Software as a service (SaaS) has evolved from a new way of licensing and delivering software to a proven and accepted practice that brings many benefits. The cloud-based model allows software companies to innovate on a constant basis, giving their customers access to new features as they are developed, rather than waiting a year or more for a major product release. And it generates steady, recurring revenue and attractive margins—one reason that pure SaaS companies command a valuation that is roughly double that of their on-premises peers. By 2018, International Data Corporation notes that nearly 28 percent of the global enterprise applications market is expected to be SaaS-based, generating $50.8 billion in revenue.
But transitioning to SaaS from an on-premises model isn’t as easy as flipping a switch. We’ve seen it affect everything from product engineering to sales force management to accounting. While SaaS delivers dependable revenue over the long term, in the short term, cash flow is likely to be disrupted and margins depressed. To manage the transition, software companies may need to raise additional capital, and this requires effective planning and a strong forecast.
Transitioning to a pure or hybrid SaaS model entails considerable up-front costs, including development of hosting platforms, R&D costs involved with rewriting the software for cloud-based delivery, security needs, data and transmission infrastructure, marketing campaigns and any new staffing required. These expenses can be complex to plan for but are critical to understand.
Hosting, for example, is a multifaceted decision. Should it be private or third-party? Single tenant or multitenant? Do your customers have strong hosting preferences? How will you ensure the highest levels of security, transmission times, availability and disaster recovery? These decisions will all affect cost.
A SaaS transition is a multiyear undertaking. It can take up to five years from conception to completion. So it’s critical to conduct market research to forecast how long your transition will take and to project the growth of your subscription base. Among the issues to consider are:
The SaaS model is a fundamentally different business model than on-premises, and the key success metrics you track—and are judged by— may change. Metrics such as monthly recurring revenues (MRR), number of subscriptions and customer acquisition and/or retention costs may become significant markers during (and after) a transition.
A SaaS transition can also be disruptive to cash flow. As cash flow gets pushed out, gross margins could be depressed for a period of two to four years. In some cases, cash flow may dip into the red. Negotiating larger up-front payments from customers as part of your SaaS pricing can ease cash flow concerns. But even if you have the leverage to do this, GAAP accounting principles require the revenue to be earned over time, resulting in an increase in deferred revenue. We’ve observed a U-shaped revenue pattern as recognized revenues take a steep dip before rebounding as the transition takes hold.
Many companies are unpleasantly surprised when this transitional dip impacts their ability to raise capital. Therefore, it’s important to project as accurately as possible so that you can plan ahead for the necessary funding to see you through the transition and set expectations with investors, shareholders and board members. A well-laid plan based on realistic financial projections can minimize disruption and allow you to raise money from a position of strength, rather than raising money later on when conditions may not be as favorable. A strong balance sheet is the best insurance policy.
More and more companies are recognizing the inherent benefits of SaaS. But transitioning from an on-premises model to SaaS involves challenges and risks. By creating a well-thought-out forecast and financial model, you can identify your capital needs in advance and prepare to raise the funding necessary to see you through the transition.
We can help you prepare for a successful SaaS transition.
For additional insights and assistance, contact Tim Sandel, Head of Technology Banking for Middle Market Banking & Specialized Industries, at (415) 315-8182.
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