I divided in my previous blog post how a cloud transition will impact an ISV. The first blog entry was about the change in business model and this blog entry is about the impact in financial model. However, it is important to recognize that the financial side has lots of different drivers and I will only portray a few of these in this entry, and deal with some others such as sales related metrics later.
Independent software vendors (ISVs) have the concern of profitability when running a cloud business. Mature software vendors with ongoing annual maintenance and support revenue are wondering how to make a transition to avoid future cash flow issues. The most typical question that I get from ISV management team members is: “how do we transition to the cloud without jeopardizing our current business?” Unfortunately there is not one and simple answer to this and what nobody wants to hear as an answer is: “it depends”. There are many different variables to consider and some of them are ISV specific and cannot be generalized. It is like comparing two different cars that have a different purpose: one that is used for racing and the other for transportation of heavy equipment. How does one compare these two and what is the comparison metrics?
I can still remember my early career when we did a bunch of comparisons between publicly traded companies in my business school using metrics that was regarded as “industry norm”. We had to learn in our accounting class each ratio that could be calculated concerning income statement and balance sheet. When we added cash flow statement to the equation, we were sometimes completely lost… me included. Once I understood the connection between income statement and balance sheet, life become so much easier. I would argue that ISV management has to do the same thing to really get to understand where a cloud business is taking them. I am sure that the ISV CFO and controller are on the right page, but I am not that convinced that the management team members all understand the impact of the change. That is just my observation from both research and talking to a bunch of entrepreneurs.
It is obvious that accounting metrics has not changed but was has changed is how we measure our operational activities that eventually leads into the financial accounting metrics that we track and our auditors are interested of. If we change our model from classic perpetual software licensing model to subscription-based model and keep our operational metrics in the prior, I will guarantee that the company will run into a wall pretty soon and one of the things that would be recognizable is that there is no cash in the coffers. Do we really know how to recognize revenue in a way that tax authorities are OK with it? Do we know how to recognize service revenue with a software sale from revenue recognition perspective? You do not want to find this out later on when an audit is taking place or when you are during due diligence when selling your company.
The ISV management has many questions to answer. Is your current business and software solution built in such way that it is easy for the current client to move to pure SaaS environment? What is the current complexity of your solution and does it require lots of human interaction to get delivered? Does your solution have lots of integration points to other operational applications? Does your current software solution support a migration to a pure SaaS environment? If it does not, what is the alternative? I am sure you are getting my point here. Running a solution from the cloud is not just to “port” the solution, but it is to have it run natively and I do recognize that this is not easy for many legacy ISVs.
What about the financials? The number one term that you need to familiarize yourself with is CMRR (Contracted or Committed Monthly Recurring Revenue), Churn and Cash. Other key metrics are Customer Acquisition Costs (CAC), Customer LifeTime Value (CLTV) and there is a bunch of others that are related to different operational functions such as sales, marketing etc.
Fortunately there are lots of good resources in the Internet that I have found very helpful in doing my own research. Many of these examples come with lots of use cases and practical advice so my recommendation to any ISV is not to try to figure these out on their own, but to really learn from what is already known.
Some of these resources such as David Skolp that maintains a blog for entrepreneurs with a specific focus on SaaS business as well as Joel York that brings lots of financial mathematics to the game. He also addresses something that I have not seen anybody else do which is the concept of Net Present Value (NPV) in the calculations.
What many ISVs forget is to keep their Customer Acquisition Costs (CAC) down as much as possible as many ISVs are still used to the old model where the prospect/lead needs lots of human interaction before the deal is closed. This is no longer possible in scenarios where the price is on a level that the ISV can never achieve break-even with providing too much support in the deal closing. If you look at the Customer LifeTime Value (LTV) and Customer Acquisition Cost (CAC) figure below, the trend needs to be according to the following picture.
If the ISV did not control the CAC, it would very soon run into a situation where LTV and CAC are getting closer to each other and the ISV would be bleeding money.
Following picture from Joel York gives an even more interesting view how Customer Acquisition Costs (CAC) combined with Churn will impact an ISV and how each customer adds to the accumulated CMRR until it covers the accumulated CAC cost. In the picture the sixth client creates a situation where company becomes profitable. The picture also shows how churn will impact the overall MRR with time.
The picture gives us an idea how CAC and Churn plays a central role in SaaS financials, but there are many other financial measures that an ISV should think of and also measure. Skok provides an interesting breakdown in how key SaaS goals can be divided into different components: Profitability, Cash, Growth, Other (like Market Share) and each one of these components can be divided into smaller components.
If we further divide the profitability into components, this is how it can be seen:
When you view the picture in more detail, you can see how Customer Acquisition Costs (CAC) and LifeTime Value (LTV) drives the customer profitability, Monthly Recurring Revenue (MRR) and Services Revenue drives the overall revenue and when you add expenses and COGS to the formula, you will have the regular accounting related profitability. Measuring your employees can be done from many perspectives and I will address sales measurement separately in a later blog entry.
As we can see, there foundation for an ISV is still the same, to generate ROI for the investment and dividends for the shareholders. What has to change is how and ISV measures the operational activities when running a SaaS business. ISVs that have not made the move towards the Cloud might really have issues with their competitiveness going forward. My recommendation to mature ISVs is to start looking what can be done in the cloud world and get the development team focused on the changes that a pure Cloud solution will require to be truly multi-tenant so the ISV can achieve the scalability benefits of a PaaS platform such as Windows Azure. Stay tuned for more about metrics and changes in operational models for an ISV.