Four Things to Consider Before Switching to a SaaS Business Model
If your software business is considering a switch to SaaS, here are some financial considerations to take into account before making the change.
By Robert Casey, partner and Anish Amin, senior associate
The Software-as-a-Service (SaaS) business model, where software is hosted on the cloud and licensed as a subscription, has become very popular in recent years, mainly thanks to customer benefits such as faster implementation, lower up-front investment, scalability and minimal IT dependency. If your software business is currently providing on-premise software (OPS) and you’re considering a switch to SaaS, here are some financial considerations to take into account before you make the change.
VALUATION ON EXIT
Business valuation often drives companies to utilize the SaaS model. A significant number of factors go into valuing a company, including earnings, revenues, year-over-year growth, market penetration, competition and strength of the management team. Generally, the value applied to recurring revenue from SaaS (and in some cases, recurring support and maintenance fees under an OPS model) is higher than the value applied to one-time license revenue and significantly higher than the value of service revenue. Based on exits and investments we’ve seen in recent years, we expect the valuation gap between recurring and non-recurring revenue to continue growing.
With SaaS, there is generally a lower up-front cost to implement and the implementation time is quicker, which may result in a shorter sales cycle. The lower up-front payment can be challenging for some businesses from a cash flow perspective. Vendors accustomed to receiving large up-front payments may receive lower up-front payments but higher recurring payments when moving from OPS to SaaS. Over time, it makes revenue projections and future cash flow forecasting easier, but in the short term, it can leave some gaps in cash flow. Companies also need to make significant investments in software development and infrastructure to support a secure SaaS environment.
Before starting the process of moving from OPS to SaaS, you should model out the cash flow effects of lower up-front customer payments combined with higher development and infrastructure costs. The additional investment needs may result in a shorter cash runway, requiring more capital and ultimately dilution of existing stakeholders. Companies should understand their capital needs and how the change in cash flows will affect stakeholder value long-term.
OPS, under existing GAAP, falls under industry-specific guidance for software, whereas SaaS falls under general revenue recognition guidance – sometimes resulting in significant differences. Many elements must be considered before determining the appropriate GAAP revenue recognition. Minor changes to a contract, such as platform transfer rights, customer acceptance clauses or promised future functionality, can create situations where all revenue is deferred over longer periods of time.
One of the major revenue recognition differences between SaaS and OPS is that, in many situations, OPS vendors are able to recognize license fees upon delivery and implementation service fees as the implementation services are provided. Under a SaaS model, up-front payments for licenses and implementation that don’t have stand-alone value are both deferred until the go-live date and then recognized over estimated life of the customer. This concept is often challenging for many business owners to understand. In many cases, they have charged the customer a fee to implement a SaaS solution and the non-refundable fees have been paid, but they still can’t recognize the revenue under GAAP. This can have a significant impact on GAAP revenue recognition by delaying revenue recognition and ultimately affect bank covenants. Before migrating to a SaaS model, be sure to understand the impacts the migration will have on GAAP revenue recognition.
In some cases, vendors add a SaaS option for their products and market both SaaS and OPS, which can create additional costs for both development and support. Other vendors have stopped future development of OPS and plan to migrate existing customers to the cloud before they discontinue support for the on-premise solution altogether. The methodology of migration applied could impact customer retention as customers who know you are concentrating fewer resources on product enhancements may not purchase the support. Also, certain companies may have policies prohibiting certain types of information in a SaaS environment, which could exclude them as potential customers.
Before deciding to migrate from an OPS to SaaS model, software vendors need to understand the effect the change will have on their business. Business valuation, cash flow, revenue recognition and client retention will all be impacted. Take the time now to understand those changes so you can ensure SaaS is right for your company and prepare for a successful switch.
For questions on how changing to a SaaS model will affect your company partner, at 404-898-7432 or firstname.lastname@example.org.