When a product team launches a B2B app, they may experience a surge in sign-ups (1,000) but then suddenly run into a cash crisis because their server costs increase rapidly while their monthly subscription revenue lags behind.
This guide shows you the actual processes that cause software companies to grow as well as the differences between the cash flow and revenue reality of software companies.
Surviving the Subscription Engine
Software companies are not the same as other businesses in that software companies grow based on the cash flow generated by the subscription engine rather than product delivery.
The majority of founders believe creating a web app and charging a monthly subscription fee is sufficient to sustain the company. While this is an oversimplification of the process, the key to success is understanding four different layers of the subscription model.
If your CAC (customer acquisition cost) takes two years to recoup but the average user churns after 14 months, you are already out of business. All that you have done is to continue funding your business through external sources.
Therefore, no matter how many customers you have, your unit economics are bleeding cash. The SaaS model has many moving parts; most advice on the Internet lumps all of these moving parts into one generic model.
If you want to grow without hurting your company's operations, you must break down the saas business model into four distinct layers.
The Delivery Layer
This is the technical process that enables users to receive the product. Your software is hosted by you, and the database is managed by you.
Security patches and updates are provided and managed by you, and your customers access the software via their web browser or mobile app. Additionally, your customers do not host or use the software on their own computers.
Because you store one set of code on one server and provide that to all customers at once, every time you need to update your product, all customers will be able to use the new version at the same time. Using a multi-tenant architecture allows you to reduce the number of engineering resources you need as you add additional customers.
The Pricing Layer
This layer provides the way in which you charge your customers.
Will you charge a flat monthly fee? Will you bill customers for every additional seat they add to their team? Will you base their fees on the amount of data they process through your service?
Your pricing model must match the actual value received from your service.
The Revenue Layer
This layer indicates how you make money on your books. Recognized revenue and cash flow are not the same things.
When a customer pays $12,000 for an annual service contract, you have $12,000 to deposit; however, you have not yet earned that $12,000. You will recognize $1,000 of the annual contract as earned each month, as you provide the service.
The Sales Layer
This layer describes how you gain and convert prospects into customers.
You cannot sell a product that costs $20 per month through a team of trained enterprise salespeople that are compensated with very high salaries. Your pricing structure will dictate the way in which you sell your product.
This ranges from self-service sign-up for inexpensive products to assigning dedicated account executives and security to high-end products, handling everything from the sales review to negotiating lengthy contracts.
How a SaaS Business Model Makes Money
Software companies typically do not rely on a single revenue channel. A healthy software company will develop multiple revenue streams to stabilize its cash flow.
Predictable Subscription Revenue
The most desirable form of revenue is predictable subscription revenue, also known as recurring revenue. With this type of revenue, customers are charged on a recurring basis (monthly, annually or every 2 years) in exchange for access to your software.
With this predictable revenue, you know exactly what your minimum monthly revenue will be. This will help you make hiring and marketing expenses based on the amount you know will come into your business in the future.
To determine your baseline monthly revenue, take the total amount of anticipated cancellations from your subscription revenue.
Usage-Based Revenue
Many software companies currently have usage-based pricing (pay-as-you-go) structures.
For example, if a customer uses your API (application programming interface) 10,000 times in a given month, the customer will pay you a small fee. A customer who uses your API 10 million times would pay you a much larger fee.
According to a recent Metronome study, 85% of software companies use usage-based pricing models. This type of revenue allows your company to grow alongside its customer base.
The disadvantage of usage-based pricing is that your revenue can be very volatile. For example, if a customer experiences a downturn in business due to a recession, your revenue will drop very quickly.
Implementation and Professional Services
When you sell your software to large corporations, the implementation process will generally require extensive setup work.
As with most enterprise software products, you will likely not be able to simply set up your system and allow your customers to begin using it at their discretion immediately after purchasing it. This means you will need to perform several tasks to convert your customer’s existing data, connect the new solution to their existing systems, and provide the necessary training.
A common range of fees for this initial setup phase is between $1,000 and $50,000. The infusion of cash may be a positive thing; however, it is also a one-off and comes with a low margin for profit.
Upselling and Expansion
The easiest money you make comes from existing customers.
When existing customers keep increasing their accounts (e.g., upgrading, buying more add-ons, or adding employees) to a higher tier, your company has not expended any money on marketing and increased revenue.
This allows strong companies to recover losses associated with users that cancel their subscriptions by offsetting lost revenue with expansion revenue.
Choosing an Appropriate Pricing Structure
Your pricing structure determines how you gauge your customers' accomplishments and/or results. If you utilize the wrong unit of measure for gauging success, your customers will ultimately leave you.
Flat Rate Pricing
You charge a flat fee for a complete product.
