Ask a founder or investor what drives value in an early-stage SaaS business, and “revenue growth” is probably the consensus answer – essentially, quantity of revenue. Everyone wants that hockey stick to show they can hit a “triple, triple, double, double, double”. And undoubtedly, revenue growth is indeed significant for valuation. There is another aspect of value that deserves just as much attention as well, though – quality of revenue. What makes a good quality of revenue for an early-stage SaaS business?
While you watch those month-over-month and year-over-year revenue growth numbers as you scale your startup, you should also focus on revenue quality to drive long-term value. In general, revenue quality is defined by three things: predictability, profitability, and plurality.
Revenue continuity is the foundation of every good SaaS business, and it often looks achieved by default because of recurring customer contracts. However, not every recurring contract equals predictability. What are some factors that contribute to the quality of that revenue?
SaaS Revenue Predictability Considerations
How much of an annuity does your contract provide? Longer-term committed customer contracts (i.e., one year, multi-year) make for much more predictable revenues over time.
Are your customer contracts consistent? Predictability of revenues is much higher if there are no material deviations from customer to customer with respect to discounts, terms, pricing, etc
Contract Payment Terms
When do you receive the cash for your product or service? Payment in advance (e.g., quarterly, annually) is much more predictable than month-to-month or payments in arrears.
What mechanisms do you have to re-engage your customers before their contracts expire? This is more likely to be driven by product customer fit but at the very least can be aided by a sound renewal clause and a proactive renewal process.
Revenue is literally top line when it comes to financial reporting for businesses. However, look a little further down that income statement, and you’ll see an indication of profit. And since we’re focusing on startups, we’ll focus on gross margins. If some gross margin is good, more gross margin is better, but understanding that gross profitability is the key to good revenue quality. Let’s examine a couple of key questions about the gross profitability of your business.
If some gross margin is good, more gross margin is better, but understanding that gross profitability is the key to good revenue quality.
Are your gross margins transparent? Categorization of profit is a crucial component to understanding your profitability. If you have different revenue streams (e.g., product revenue, service revenue, etc.), it is imperative that you match or combine the revenue of the streams with the cost of revenue for those streams to determine the true gross margins. You cannot understand the components or levers of profitability otherwise.
Are your gross margins accurate? Proper allocation of product/service delivery costs is significant for determining profitability. The typical fixed and variable costs tied to product delivery should obviously be included (hosting, data, licensing, etc.). However, product implementation and customer service costs should be accounted for as well. And any justifiable research and development costs to be expensed in the period should be excluded, so they do not pollute margins.
Do your gross margins reflect proper pricing? Costs tend to dominate a discussion of margins but pricing your product to match the value you are delivering to customers is the most immediate way to improve your margins. Holding everything else constant, a higher priced product generates higher quality revenue.
Are your gross margins competitive? A typical SaaS business has 70% to 85% gross margins. With few exceptions and explanations, your company should not fall outside the lower end of that range. If it does, restructuring and reoptimization are needed.
A typical SaaS business has 70% to 85% gross margins. With few exceptions and explanations, your company should not fall outside the lower end of that range.
Plurality of revenue refers to the diversity and repeatability of your customers, their contracts, and your products. While it is true that super early-stage SaaS startups often have a few key customers that make up a significant portion of their revenue, this is not ideal. For higher quality of revenues, you want to continue to move away from this kind of concentration and accumulate a plurality of customers as the company scales. The rule of thumb is that you want no more than 10% to 15% of your revenue tied to any one particular customer.
The rule of thumb is that you want no more than 10% to 15% of your revenue tied to any one particular customer.
The plurality of contracts component is an indication of customer retention. That is – customers that stay with your company from one contract period to the next contract period and so on. Higher quality revenue is always associated with a plurality of this type of customer behavior which also leverages revenue value and minimizes acquisition costs.
The last element is plurality of product. Build the type of product that can support additional users, features, and usage at every pricing level for an additional fee. Every SaaS company has a mainstay product or service, but one with a good plurality of product has the flexibility to expand.
There you have it. Good quality of revenue requires predictability, profitability, and plurality. It is a straightforward concept that requires deliberate awareness and attention in practice. The next time you hear about astronomical growth at an early-stage startup, the savvy thing you should be contemplating is whether or not that quantity is high quality. That is the platform for long-term sustainability and value creation.