Last version published: 04/11/2016 14:30
Publication number: ELQ-71849-2
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SaaS Model - Net Present Value for Simple Web Business
A simple NPV model for you to evaluate the likelihood of success for your business
"Use Excel, not Magic, to Calculate Success"
Almost all software is now available online as "Software as a Service', more commonly known as "SaaS". If you are in the process of building a SaaS business model, you can expect recurring revenue and high profit margins...if you've hit the nail on the head of course. However, the gist to developing a successful SaaS business is to have numerous paying customers while keeping your costs of sales low.
[Please note that all the facts in this model are linked to ANY high-growth subscription business model. Software as a Service is only one illustration of a subscription based business model.]
Many entrepreneurs and VCs use a "Magic Number" to evaluate the likelihood of success for a SaaS company. The theory says that you are successful only if your annual revenue for a client is at least 75% of your cost of sales (the money needed to acquire a paying customer).
Or in other words. Invest 1$ today to make 75 cents in the year to come.
Excerpt from Scale Venture Partners blog:
“Looking at SaaS deals over the past ten year at Scale, we have found that a simple calculation is highly predictive of which companies have a profitable subscription business model and which ones do not. Take the change in subscription revenue between two quarters, annualize it (multiply by four), and divide the result by the sales and marketing spend for the earlier of the two quarters. A result greater than 1x, has proven to be a compelling business investment, a result below .5x is a company that still has not figured out it’s model, and a result in between, is a deal that will probably get to success and cashflow breakeven but only in a relatively capital in-efficient way. Trying to be cute, we called this the Magic Number.“
A rule like this of course doesn't need to be right 100% of the time to be valid, but it however has to be more often right than incorrect. Sadly, this "Magic Number" used in SaaS is too simple and quite honestly ambiguous when you try to understand it.
David Brode, a friend of mine, actually found that this so called "Magic Number" can give you "False Negatives" (it says that you've got a good business when actually its the opposite) and also "False Positives" (it says that you've got a really bad business, when it's actually pretty decent).
How can this be? There a few things that such a rule cannot bare in mind such as timing of customer payments (monthly, quarterly, annually) and also the churn rate among your customers (number of customers dropped out and were replaced by new ones). Actually, an NPV, Net Present Value Model, is the only way to know the what your SaaS business is truly worth.
Fortunately, its actually straightforward to create a decent SaaS Business Model Excel File which computes Net Present Value (NPV).
The file attached for download here is for you to download, learn from and play with.
The file a free NPV model for a SaaS business and i'd be more than wiling to adapt it to your needs. You can reach out to me to get a FUSE Finance CFO to do this for you.
[With thanks to my friend David Brode, a business valuation and financial modeling expert in Boulder, Colorado and online at at www.BrodeGroup.com!]
- David Worrell
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