Thinking of switching your software company’s business model from License & Maintenance to Software-as-a-Service (SaaS)? The transition to SaaS is an increasingly popular option, but it’s not without its own challenges. This post will lay out some of the key considerations while making the switch.
In 2018, Gartner made the bold prediction that within two years, “all new [enterprise software vendors] and 80% of historical vendors will offer subscription-based business models.”
Today, SaaS has largely lived up to that claim, but only in some areas. While SaaS is remarkably ubiquitous in 2020, in areas such as cybersecurity and infrastructure, or highly regulated industries such as pharmaceuticals, aerospace & defense, and government, selling perpetual software licenses and/or on-premise deployments is still common.
In fact, this model is a great way to start and bootstrap a business as customers pay much larger sums upfront to outright own the software. This can really help increase cashflow, especially early on. However, in times of economic uncertainty such as today, where prospects might be hesitant to invest large sums of money upfront, our Volition B2B survey has found that the higher the price point, the more likely that procurement decisions get pushed off. Hence, for companies that have been debating the transition to a SaaS model, this may be a good catalyst to embark in the journey.
While this transition may seem like a daunting task, if planned for and executed carefully, we’ve found that it can also bring long term benefits to customers and vendors alike as the adoption of SaaS continues to grow.
The Benefits of SaaS
We have seen and worked with a number of companies that have gone through a transition from license maintenance to SaaS. There are three general motivations for entrepreneurs to shift business models in addition to economic uncertainty:
- Recurring revenue is more predictable, helping manage the business and balance sheet more effectively
- Recurring revenue is valued at higher revenue multiples when considering a strategic exit or additional financing
- SaaS is generally more scalable in periods of rapid growth
Despite the advantages, there are a host of challenges to shifting to a SaaS model. According to a 2019 Salesforce and CFO Research report, 65% of companies launching recurring revenue businesses face operational challenges in doing so. If you’re going to make the transition to a SaaS model, you should know some of the challenges you’ll meet along the way so you can best prepare for them.
Five Key Challenges to Making the SaaS Transition:
1. Managing the change in cashflow
Because you’ve moved away from the license and maintenance model, you’ll no longer get a lump sum of payment upfront. This means management teams need to start monitoring return on operational expenses more closely. Before, this was relatively easy to track, as getting paid a large license fee upfront makes evaluating the efficiency of a sale as simple as subtracting the money spent on Sales & Marketing (S&M) from the profile made from the sale. Managing a business on a cash-in-cash-out basis makes perfect sense.
With SaaS, you get paid over an extended period of time, so the impact of a sale relative to S&M spend is less clear. Management teams need to strike a balance between adding business, estimating the Lifetime Value (LTV) of the new revenue stream, and cash burn. As a result, the KPIs that management needs to track change dramatically.
2. Sales team transition
Because there is no longer a large sum of money coming in upfront, the compensation structure for the sales team must be altered. Will you calculate commissions using the Annual Contract Value (ACV) or the Total Contract Value (TCV)? What kind of incentives will you build to encourage multi-year deals? Will you incentivize upfront payments? This choice plus the timing of the commissions need to strike a balance to manage cashflow.
Additionally, motivating renewals and upsell needs to be more carefully architected. You can’t just make a sale and forget about it; your sales team needs to be motivated to maintain relationships as this will pay off dramatically in the long term. Additionally, some renewals require just as much effort as a new sale, limiting your bandwidth to go after new business. Finally, from a human resources standpoint, you need to be empathetic and cognizant of the way these changes could disrupt your sales reps, and you should develop strategies to keep them engaged and motivated through the transition.
3. Cultural transformation
SaaS requires your organization to culturally shift its view of your software. It needs to be viewed as a continuous service, not a one-time sale. This starts with the sales team but moves throughout the organization. Engagement, satisfaction, and usage become key variables as companies continue to compete for business and renewals from existing customers – KPIs such as Revenue Retention and NPS will need to be ingrained throughout the organization. “Customer Success” (CS) is often a function that needs to be created from scratch, and it is a critical component of building customer loyalty, as this all-star cast of experts can attest.
4. Higher initial costs than anticipated
A major change will be the need to host your software on the cloud and incur those costs on your Profit and Loss Statement (P&L). Hosting costs sometimes become higher than projected and can hurt gross margins early on. This is sometimes caused by lack of historical data points to model consumption and pricing, but also from a product architecture that is not natively built to be on the cloud – a lift and shift transition is not uncommon, which can eat up resources if unplanned. Gross Margins are a key value driver in the long run, and teams should strive to lower hosting costs by leveraging as many native offerings from the hosting providers as possible, which could either decrease consumption or increase discounts via bundled pricing.
Another factor that could negatively impact your gross margin is that the newly created Customer Success (CS) function will be allocated under Cost of Goods Sold (COGS) as opposed to your Operating Expenses. This makes for easier reporting and tracking but will decrease Gross Margins. Management teams should think through ways of automating Level 0 and 1 requests as much as possible while scaling the CS team with growth and ramping times in mind.
Finally, implementation and professional services are often used as a negotiating mechanism to help capture more of the recurring revenue in the long run, so it may no longer be the profit center one is used to. From a strategic perspective, capturing more of the subscription revenue is favored because it helps increase Gross Margins and SaaS businesses are often valued as a multiple of recurring revenue. You’ll need to have a clear strategic view on this trade-off between equity value and cashflow, and you should track gross margins by revenue line item to make informed decisions.
5. Constantly chasing Time-to-value
There are 3 types of SaaS pricing we see – monthly, annual, and multi-year. Time-to-value is important as customers need to see value and ROI before making the renewal decision. Hence, the speed of implementation is key.
You’ll need to onboard customers efficiently and then quickly begin to show the value of your solution before the renewal cycle begins. The more productized use cases, out-of-the-box functionalities, and configurability (vs. customized) are built into the platform, the easier it is to realize value for customers. An implementation + customization process that takes 12+ months no longer works, and the orchestration between the implementation team and customer success team will be crucial as you imbed the product into the customer’s daily workflow.
The SaaS Transition: We can help make it successful
Volition Capital, over the years, has worked with a number of companies that have successfully transitioned from a License and Maintenance model to SaaS. We believe we are in a unique position to help companies given this experience. While securing a strong balance sheet before embarking in this journey is important, we believe it is equally important to have a partner that can help management teams avoid common mistakes, identify the right value drivers during this transition, and help build out a team and culture that makes a strong SaaS company.
As mentioned earlier, this transition might seem daunting at first, but if executed carefully, we believe it will help increase the velocity, growth, and value of many software businesses and are looking forward to partnering with entrepreneurs in this new phase of value creation.
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Meet the Author:
Tomy joined Volition Capital in 2012 as part of the first Analyst class. He focuses on software and internet investments in compliance, security, supply chain, and vertical applications.
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