“Software is eating the world.”
Today Marc Andreeson’s famous quote is truer than ever. Cloud computing and new programming tools mean that anyone can start a software as a service (“SaaS”) business without the massive capital outlays that were necessary a decade ago.
But even now, SaaS businesses have one of the highest failure rates of any industry.
It’s well known that the SaaS business model has the potential to be extremely profitable, but it’s also one of the hardest possible business models to operate when keeping in mind cashflow for startups and scaleups.
First, SaaS companies require rapid growth just to survive. According to McKinsey, growth of 20% or lower would cause 92% of SaaS businesses to fail in a few years. This fast growth puts them at constant risk of overtrading, the killer of many highly profitable companies.
Second, their SaaS business model requires significant cash outlays (development, marketing, salespeople) well in advance of recouping cash from customers. The subscription model compounds this. Several months (or sometimes even years) of revenue are needed before the investment of acquiring a customer is repaid.
In short, a SaaS business requires growth to survive, but its growth is much more cash intensive than other business models.
This means that it is essential for SaaS CEOs to be cash flow experts.
Here are the most common mistakes that we see founders making preparing cash flow projections in practice.
1 – Mixing up the cash flow and profitability
I frequently see founders prepare forecasts that confuse cash flow and profitability, and then get confused when the results aren’t as they expect.
A cashflow forecast predicts every income and expense of the company, at the exact moment it touches the bank account. Profitability, on the other hand, is an accounting measure that seeks to mitigate short term timing differences.
For example, if you bill a customer in January but they don’t pay until March, then the profit will show in January but the cash won’t show until March.
Cash flow and profitability are both important to SaaS businesses, but they will not be the same. If you’re only planning to forecast one I would advise you to focus on the cash. A business can survive for a short time making no profit, but it cannot survive with no cash.
2a – Not planning for VAT…
VAT is a very common example of this confusion.
VAT is not included in your profit and loss, because it is income that you collect on behalf of HMRC and not your own income. However, it is often a huge factor for cash flow.
In fact in the UK when businesses fail due to running out of cash, HMRC is by far the most common creditor to take the legal action which closes them down.
The complexity with VAT is that whilst you collect it from your customers every month, you only make a balancing payment to HMRC once every quarter.
The largest costs incurred by SaaS businesses are salaries and online marketing platforms, which means that they will not typically pay large amounts of VAT to suppliers on a monthly basis. This can result in large quarterly VAT bills long before the company has become profitable.
Failure to plan for these large quarterly payments can be disastrous for any business on a short cash runway.a SaaS business requires growth to survive, but its growth is much more cash intensive than other business models. This means that it is essential for SaaS CEOs to be cash flow experts. Click To Tweet
2b – …and other taxes…
National insurance and corporation tax are equally problematic.
Many smaller businesses pay their staff monthly but only pay out payroll taxes to HMRC every quarter.
However, founders often forget to add national insurance and pension contributions onto their forecasts at all, leading to inaccuracies both in timing and magnitude of payments.
Similarly, when your SaaS business becomes profitable, you will need to start paying corporation tax. Although this only gets paid once a year the best practice is to account for the tax accumulated on a monthly basis.
Due to the timings of payments, it’s common for SaaS businesses to become profitable whilst they’re still losing cash, so don’t let this catch you out. This could be caused by cash being tied up in sales invoices, development work getting capitalised on the balance sheet or cash outflows on VAT bills.
3 …including R&D credits
On the flip side to get the most of your runway you need to claim your R&D credits as soon as you possibly can.
Frequently founders putt off their R&D reclaims, because it seems like too much of a chore. What they inevitably learn is that running short of cash because HMRC takes months to process the claim is much more painful.
4 – Overestimating revenue and underestimating costs
Virtually every cash flow projection I’ve ever seen a founder produce has overestimated revenue and underestimated costs, to such an extent that I’m sure that everyone is going to ignore this paragraph!
If you are a SaaS founder you are no doubt a naturally optimistic individual (you wouldn’t have started a SaaS business otherwise!). However, whether you are preparing a forecast for investors or for your own use it pays to be realistic.
Common culprits in my experience are:
- Underestimating recruitment costs
- Not taking into account fundraising costs such as due diligence, often a condition of receiving investment
- Forgetting to add national insurance and pensions to payroll costs
5 – Losing sight of key metrics
The most successful forecasts are prepared with a close eye on key metrics and provide an opportunity to revisit assumptions around lifetime values, and the cost to acquire customers.
The worst forecasts, on the other hand, are prepared in isolation, often applying a simple markup on historic data, or worse, make complete guesses. If you are managing performance against a forecast that lacks clear direction your business is going to lack direction.
6 – Filling the top of the funnel
As we know SaaS founders are under a lot of pressure to show rapid growth, and this often translates to a desire to achieve more leads, more prospects or more customers.
However it doesn’t matter how many leads you can generate if they don’t turn into customers, and it doesn’t matter how many users you have if the unit metrics don’t stack up.
According to a survey carried out by SaaS guru David Skok its four times cheaper to upsell existing customers than it is to gain new customers. That means that for SaaS businesses who need to be ruthlessly efficient with their marketing spend, it makes sense to maintain your focus on old customers, not new leads.
About the author
Dan Hully is an accountant and entrepreneur who uses technology to help founders build great businesses. He’s unique in his ability to combine his PwC training, with direct startup experience and in-depth knowledge of accounting technology and APIs.
He is the founder of Quantico, a new type of accounting firm that provides outsourced Finance Director services and accounting to startups and scale-ups.