Imagine a scenario where you get the opportunity to pitch your SaaS startup to a group of potential investors. How would you prove to them that your company can build a profitable and sustainable business over time?
If you didn’t include revenue models in your answer, your pitch isn’t as strong as it could be.
In a recent episode of Startup Success, we spoke with Jonathan Cochrane, Director of Product Management at SaasOptics, and Debbie Cohen Rosler, Fractional CFO at Burkland, about how revenue modeling can convey the story of your business to investors and help you plan for the future.
How Revenue Modeling Helps SaaS Startups
Revenue modeling is of particular importance for SaaS startups. While other companies generally depend on individual transaction sales, SaaS companies have streams of recurring cash flows from subscription services which can be retained over long periods.
These recurring revenue streams require SaaS startups to utilize unique metrics such as Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR) to model their cash flows.
Advantages of Forecasting MRR and ARR
Forecasting MRR and ARR can help companies determine their cash runway. Cash runway is a metric used by companies (particularly startups) to indicate how long they can operate at a loss before running out of cash.
Also, SaaS companies have a wide range of billing and collection practices. Companies may bill on a monthly, quarterly, or annual basis—some bill in advance and others in arrears. And collection windows can range from 30 to 60 to 90 days.
Companies with the same ARR could have wildly different cash flows due to differences in billing and collection practices.
Revenue modeling takes into account all of those variables and can help companies understand the recommended timeframes to raise their next round of capital. In other words, revenue modeling allows companies to prepare for the worst-case scenario, the best-case scenario, and every scenario in between.
Challenges in Revenue Modeling for SaaS Startups
1. Seasonality
Some startups have to factor in the seasonality of their product launches into revenue calculations. For instance, a company that sells contracts throughout the year might launch its products twice a year. If the company only sends out invoices when they launch the product, they have two points in the year where they receive big cash inflows, while the rest of the year, they may have no cash inflow. The revenue model would have to account for that to stretch the revenue throughout the year.
“For a company like this, correctly modeling the timing of these seasonal cash flows is really critical for understanding their cash runway. You can’t look at a company like this and say, what’s their annual or even their quarterly cash flow, and get a full picture.”
— Debbie Cohen Rosler
2. Large Enterprise Customers
There are two reasons why large enterprise customers pose a challenge when building revenue models for SaaS startups.
The first has to do with the pace of doing business. Because friction is often present in enterprise purchase order approval processes, the collection of payments can sometimes take 60 to 90 days. This is especially true for the first invoice because it takes a while to get set up in the vendor management system.
The second reason has to do with purchasing power. Because startups depend on large customers to help them build their business, they don’t always have the power to get those customers to pay on time. For example, during COVID, some large enterprise customers slowed down payments to startup partners to conserve cash.
“It was shocking to me that these large, deep-pocketed companies—which theoretically have more options to be able to fund their working capital—were squeezing the little guys, the startups.”
— Debbie Cohen Rosler
3. Incorrectly Measuring ARR
One of the key benefits of a SaaS business model is the recurring revenue stream, and investors want to understand what portion of the revenue is recurring. But sometimes, startups only calculate their revenue based on cash collections. This can make it really difficult for them to communicate the company’s business model and story to investors.
Annual recurring revenue has a big impact on a SaaS startup’s prospects for growth. Failing to report recurring revenue streams accurately causes a loss of credibility with investors who feel that the startup doesn’t understand its own business model. And that, ultimately, hurts the company’s ability to raise venture capital.
“If you get it right, then all of a sudden, you now have the metrics to back up the story that you’re telling about your business.”
— Jonathan Cochrane
Start Building Revenue Models
If you’re wondering when to start revenue modeling, the answer is before you even have revenue.
Building out a revenue model can help you validate that the company has the potential to deliver on growth objectives. It can also help you understand the unit economics so that you can validate the pricing strategy. Finally, it can confirm that your company has the potential to build a profitable and sustainable business in the long run.
Debbie Rosler and Jonathan Cochrane wrote a short e-book that outlines two approaches for forecasting SaaS revenue:
- Tops-down trendline approach
- Bottoms-up revenue driver approach
They provide a practical, step-by-step guide to each of these SaaS revenue forecasting methodologies and outline the considerations when choosing your forecasting approach. Download the Burkland and SaaS Optics Guide to Revenue Forecasting and listen to the Demystifying Revenue Modeling podcast.