SaaS Business Model: Use Excel, not Magic, to Calculate Success

Nearly every kind of software is now offered online as “Software as a Service“, or SaaS.  If you’re thinking of creating a SaaS business model, you can look forward to recurring revenue and high profit margins… if it works. But the key to growing a great SaaS business is to sell a lot of customers while keeping the cost of sales in check.

[NOTE: All facts in this article relate to ANY high-growth subscription business model.  SaaS is just one example of a Subscription-based business model.]

A lot of entrepreneurs and VC use a “Magic Number” to judge SaaS companies’ success. The theory is that you can only be successful if your annual revenue for a customer is greater than 75% of what it costs you to make the sale.

Sometimes this Magic Number theory starts to sound like hocus pocus — like this excerpt from Scale Venture Partners blog — but the meaning is about the same.  Invest no more than a dollar today to make at least 75 cents over the year ahead:

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 good rule of thumb doesn’t have to always be right, but it ought to be true more often than not. Unfortunately, this SaaS Magic Number turns out to be way oversimplified and quite misleading.

My friend David Brode did the calculation long hand using Net Present Value (NPV) and agrees.  As you may know, NPV calculates the value of cash flows over time. Brode found that the magic number “can give both false negatives (indicating you’ve got  a good business when you really do not) and false positives (indicating you’ve got a bad business when you really do not).”

Why? A couple of things that a rule of thumb cannot take into account are the timing of customer payments (do they pay monthly, quarterly, annually?) and the churn among customers (how many dropped out and were replaced). A good NPV model is the only way to know the true value of your SaaS business.

Fortunately, it’s not hard to create a great SaaS Business Model Excel spreadsheet that calculates NPV. I’ve attached file here for you to download and play with. This is a free NPV model for a SaaS business and I’ll be happy to help you adapt it to suit your business.  Call a FUSE Finance CFO today!

DOWNLOAD THE FREE SaaS Model – Net Present Value for Simple Web Business

Dedicated to your (positive NPV) profits,  David Worrell

[With thanks to my friend David Brode, a business valuation and financial modeling expert in Boulder, Colorado and online at at www.BrodeGroup.com!]

photo credit: FutUndBeidl via photopin cc

9 Comments
  1. Hello! Thank you for a wonderful, straightforward spreadsheet! I noticed that NPV formula in cell E29 has a negative sign in it, which turns the model upside down and confuses me. Just wanted to let you know and understand the rationale.

    • Thanks Olga:
      You earn a gold star today!
      I found two errors in my original file and have fixed them both.
      The download is now correct.
      Cheers,
      David

  2. Thanks for the great workbook. What is the definition of “Base Case Number” and how is it factored against Subs opening and new? I’m a bit confused on your terminology.

    Thanks

    Sean

    • Thanks Sean!
      I’m not sure where you are getting “Base Case”.
      I’ll reply to you via email and see if we can answer your questions.

  3. How did you come up with a discount rate of 12%?

  4. How did you come up with a discount rate of 12%

    • Thanks Valerie:
      Good question — as you know, every NPV needs a discount rate. It’s the “rate of return” to which we are comparing the new business. You can, of course, pick almost any number and it will change the results accordingly. It’s been a while since I made this model, but 12% is in the ballpark for the rate of return that many entrepreneurs strive for in their day-to-day business. It’s lower than an outside investor might want (which has been quantified by Pepperdine University as 28%) and higher, of course, than any return you can safely get at the bank or stock market. Since it’s in the middle, it seems like a safe discount rate to me… but everyone has a different basis for measuring success.
      There may have been more to it than that, but at this time that’s my recollection. If you have a different logic, please share it. I’m sure that there is no one right answer, and invite all inputs from readers!
      David

  5. You plugged in =NPV($E$27/12,E22:BL22) Why are you dividing the discount rate by 12?

    • Thanks Jordan:

      The discount rate is an annual percentage rate, whereas the cash flows in the table are monthly results.
      So the NPV has to make them match up — dividing the discount rate by 12 is a quick way to estimate the interest rate “per month” and use it to calculate the Net Present Value of the monthly cash flow.

      Thanks for the question!
      David

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