CFO's Ultimate Guide to Successfully Transitioning to SaaS

Monetization models fall into two categories: recurring and one-time (non-recurring):

Recurring:

• Outcome (aka “value-based”) is billed based on measurable customer value. It is a logical model, similar to a contingency fee, but more difficult to implement, measure and budget for (for both the supplier and the buyer).
• Usage-based is billed based on actual usage of the software.
• Subscription (aka “term licensing”) is billed monthly or yearly. It is a much simpler model than other recurring models. Subscription delivers a steady revenue stream.

One-time:

• Perpetual (aka “perp”) involves a large upfront investment, which does not recur. Because it is a lumpy revenue stream, perpetual is much less valuable to the company that’s selling it.

Subscription monetization is popular and desirable because it delivers advantages to suppliers and buyers of software. For suppliers, subscription provides more visibility, stability, and predictability in the revenue stream. These attributes benefit the company valuation, strengthening the supplier’s ability to continually invest in the product. When moving to SaaS, the software supplier absolutely needs a recurring revenue stream from the customer in order to maintain the service. Subscription is the ideal way of delivering this recurring revenue to the supplier.

Subscription appeals to buyers because there is no large upfront investment—an advantage when buying technology that changes rapidly. Subscription is an OpEx, not a CapEx, expenditure. Because it can be changed as needs change, subscription is more flexible and less risky.

MOTIVATION FOR BUYERS AND SUPPLIERS: THE SUBSCRIPTION WHY

When moving to subscription—an economic model tied to the duration of a contract—as the logical monetization model for SaaS deployments, there’s a time of transition with short term pain for long-term gain.

Shifting away from predominantly perpetual licensing (where revenues are recorded up front) will lead to an initial revenue dip. This initial revenue uncertainty is the impact of changes in pricing and predictability (for adoption and renewal rates). With that transition, the focus may change on how the finance team thinks about cash flow rather than GAAP revenue recognition.

Once implemented, subscription becomes a more predictable revenue stream, making it easier to forecast the business and to manage investors’ expectations, long-term. This short-term tradeoff is often easier for private companies to withstand; the change usually makes sense for public companies, as well.

Several important metrics, which may or may not be new to companies shifting to subscription, are:

• Annual contract value (ACV): The value recognized in a single year of a multi-year subscription.
• Annual/monthly recurring revenue (ARR/MRR): The sum of all subscription revenue in a year/month.
• Billings: The number on the invoice that goes out the door to the customer, billings occur when the actual invoice is sent, based on the contract terms.
• Customer acquisition cost (CAC): The cost to acquire a new customer (e.g., marketing expenses), which in turn starts a new recurring revenue stream.
• Lifetime value of a customer (LTV): the total expected revenue over the lifetime of a customer relationship. The LTV must be larger than the CAC.
• Revenue retention: revenue change for existing customers over a period of time.

ARR is the single most critical metric for a subscription company. It brings all the major elements in the business together: renewal; visibility into components of renewals (such as churn and price increases); and capturing new business (with components including new logo revenue and upsell revenue from existing customers). Growth in ARR indicates a healthy software business. Examining ARR can also help uncover retention issues; if existing customers aren’t renewing, ARR will be stunted or even negative.

Billings become even more important than they were before. Because billings is a metric more closely tied to the actual cash flow of the company, revenue (an accounting metric caught up in the GAAP revenue recognition role) becomes arguably less important than billings.

Customer success and retention are most critical for the ongoing success of a software company. Customer retention is the key driver of ARR and long-term value, so the supplier must be customer-centric, focusing on customer health to minimize net churn.

Contract length can help solidify long-term value. Typical billing for subscription (for SaaS or other deployment models) is through upfront installments, usually billed annually. Most common is the industry-standard three-year contract; the customer pays year one upfront at the beginning of the contract, pays year two on the one year anniversary of the contract start date, then pays for year three on the two-year anniversary of the contract start date.

Strong retention rates are crucial. The renewal rate and the gross retention rates percentages—signals of how much value customers receive from the software they license from the supplier—are the best indicators of customer health and customer success.

Look at retention rates by each product line or by type of software, then in aggregate for the company a whole. Retention can be measured in multiple ways and should be evaluated from multiple angles:

• In terms of revenue: gross revenue retention rates.
• At customer level: the renewal rate percentage measures renewals of the contracts that are up for renewal that year. A significant benefit of a contract renewable every three years, is that it has a built-in 100% renewal rate in year two and three.

Gross retention rates above 90% generally indicate a healthy product and healthy customer success rates.

To achieve a customer-centric model, a supplier must embrace a customer success mentality to ensure ongoing renewals. LTV must always remain larger than CAC. This requires organization-wide buy-in, likely requiring a shift in operations. Suppliers need to break down silos and align all roles—sales, services, support, customer success and renewals—with a customer-centric model, working together to drive customer value.

Steps for a customer-centric organization include:

• Provisioning: Enabling customers to deploy your solution rapidly.
• Onboarding: Supporting the customer journey.
• Driving success: Analyzing account health and renewal risk.
• Renewals & upselling: Monitoring consumption and creating transparency.

Software suppliers should rely on more than anecdotal evidence about renewals and about why churn is taking place. Operational requirements include measuring and tracking ARR on a monthly basis, identifying customer cohorts that are (or aren’t) successful to identify where churn is happening, understanding software usage to predict (and prevent) churn, and proactive renewal management.

Advanced product usage analytics is the most effective way to collect quantitative data. That data can then be combined with qualitative methods (e.g., surveys, interviews, sales feedback and support calls) for a comprehensive view of how customers are using the product.