The SaaS business model has grown exponentially in recent years. When done successfully, SaaS can offer a steady cash flow beyond the break-even point and generate unlimited income from one product — assuming the churn is minimized. Even though the SaaS model is popular and has several benefits, it also poses new obstacles that a traditional sales model (one-time purchase) does not have.
Two of the key metrics that determine the success of a SaaS company are the customer acquisition cost (CAC) and the lifetime value (LTV). The difference between a SaaS model and a traditional one is that the CAC is recouped over an extended period of time with SaaS, whereas one-time purchase products are priced to cover the CAC plus profit. Therefore, it’s very common for SaaS companies to have a negative cash flow in the beginning, which increases the importance of the LTV.
These are issues that must be addressed before product launch. The risk of falling into an extended period of negative cash flow can be reduced by asking these five questions when structuring your SaaS product.
1. What is the lifetime value of each customer?
In order to establish whether or not the business will be cash flow positive in the long run, you need to figure out the LTV of a customer. By finding out how much a customer will be worth during the duration of their subscription, you can see if they will earn you more money than your CAC.
First, you need to find out how long you’ll keep each customer. The formula for this is 1/churn. Churn is expressed as a percentage and is either calculated monthly (number of months) or annually (number of years). For example, the formula for a four percent monthly churn rate would be 1/0.04, which is 25 months. A 25 percent annual churn rate would have the formula 1/0.25, which is four years.
To find the LTV, you multiply Customer Lifetime Value (the number calculated above) X average monthly or annual payment amount X gross margin percent.
Once you have calculated the LTV, compare this number to the CAC. If the LTV is lower than the CAC, then it’s probably not a worthy investment and you should tweak your business model. On the other end, if the LTV is enough to make a healthy profit, the venture might be worthwhile.
2. How long will cash flow be negative?
Unless you’re spending next to nothing to acquire customers or your subscription costs are high, a SaaS company typically will have a negative cash flow initially.
In a traditional business model, rapid growth (gaining new customers) will result in meeting the break-even point sooner and earning more profits. But with SaaS, you will notice that the more customers you earn initially, the worse your cash flow will be.
However, once a customer passes the break-even point and becomes profitable, the new income will help reduce the loss you take on new customers. And once more customers become profitable, a sustainable business starts to form.
If you discover that you will be cash flow negative for longer than you’re able to cover the costs of running the business, then you know that your company will have financial issues and won’t last.
To calculate how long your company’s cash flow will be negative, you can use the formula outlined here.
3. Should you collect money in advance?
Many of the issues described so far in terms of having a negative cash flow and recovering the CAC are primarily due to collecting payments monthly. But what happens if you require customers to pay for three, six or even 12 months in advance? The CAC is recovered much quicker and negative cash flow periods are shortened or even completely eliminated.
For newly formed companies, collecting payments in advance can be difficult. Your brand isn’t known, and most of your initial customers will just be testing out the software rather than fully committing. Bigger brands are able to collect annually or in three- or six-month increments because customers are confident that they will be around and know that they will benefit from the service. A great example of this is Amazon’s Prime membership. They require customers to pay for a year in advance and, due to their reputation, they have been successful.
For new SaaS companies, a great way to get customers to pay in advance is to incentivize them. For instance, offer a month-to-month plan, a six-month plan and an annual payment plan. Slightly discount the six-month and annual plans to give customers a reason to pay in advance. You may risk making a little less from long-term customers, but you will be able to immediately recoup the CAC and avoid the negative cash flow that month-to-month customers create.
Additionally, month-to-month customers may end up canceling before you’re able to recover the money spent to acquire them. By collecting the revenue in advance, churn becomes less of an issue and you’re guaranteed to recover the money spent to acquire the customer.
4. Who are your most profitable lifetime value customers?
The LTV of a customer is based on the total average, but you should also take it a step further and segment your customers into smaller groups and find the LTV of each of those groups. The customers that earn you the greatest LTV will become the foundation of your company.
Finding your ideal or most profitable customer also will give you a better understanding of who your customers are, what they want and how to market to them. By focusing on these high-converting, long-term customers, you will also decrease your marketing spend and CAC.
The way you segment your customers will depend on the software you offer. If you’re selling enterprise software, you can segment based on organization size. For consumer-based software, you might segment geographically or demographically. Segmentation will help you avoid marketing to markets that have higher CAC and a lower LTV. Subscription management software can help you segment by giving you analytics on all of your subscribers.
5. What will your sales process look like?
Developing a great sales funnel or process can determine the success or failure of your SaaS business. If you cannot convert leads to paid subscribers, then CAC and LTV become irrelevant because you won’t have any customers.
Here is an example of a possible sales process:
- Qualify lead (by finding out if your software is for them)
- Offer a solution to their problem (by showing what your software does)
- Overcome objections and remove roadblocks
- Ask for the order with a strong call to action
- Follow up and upsell any additional services or products
Your sales process may have extra steps or possibly even fewer steps. You should split-test a variety of sales funnels to find the optimal mix. On your website, test different copywriting, landing page colors, CTAs, and headlines to see what works and what doesn’t.
By asking yourself these five questions, you will be able to determine whether or not your SaaS business has wings or if it’s a dud. If there are investors and other stakeholders involved, being able to provide answers to these questions will build their confidence in you and get more support.
Preciouse Gross is the Community Manager at BlueSnap, an international payment solution powering the checkout process for ecommerce merchants worldwide. Preciouse has been in the ecommerce payment industry for six years and is a regular contributor at ecommerce and SaaS news websites. Follow her on Google+.