SaaS Economics – Part 1: The SaaS Cash Flow Trough

This post provides SaaS entrepreneurs with an Excel spreadsheet model and graphs that show the cash flow trough that happens to SaaS, or other subscription/recurring revenue businesses that use a sales organization. These kinds of SaaS businesses face a cash flow problem in the early days, because they have to invest up front in sales and marketing expenses to acquire customers, and only get payments from those customers over a delayed period of time. I refer to this phenomenon as the the SaaS Cash Flow Trough. The model also compares the cash flows of businesses that charge monthly to those that are able to charge their customers for a year’s payment in advance.

The greatest value from this post will come from downloading the model and inputting your own variables. The Excel Spreadsheet and associated PowerPoint file can be downloaded by clicking here. If you store both in the same directory, the PowerPoint graphs can be updated to reflect the data in the spreadsheet by right clicking on each graph, and selecting “Edit data”.

Part 2 of this series can be found here: SaaS Economics – Part 2: Scaling the Business.

Where is this applicable

  • This model is applicable to any recurring revenue business that uses a sales force.
  • This model does NOT apply to SaaS businesses that don’t use a sales force. I refer to those businesses as having a “touchless conversion”, as there is no sales touch involved. Those businesses usually have a far lower investment in sales and marketing expenses, and become cash flow positive far earlier.

What are the different analyses?

The model looks at the following different analyses, and each is described in this blog post with graphs:

  • How bookings accumulate over time
  • The effect of churn
  • The three components of MRR (monthly recurring revenue)
  • Cash flows for an individual sales person
  • The marketing costs of providing a sales person with enough leads
  • Cost to acquire a customer
  • Lifetime value of a customer

In part 2 of this blog post series, The second part of the model looks at what happens when a SaaS company has reached the point of a repeatable, scalable sales model, and wants to start ramping their sales and marketing spend to grow revenues.

The last part of this blog post discusses how the model was built, and how to use it for your own calculations.

Part 1: Looking at a single new sales hire

How revenue builds for a single sales hire, assuming no ramp up time

For those new to SaaS or other recurring revenue businesses, the graph below shows one of the delightful things about recurring revenue. Bookings made in January, continue to be billed in every subsequent month. The chart on the left shows this effect assuming no churn rate (or loss of customers). The graph on the right shows the impact of a 2.5% monthly churn rate, which slowly eats away amount that billed monthly.

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Bookings, Churn, and MRR for a new sales hire

The above graphs assume no ramp up time. Lets take a look at bookings, churn, and  MRR for a new sales hire:

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The graph on the left shows how new monthly bookings ramp, and how churn builds up over time. The graph on the right shows MRR (Monthly Recurring Revenue) which increases every month by the new bookings, and decreases by the churn.  For experienced SaaS business people, this MRR graph is probably obvious, however for those new to SaaS, it is worth clearly understanding the three different components of MRR.

The Cash Flow Trough

Lets now look at the timing of sales expenses for a new sales hire, and how this creates a problem as revenue takes a while to build:

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In the left hand graph we can see how expenses stay roughly flat, but MRR grows slowly over time. This creates the SaaS Cash Flow problem that is the main topic of this blog post.

In the right hand graph, we can see how it takes 11 months before that new sales hire breaks even, and starts contributing positively to the profit of the company. (It is very important to note that this number is going to vary greatly from one SaaS business to the next depending on the many variables used in the model.) This timing is slightly later than the cross over point on the left hand graph, due to the model showing a gross margin of 80% after taking out the cost to serve each customer.

Now lets look at how how these expenses and gross profits look on a cumulative basis:

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The above chart shows clearly the size of the SaaS Cash Flow Trough ($110k in this case), and the time to recover the investment (23 months in this case).

These losses can be very concerning to an unsophisticated investor. However the chart also shows something extremely important about SaaS businesses, which is that once you have gone through the SaaS Cash Flow Trough, the profitability of that sales investment starts to soar. This graph is the key to understanding the economics of a SaaS business.

In Part 2 of this blog series, I will look at how ramping a sales force where you add multiple sales hires every month affects this trough. I will also look at the impact of collecting payment for a year in advance impacts cash flow.

How the inputs to the model work

The starting assumptions:

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This shows the input variables that are used to drive the model. Cells that are colored in Orange are input cells that can be changed to reflect your own situation.

Note the Sales attrition factor, which discounts bookings by 15% to take into account the failed sales hires, and departing sales people. It is pretty common to hear of 30% sales attrition. However since the failed sales people will still do some level of bookings, I have guessed at a number of 15% to take this into consideration.

Marketing Funnel Economics

The next piece of the puzzle that we need to understand is how do marketing costs increase as we add sales people. Lets start by taking a look at an assumed marketing funnel:

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The left hand diagram shows the main elements of the funnel, and the right hand diagram breaks down the actual flow of leads. If we look at the very top of the right hand funnel, we see that leads are assumed to come from two different types of sources: paid leads and organic leads (unpaid). The model assumes that organic (unpaid) leads tend to increase at roughly the same rate as paid leads, and allows you to set a variable which is what percentage of overall visitor traffic comes from unpaid sources. In the example data, I set this to 50%.

