Start-Ups and Financial Models for SaaS Companies

by: Ed Sim, CFA

The other day I met with an entrepreneur I was advising as he prepared to raise his next round of funding. In the meeting, he wanted me to narrow in and focus on his financial model.

Financial models for startups are important from a big picture perspective, but I never like to get mired in the full details as things always change in the early stages. So first and foremost, I let him know that while it was nice to have a well thought out spreadsheet, that the most important thing was getting the product developed and the right team in place.

I don't invest based on detailed spreadsheet models - getting comfortable with the team, the problem being solved, and the market opportunity are more important in the early days. Secondly, what is most important for me to understand is the expenses and what milestones will be achieved with this first round of funding and whether or not it would be suitable enough to raise the next round of financing.

Finally from a big picture perspective, I like to understand the unit economics of the business - can this really scale, is the company capital efficient, and are there high or low gross margins. While the revenue model may change as well, I like to at least understand going into the investment that the entrepreneur's head is in the right place and that the economics work right from the start.

Given my experience with SAAS based companies like GoToMyPC (Citrix Online now) and LivePerson (NASDAQ:LPSN), we also spent some time discussing key financial metrics for SAAS businesses that he should pay attention to as he ramped up his business. Once again, no startup spreadsheet is going to accurately predict the future, but it is imperative to understand some of the key variables that will drive your business so you can prepare early on to have the right people in place and the right focus.

In my mind, some of these key variables include new bookings, growth of deferred revenue, churn rate, cost of acquiring new customers, and obviously cash. New bookings are a better indicator of sales growth for a SAAS company because typically contracts are signed for 1 year or more and the revenue is recognized monthly as the service is delivered. So if a SAAS company signed up $1.2mm in bookings for December, it may only recognize $120k each month. The remainder would go into deferred revenue.

Another area that is quite important is churn rate. If your company churns or loses 5% of customers every month, then during the course of the year the company will have to replace a significant number of customers just to maintain status quo. What this tells a company is that they while focused on adding new customers, they also have to make sure customer satisfaction is up to snuff and that they keep their existing customers happy. Also if your cost of acquiring a new customer is high and breakeven is longer than the contract length, then your company will never be financially stable if you cannot keep your customers on board.

Finally cash is an important metric for all startups - watching the burn rate and being proactive about it can keep you fighting through the lean times and prepared for growth. While many SAAS companies may collect cash monthly or quarterly, some collect annual fees by offering discounts by paying upfront. This is a great way for SAAS companies to keep the cash coming in earlier so they can use it to fuel growth.