Flat-rate pricing is straightforward to sell; it gives customers certainty about their monthly bills. However, it is an operational trap because the same fee charged to your largest and loudest customers is also the same amount charged to your smallest and quietest customers.
Thus, you end up leaving significant amounts of money on the table.
Tiered Feature Limits
You have three or four pricing plans: Basic, Pro, and Enterprise.
Tiered-feature-limit pricing helps you differentiate small businesses from large enterprises. The trick is to determine what features should be restricted.
If your essential tools are available in your highest-priced tier, your small customers may lose faith in you and leave. Conversely, if your best tools are available in your lowest-tiered plan, your customers will not see a need to upgrade.
Per Seat Pricing
Charging clients a per-seat or per-user fee is a common approach within a saas business model. This strategy suits collaboration tools, project management applications, and communications software well.
When clients add new users to their organizations and begin using additional user accounts, you'll see an increase in revenue each time they do.
Another important consideration is that if your software does not have a mandatory requirement to create separate user accounts for collaboration, teams of ten may require only one set of credentials, allowing them to save costs through credential-sharing.
Usage and Consumption Pricing Model
A pricing model built around measurable units of activity establishes fairness to the consumer. This includes how many emails are sent, how much data is stored, and how many payments are processed from an organization.
Consumers should only pay for what they use. Nevertheless, creating a usage and consumption model establishes the possibility of "bill shock."
For example, if an employee leaves an automated script running overnight and then receives a $5,000 invoice at the end of the month, that user will likely dispute the invoice and leave your software platform.
Freemium Structure
Offering your product in a basic version for free, and trying to convert free users to pay for premium services is not a revenue model per se; it's a marketing strategy.
Users of freemium structure require costly data storage services, customer service resources due to potential support issues, and database storage resources.
If your product does not have a built-in viral loop to attract massive numbers of free users, the freemium model will eventually run your business into the ground.
Hybrid Model
The hybrid pricing model charges a customer a base subscription fee for using its services, and then a second, higher price for customers who require an excessive amount of usage of its products and services.
According to research conducted by Maxio, hybrid pricing models are the industry standard and have been demonstrated to provide higher median growth rates than other pricing models in the software industry.
A predictable base fee protects the customer from the downside, and allows for potentially large upside from a reliance on a lot of your system.
Comparing Sales Methods: Low Touch vs High Touch
You cannot just copy another company's sales motion as the price you are selling at literally dictates how you will sell it. The Stripe data provides clear separation between the two sales motions.
The Self-Service Machine
This is referred to as low touch. This applies to products priced at about $20 to $500 per month.
At this price point, it is impossible to support using people to talk to buyers. The math simply does not work out; the product needs to sell itself. A user needs to click on a link, register for a free trial, provide credit card information, and learn how to use the software themselves.
The primary goal for you here is to drive volume and provide automated onboarding to convert users into paying customers. The percentage of users who convert will vary widely between businesses.
For instance, if you must collect a credit card number prior to a free trial, you might expect about a 40% conversion rate to paid use. If you do not require a credit card number prior to a free trial, a normal conversion rate to paid is about 1%.
Cancellations (churn) are always a concern. It is common for low-touch products to have about 5% churn each month. If it reaches 10%, the business is in serious jeopardy of failing.
The Enterprise Grind
The other type of sales motion is often called high touch. Typical contracts are for large yearly contracts in the six-figure range or smaller B2B contracts ranging from $6,000 to $15,000 annually.
You are not only selling software but are also selling changes to how an organization operates. Therefore, high-touch sales require that an account executive demonstrate the product.
To obtain contracts from large clients (including enterprises), they typically have long, arduous sales cycles where sales engineers must undergo extensive security reviews and legal disputes regarding the terms of contracts.
While the sales cycle may last anywhere from six to twelve months, once these clients sign contracts with you, they stay with you for a long time. For most high-touch businesses, churn rates of 7% to 10% annually are considered very healthy.
Key Metrics for a SaaS Business Model
Reporting on metrics means nothing if you don't know what to do based on those metrics. Each metric should provide a specific operational answer.
CAC (Customer Acquisition Cost)
What is the cost to purchase a new customer?
To find out what your CAC is, take the total sales and marketing expenses (e.g., salaries and advertising) spent in a month divided by the total number of new paying users earned that month. For example, if you spend $10,000 (total sales and marketing expenses) to get 100 new paying customers, your CAC is $100.
A tighter economy makes it tougher to find new customers. Benchmark reports show the CAC ratio has increased 14% year-over-year. Attention acquisition costs are simply going up.
LTV and Payback
When do you break-even?
The LTV of a single customer is an estimate of the gross profit from that customer until they eventually discontinue using your service. You also need to know how long it takes for you to recoup your CAC.