Below I show the part of the spreadsheet model that computes the cost of leads required to serve a new sales hire ($8,698 per month). This turns out to be very important as it is a significant cost that is frequently ignored.

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The model also computes CAC and LTV

The model also computes rough values for CAC (Cost of Acquiring a Customer) and LTV (Life Time Value of a Customer). These values are rough as they don’t include costs for marketing staff, or sales management. (It is not too hard to add those expenses: take the monthly expense values and divide them by the number of customers acquired in that month.)

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Conclusions

The primary purpose of this blog post is to provide entrepreneurs  who are thinking about SaaS and other recurring revenue businesses with a model that they can use to understand the impact of various different variables. (It is important not to look at the specific data that I have used to populate the example company, as this will vary greatly from one SaaS business to the next.)

The model shows us several important insights:

  • How long does it take to get to breakeven
  • What is the total amount of investment required (i.e. how big is the bottom of the trough)
  • How long does it take to recover that investment
  • How profitable the business can be over time after coming out of the trough

What comes next: Part 2

In part 1, I have only discussed the data for a single sales person. In part 2, we will look at what happens when a business reaches the stage where it has a repeatable, scalable sales model and starts to hire multiple sales people every month.

  • Cash flow when hiring two salespeople per month
  • Comparison of cash flow when hiring one versus two salespeople per month
  • Impact on revenue of not stopping sales hiring
  • Discussion of the limitations to growth

We will also look at the following additional analyses:

  • Effect on cash flow of collecting a year of payments in advance.
  • Effect of lower or higher churn rate

Click here to get to Part 2.

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  • Sudhir

    Very informative. It looks like the spreadsheet has been removed… anyone know where I can get a copy?

  • http://www.forentrepreneurs.com David Skok

    Seth, I will send you a copy by email.

    Best, David

  • kwalker

    David, Thank you for a great post. Can you send me the Excel sheet?

  • Zach

    great post. one issue i’ve been struggling with is to modify the CAC to fit a partner / reseller sales model. lower margins but zero direct sales costs.

  • http://www.forentrepreneurs.com David Skok

    The usual way would be to take all your sales and marketing costs for a quarter, and divide by the number of customers that were acquired in that quarter. It gets harder if there are different types of customers and you want to get different CAC for each type.

  • Daniel Thomas

    David, just came across your post and I’m struggling to understand the whole concept. Can i please have a copy of the xls sheet. I really appreciate your help here

  • João

    Hi David. Where I can find a similar model that applies to SaaS businesses with a “touchless conversion”? Thanks.

  • http://www.forentrepreneurs.com David Skok

    Hi João, unfortunately I am not aware of anyone that has posted such a model. Sorry I can’t help you.

  • http://www.flickr.com/photos/taterhead/ Gregg Smith

    Hello David. I really appreciate the insight you share in these two recurring revenue posts. Very helpful even to our old school business. Are you still able to email your Excel model? Thanks again.

  • http://www.forentrepreneurs.com David Skok

    Hi Greg, I have sent you the spreadsheet by email.

  • Sean Penrith, Thetus

    Hello David, I hope this make it to you given that the comments are a few years old now. I downloaded the PPT and Xcel sheet and saved them together as suggested. However, they do not seem to be linked any longer to that updating Xcel updates the PPT charts. What did I miss?

    Thanks!!

  • http://www.forentrepreneurs.com David Skok

    Unfortunately I think that PPT and Excel are not as smart as I originally thought, and they link back to the exact files on my hard drive. Sorry this doesn’t work. I don’t know of a way to fix it.

  • Sean Penrith, Thetus

    Hi David, not to worry at all. In fact, it is not an issue on your end. While Windows PC’s can keep the links intact if saved to the same location, Mac fails; a bug that has been on the fix list for two years apparently judging from what I found online.

    I did have a quick question or two relating to the Xcel sheet.

    i) In cell B25, the “10” Leads to closed deal is your estimation that it takes 10 leads to land a qualified “buy,” correct?

    ii) I too found the population of “(ACV) Annual Contract Value” in various places (C14, C15, A15, & C23) confusing. Isn’t B14 simply the annual sales target for the salesperson? And, B15 is then the monthly sales target (B14/12)? To me, the only true ACV is cell B23, the Average deal size, or am I wrong?

    iii) I understand that B16, “Monthly Bookings (MRR)” is “the monthly recurring revenue which increases every month by the new bookings, and decreases by the churn. But its confusing that is calculated simply by dividing the monthly sales target (B15) by 12?

