We’ve discussed the CFO’s role in growing revenue and company valuations, and how switching on-premises offerings to SaaS and moving from one-time perpetual license sales to recurring revenue models are at the top of the strategic project lists for many technology CFOs.
It is important to know that moving to a subscription model (as a logical model for SaaS deployments) involves a time of change with some short-term pain leading to long-term gain.
What’s the Financial Impact of Moving from Perpetual to Subscription Licensing?
Shifting away from predominantly perpetual licensing (where revenues are recorded up front) will lead to an initial revenue dip. This initial revenue uncertainty is the impact of changes in pricing and predictability (for adoption and renewal rates). With a SaaS transition, the focus may change on how the finance team thinks about cash flow rather than GAAP revenue recognition.
Once implemented, subscription becomes a more predictable revenue stream, making it easier to forecast the business and to manage investors’ expectations, long-term. This short-term tradeoff is often easier for private companies to withstand; the change usually makes sense for public companies, as well.
What Metrics are Important for Software Subscriptions?
Several important metrics (which may or may not be new to companies shifting to subscription) are:
- Annual contract value (ACV): The value recognized in a single year of a multi-year subscription.
- Annual/monthly recurring revenue (ARR/MRR): The sum of all subscription revenue in a year/month.
- Billings: The number on the invoice that goes out the door to the customer, billings occur when the actual invoice is sent, based on the contract terms.
- Customer acquisition cost (CAC): The cost to acquire a new customer (e.g., marketing expenses), which in turn starts a new recurring revenue stream.
- Lifetime value of a customer (LTV): the total expected revenue over the lifetime of a customer relationship. The LTV must be larger than the CAC.
- Revenue retention: revenue change for existing customers over a period of time.
ARR is the single most critical metric for a subscription company. It brings all the major elements in the business together: renewal; visibility into components of renewals (such as churn and price increases); and capturing new business (with components including new logo revenue and upsell revenue from existing customers). Growth in ARR indicates a healthy software business. Examining ARR can also help uncover retention issues; if existing customers aren’t renewing, ARR will be stunted or even negative.
Billings become even more important than they were before. Because billings is a metric more closely tied to the actual cash flow of the company, revenue (an accounting metric caught up in the GAAP revenue recognition role) becomes arguably less important than billings.
The CFO plays a central role in preparing the organization for the move to SaaS (and subscription). It is critical to understand the new financial landscape and set expectations accordingly. Whether you are on the Finance team or are a Product Manager who needs to understand what drives that team, be sure to download “The CFO’s Ultimate Guide to Successfully Transitioning to SaaS” for insights into different deployment and monetization models and how to manage the move to SaaS.