The key difference between traditional software and software as a service: Growth hurts (but only at first)

In the traditional software world, companies like Oracle and SAP do most of their business by selling a “perpetual” license to their software and then later selling upgrades. In this model, customers pay for the software license up front and then typically pay a recurring annual maintenance fee (about 15-20% of the original license fee). Those of us who came from this world would call this transaction a “cashectomy”: The customer asks how much the software costs and the salesperson then asks the customer how much budget they have; miraculously, the cost equals the budget and, voilà, the cashectomy operation is complete.

This is great for old-line software companies and it’s great for traditional income statement accounting. Why? Because the timing of revenue and expenses are perfectly aligned. All of the license fee costs go directly to the revenue line and all of the associated costs get reflected as well, so a $1M license fee sold in the quarter shows up as $1M in revenue in the quarter. That’s how traditional software companies can get to profitability on the income statement early on in their lifecycles.

Now compare that to what happens with SaaS. Instead of purchasing a perpetual license to the software, the customer is signing up to use the software on an ongoing basis, via a service-based model — hence the term “software as a service”. Even though a customer typically signs a contract for 12-24 months, the company does not get to recognize those 12-24 months of fees as revenue up front. Rather, the accounting rules require that the company recognize revenue as the software service is delivered (so for a 12-month contract, revenue is recognized each month at 1/12 of the total contract value).

Yet the company incurred almost all its costs to be able to acquire that customer in the first place — sales and marketing, developing and maintaining the software, hosting infrastructure — up front. Many of these up-front expenses don’t get recognized over time in the income statement and therein lies the rub: The timing of revenue and expenses are misaligned.

The income statement alone therefore can no longer tell us everything we need to know about valuing a SaaS business.

Even more significantly (since cash is the lifeblood of any business), the cash flow timing is also misaligned: The customer often only pays for the service one month or year at a time — but the software business has to pay its full expenses immediately.

Thus, as with many innovative new businesses, cash flow is a lagging not a leadingindicator of the business’s financial health.

Take a look at the cumulative cash flow for a single customer under a SaaS model — the company doesn’t even break even on that customer until after a year:

cumulativecashflow_a16zsaasprimer

And as the company starts to acquire more customers, the cash flow becomes even more negative. However, the faster the company acquires customers, the larger it grows its installed base and the better the curve looks when it becomes cash flow positive:

Cash flow becomes even more negative before getting significantly better.

For the full post please read: Understanding SaaS: Why the Pundits Have It Wrong | Andreessen Horowitz.

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