaaS in 2023? Things did slow down and the whole spending was based on the same adaptation.
Yeah, we all felt it.
Meaning SaaS is not an unstoppable miracle. Something we have been listening to for the last few years. Everything was looking great and everyone was bullish. Same as the misconception that every SaaS company's ability to generate FCF has gone through the window.
To wrap up the article. Make sure you understand what you are selling and to whom you are selling. Knowledge such as that will make you a better sales rep in the long run.
Shoutout to RevRonin for helping to set this up.
Enjoy the rest of your day.
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