Financial Modeling for Software-as-a-Service Businesses

Source: Nick Hammerschlag

The four key elements of successful financial modeling are: simplicity, flexibility, improvisation, and an underlying economic model!

Creating a basic financial model does not have to be a daunting task, though it can often turn into one. I can’t count the number of business models I’ve received from companies that are utterly complex with models inside models, several hundred line items, assumptions that stretch over multiple Microsoft excel tabs — ultimately incapable of allowing me to understand and test the key drivers of the business. Assuming that you have a basic economic model in mind (and one that leads to profitability), I recommend constructing a simple three-tab model to better understand the mechanics of the business.

The point of this exercise is to understand the big picture: the unit economics of the business, the capital efficiency/cash burn, gross margins, etc. Think of your first crack at this as a battleship, not a sniper rifle approach.

Keep it simple, keep it flexible, and improvise if you get stuck!

Create an assumptions or “drivers” tab from which you can drive the model, a sales representative ramp page where you can build out a number of sales people and their productivity, and an output page where you can see what the monthly numbers actually look like.

If you are in the very early stages of business planning, it might make sense to drive all the expense line items (both cost of goods sold and operating expenses) as a  % of revenue. A good sanity check, or even guideline, for those without a sense of their expenses is to use publicly traded SaaS businesses metrics. You may want to use a slightly higher % of revenue than you find in the publicly traded companies as they have achieved scale/synergies and are likely able to have lower costs than you, the small but noble SaaS business.

I also find that it helps to keep the process moving forward, so don’t allow yourself to get stuck in minute details and do resort to plugging in elements like publicly traded metrics. An assumptions page could look like this (note that these are not appropriate values):

The key is flexibility, so that you can test different scenarios by quickly changing or “flexing” different assumptions.

As for revenue, I find it helpful to drive revenue from both the main assumptions page and sales representative ramp assumptions page. On the assumptions page, lay out assumptions for the monthly contract value, churn as a % of revenue, and lag time between awarding of the contract and receipt of first payment. This last component is important for many SaaS businesses as often companies start supporting customers and incurring expenses before they receive payment for services. This could articulate that you need to raise more money to bridge the gap between your expense and receipt of payment, or alternatively, figure out a way for your customers to pay you in a tighter timeframe. For the sales representative ramp page, I think it’s easiest to create something that looks like this:

This way you can make assumptions (and test) different scenarios for the number of sales people on staff, their productivity (i.e. how many contracts they can sell per month) and how long it takes to get them ramped up (i.e. how long are they on staff before they start producing results). Having the visual aid of seeing how many reps you have on staff and what they are projected to produce helps you maintain a more comprehensive view of your sales organization on one piece of paper.

You can then build out each month’s revenue on the third and final tab (the output tab) by creating the appropriate formulas with the various assumptions. The idea is to tweak the model from both the assumptions pages and never change a number manually on the output page!

Building a very basic financial model is a combination of art and science. There are no rules (outside of basic accounting), so don’t allow yourself to get stuck in the details on the first go-around. The beauty of a financial model is that it can be refined and tweaked over time — so long as you’ve constructed one that is sufficiently flexible.