For instance, if your CAC is $500, and your customer generates $50 in gross profit per month, it takes you ten months to fully recoup your CAC. After month ten, every dollar generated from that customer is considered gross profit.
If the payback period to recoup acquisition costs for a new customer is 24 months, and then the average customer churns out after 12 months, your company is essentially broken.
Churn and Net Retention
Question: Is the existing customer base growing or shrinking?
When evaluating your churn rate, keep in mind that there are two ways to view it. The first is through "logo" churn, which means the total number of customers lost. The second is through revenue churn, which is the actual revenue lost due to those cancellations.
An example: if you have 100 customers and 5 of those customers (small start-up companies) cancel their subscriptions, that will give you 5 percent logo churn from that group. However, if those 5 customers were only paying you $20 a month, your revenue churn would be very small.
On the other hand, if you lost just 1 of your enterprise customers that paid $50,000 a month, your logo churn would be only 1 percent; however, your revenue would take a big hit.
The net revenue retention (NRR) metric is the best way for investors to see what's happening with the money generated from existing customers over time, including churns, downgrades, and upsells.
If a business has an NRR greater than 100 percent, it indicates that even after some customers have cancelled their services, the remaining customers have increased their overall spending with that business through upselling and cross-selling. According to industry data, the median NRR is currently 101 percent.
Activation and Time to Value
Question: Are users finding value from the product?
Signing up a user is only the beginning of the onboarding process; understanding how long it will take that user to achieve their "aha moment" is key.
For example, if you sell invoicing software, the activation event would not be logging in for the first time, but rather sending out the first invoice successfully. When your reports indicate that 80% of newly registered users never send out an invoice, it’s not a marketing issue; it means there’s an issue with the onboarding process.
Structural Flaws That Hurt Software Companies
Software companies do not go down as a result of one big event; they slowly bleed to death from structural flaws that have been overlooked by those operating them until it is too late.
Failed Onboarding
Typically, when a product team sees an enormous influx of people signing up for free trials, the team sees little to no increase in paid sign-ups.
The product team often blames the pricing page for their problems. What they often overlook is a bigger issue. People create a user account, log in, see the empty dashboard for 3 minutes, become confused, and close their web browser.
If the system requires people to invite team members, import large CSV files, or learn complicated workflows just to get their first taste of value, many users will not complete the sign-up process.
To ensure success, your responsibility is to shorten the amount of time it takes for a user to get to their first meaningful result and reduce the number of steps required to achieve that result. Each additional step is one more opportunity for a potential user to abandon your app.
Cash Flow Illusion
A founder who is bootstrapped sells 100 of their annual deals in January, sees a huge balance in their bank account, and promptly hires three new engineers and a marketing manager.
By August, they have no funds left.
The founder confuses the cash collected from customers for the annual deals with recurring revenue. When a customer pays for an annual plan, there’s a promise of providing uninterrupted service to that customer for the full twelve months paid for.
The cash your startup receives from customers pays for the server costs, customer support costs, and bug fixing costs of the startup for the year ahead. If you spend all that money hiring new staff in the first month, you will hit a cash barrier in the months following.
Custom Code Traps
A new startup gets its first large enterprise client. The client is prepared to sign a $100,000 purchase order for your software, but you must develop three very specific custom features just for the internal use of that client.
The owner of the new startup agrees to build those custom features and spends two months doing it. You have now destroyed the primary economic advantage provided by software products.
Amazon Web Services has a number of restrictions in its documentation regarding creating additional branches of code for individual customers. Once you create additional versions of your application to support custom development, you will be in the business of developing custom applications and not building software as a product.
Your customer support team needs to remember which customers have which features. The engineers developing your custom application break custom tools while performing regular updates to your core application; this results in your inability to efficiently deploy an updated version of your application.
It is painful to turn down a large amount of cash; however, by agreeing to produce custom features for individual customers, you are blocking the operational efficiency of your software and will pay the price for this.
Final Thoughts: Build an Ongoing Relationship with Clients
The goal of building software is to win long-term loyal customers. The best way to accomplish this is by having all the components of your saas business model that are tied together that will attract and keep customers for long periods of time.
For example, if your pricing model is based on customer seats and your software is easier to use, having multiple users on the same login will cause conflicts in your pricing model. Also, if you develop a software tool that has a very complicated data migration profile and is sold on a self-service basis (low-touch), your users will not succeed and will leave.
When your acquisition costs reduce and your customers get a meaningful return on investment quickly, you will see that your growth is proportional to the amount that you will lose naturally through cancellations.
Build a sound financial engine by developing good unit economics and match the sales process to the price point. Also, never confuse receiving a large sum of cash upfront with the idea of building a viable and sustainable business.