    Thanks for this great resource, and the willingness to engage further with those who still have questions :)

    Sean

  • http://www.forentrepreneurs.com David Skok

    Hi Sean, Answers to your questions below:

    i) Correct.

    ii) Yes – B14 is simply the annual sales target for the salesperson. However the reference to ACV tells you that that target measures that target by looking at the annualized value of each customer they sign up. This is to avoid confusion, as sometimes there is just a month to month contract, not an annual contract. So in that case, we’d still look at the value of that customer as 12x the monthly value when setting the quota for the salesperson.
    And you are right B15 is simply B14 divided by 12.

    iii) B16 is simply B15/12. The reason for this is to simply show the amount of NEW bookings that a salesperson would have to bring in to meet their quota, if you were looking at the MRR for each customer contract. (It does not consider churn, as it is really about the sales target for new bookings.)
    Feel free to ask additional questions if this doesn’t fully answer your original questions. Best, David

  • Sean Penrith, Thetus

    Great, much appreciated David. May well come back to you as I build this out.

    Cheers!

  • Ben

    David, awesome post and model. Very helpful. I am struggling to understand the cost of leads required line in line 52. Are you reversing the attrition (15%) impact? If so, would the formula not be (cell b52): =b39/(1-b11)/b23*b25*b26? Would be amazing if you could look into this and let me know. Best, Ben

  • Dom

    David,

    I’m from Italy and I just set up a SaaS company a year ago. I want to ask you a question about our organization chart. We have five different departments as Software Development, Partner Success Team, Sales, Operation and Product Development. These all five connected the one -CEO-. and organization chart is horizontal. Do you have any suggestions to improve this chart? Can I change it to make effective?

  • Pedro

    Could you please email me a copy….thx

  • swathi

    Anybody has a copy for the excel. Please share..
    Thanks.

  • http://www.forentrepreneurs.com David Skok

    I will email it to you.

  • Kishore Ram

    Hi Bob,
    Fantastic post. Could you please email me the excel sheet? Thanks a lot.
    Kishore

  • http://www.forentrepreneurs.com David Skok

    Will do.

  • Kerian

    Hi David,
    I am new to the SaaS business. Could you email me the excel version of this as well. It would be so helpful in analyzing our company in this manner.

  • Yul

    Dear David,

    Excellent work here! Tried opening xls and ppt but could not. I would greatly appreciate if you could send. I am looking at a SaaS model without a salesforce, namely trying to get the right metrics.

  • http://www.forentrepreneurs.com David Skok

    This particular model is oriented around SaaS companies using a Salesforce, so may not be ideal for you. However I will send it to you by email.

  • Pierre

    Hi David! Thanks a lot for this very interesting post! May I ask you to send me also the excel sheet? (sorry if you received this message twice, but I am not sure that I sent it correctly the first time… )

  • http://www.forentrepreneurs.com David Skok

    I have just emailed that to you.
    Best, David

  • sanjay

    David – thanks for publishing the good work. Is it possible to email me the excel sheet so I can play with the numbers

  • Elliot

    David, thanks so much for these incredibly useful posts.

    I’ve spent the last few days pouring over the metrics and data and I’m a bit confused about one of the lines in the Sass Salesforce Economics spreadsheet.

    In line 186 ‘Billings less churn’ (from month 13 onwards) the figure is slightly higher than line 185 ‘Bookings’. I would have thought this would be lower, or have I misunderstood something?

  • http://www.forentrepreneurs.com David Skok

    The model assumes you are using an annual contract. So at month 13 you get to bill all your old customers that didn’t churn in addition to your new bookings. That is why the number is higher than bookings.
    Let me know if this is still confusing.

  • Gerra Bosco

    Hi David, this is great, thank you so much for creating such a useful spreadsheet. I am confused, however, about why the average customer lifetime isn’t included in the LTV calculation. I know that the churn rate is included, but still, a customer lifetime of 2 years is going to gross more than one of 1 year, correct? Thanks.

  • http://www.forentrepreneurs.com David Skok

    Hi Gerra, I had difficulty understanding your question. Could I ask you to tell me where you are looking in the spreadsheet (row number) to help clarify?
    Thanks, David

  • Richard Doody

    Hi David, thanks for the post its been really helpful, I’ve pretty much the same question as regards re-sellers and margin as well as whether it should be front-loaded or your thoughts on optimal ways to have the re-seller motivated. Any advice would be brilliant, Thanks

  • Benjamin Hoffman

    Hi David, awesome post (as usual). Could I trouble you for the excel template? I see the comments here are many months old but I hope you are still providing the template.

  • http://www.biosme.com dominic

    Dear David, Excellent post. May I also have a copy of the exel?

  • Munya

    Hello David, I am a first time SaaS entrepreneur and I just came across your blog. So many valuable insights and I was wondering if you can share some of your models with me?

  • http://www.forentrepreneurs.com David Skok

    Hi Munya, the models that are relevant are all linked to in the various articles for download. The main one’s are in the SaaS Economics blog post. Plus there is a sample spreadsheet in the SaaS Metrics 2.0 post. But be careful with the latter as it is not a model. The formula in that sheet are not meaningful. Best, David

  • Woody

    Please email the Excel. Thank you. Excellent.