Warning: preg_match(): Compilation failed: quantifier does not follow a repeatable item at offset 10181 in /home/wovenare/public_html/blog/wp-content/plugins/powerkit/modules/lazyload/helpers/helper-powerkit-lazyload.php on line 146
Introduction
There are different software offerings in the market. While many solutions may try to tackle one problems, pricing may vary among providers. In the past, companies like Microsoft have been known for offering off-the-shelf solutions that are paid for only once. E.g. MS Office for $200. You buy it once, and as long as your computer is alive and kicking, you get to use it. Other companies like Google offer a service that is invoiced on monthly basis. E.g. Google Apps for $5 per month per user. While both of these products address the similar user needs, they have very different cash flow streams. One is the one-time sale (“OTS”), while the other is known as Software-as-a-Service (“SaaS”). Both have advantages and disadvantages. In this post, we are going to identify and compare the basics of cash flow behavior for the One-Time Sale and the Software-as-a-Service models. Hopefully after this post, entrepreneurs exploring revenue models for their project will have a starting point.
We start by identifying development costs and expenses. Both models must incur in development costs and this is not particularly affected by the sales model selected. The product must be coded and these costs are normally paid up front, as you will need to hire developers to start coding your product before its ready for the market. In this example, we are assuming our product development will cost $500,000.
Five Examples – Total Cash Flow + Break-even point
Example #1
In our base case, we assume the follow:
| Assumptions – Ex. 1 | Software-as-a-Service | One-time Sale |
| Development costs | $500,000 | $500,000 |
| Sales price | $25 / month | $300 |
| Sales & Marketing expenses | 15% of sales | 15% of sales |
| Customer service & warranty | 15% of sales | 15% of sales |
| New clients per month | 1,000 | 1,000 |
| Churn rate (clients cancellations) | 0% | 0% |
Our development costs are the same, the sales price is $25.00 a month for the SaaS and $300.00 (12 months at $25.00). Our marketing, customer service and warranty expense adds up to 30% of our monthly sales and we manage to get 1,000 new clients per month, without losing any clients (“churn”).
Figure 1
As you can see, there is a big difference between the two models. While the variables are quite similar, the fact is One-time Sales generates 12 times more cash flow due to the upfront payments. Total net cash flow generation at December is $2,020,000. Which is $1,155,000 more than the SaaS model would generate ($855,000). Total cash flow generation is one of the most important factors when analyzing the different models.
This is true because the 1,000 clients acquired in December through the SaaS model still need to pay for 11 months, in order to generate the total cash flows that the OTS would generate. The 1,000 clients acquired in November still need to pay for 10 months, in order to generate the total cash flows that the OTS would generate… and so forth.
Total cash flow generation is one of the most important factors when analyzing the different models. The second important factor is the break-even date. The break-even date answers when the total product sales provide enough cash to cover all the development costs. As the Figure 1 shows, OTS breaks even somewhere between February and March, while the SaaS model barely crosses the mark in August. If you have third-party financing (investors, bank loans, etc.), this is an important metric.
Example #2
In our second example, we assume the same facts as Example 1, except that only half of the clients accept the OTS model, 500 new clients a month. While we are not basing this on hard data, we can assume that because many clients have not tried the product, 50% of them would not pay the full price. In other words, asking for $25.00 is a lot easier than asking for $300.00.
| Assumptions – Ex. 2 | Software-as-a-Service | One-time Sale |
| Development costs | $500,000 | $500,000 |
| Sales price | $25 / month | $300 |
| Sales & Marketing expenses | 15% of sales | 15% of sales |
| Customer service & warranty | 15% of sales | 15% of sales |
| New clients per month | 1,000 | 500 |
| Churn rate (clients cancellations) | 0% | 0% |
Figure 2
Decision makers will not lean towards the OTS model so swiftly with these assumptions, would they? Analyzing total net cash flows, the SaaS model now generates $865,000. Which is $105,000 more than the OTS model. Still, the total cash flow generated by the OTS model in Example 2 is $760,000, or $1,260,000 less than Example 1. ($2,020,000). Furthermore, the break-even point for OTS is somewhere in May (instead of February) and the SaaS model’s break-even date stayed at August.
Example #3
Example 3 uses the same assumptions from Example 2, except we add a “Churn rate” of 5% to the monthly clients. In other words, the software is pretty awesome, but 1 out of 20 clients cancel subscriptions every month. Churn is normal in subscription based models. There might be a period where the company experiences no churn, but eventually, clients will start leaving. While some of the reasons can related to the product per se, some other times it is really because the company has completely independent motives not related to the product (Ie. Client closes operations, client no longer needs to the software, client is acquired and holding company uses your competition’s service, etc.)
| Assumptions – Ex. 3 | Software-as-a-Service | One-time Sale |
| Development costs | $500,000 | $500,000 |
| Sales price | $25 / month | $300 |
| Sales & Marketing expenses | 15% of sales | 15% of sales |
| Customer service & warranty | 15% of sales | 15% of sales |
| New clients per month | 1,000 | 500 |
| Churn rate (clients cancellations) | 5% | 0% |
Figure 3
By taking into account the churn rate for this product, the OTS model generates $760,000. Which is $116,605 more cash flow than the SaaS model ($643,395) . This should be easy to understand, since you are catering to a lesser amount of clients.
Example #4
Again, we maintain the same assumptions of Example 3, but add a 20% discount to the OTS model sales price to lure clients into paying a lump-sum. Like mentioned in Example 2, selling OTS for $300.00 is more difficult than selling a $25.00 a month SaaS. So, in order to provide them an incentive to go for the OTS rather than the SaaS, we provide them with a discount for paying upfront.
| Assumptions – Ex. 4 | Software-as-a-Service | One-time Sale |
| Development costs | $500,000 | $500,000 |
| Sales price | $25 / month | $300 – 20% disc. = $240 |
| Sales & Marketing expenses | 15% of sales | 15% of sales |
| Customer service & warranty | 15% of sales | 15% of sales |
| New clients per month | 1,000 | 500 |
| Churn rate (clients cancellations) | 5% | 0% |
Figure 4
These assumptions have changed the game again. Total net cash flow for the OTS model is $508,000. Which is $135,395 less than the SaaS model ($643,395). Our break-even point for the OTS has moved from May to June. That means that while we are generating less cash, it will take up one month longer to recover the investment. Again, a change in our models can convince us to change our strategy between selecting an OTS or SaaS model.
Example #5
In our last example, assumptions of the prior example remain unchanged, except for the total marketing and customer service / warranty expenses. We are assuming that the OTS model cost for marketing and customer service / warranty expense is 20% instead of 15%. We assume that because selling at $240.00 is more difficult than selling a $25.00 monthly service. So, we modify the pay structure because we need more aggressive and incentivized sales rep.
We change the commission assumption, but in reality this can be anything. We just used sales & marketing to express how important small changes in the structure change the cash flow models…
| Assumptions – Ex. 5 | Software-as-a-Service | One-time Sale |
| Development costs | $500,000 | $500,000 |
| Sales price | $25 / month | $300 – 20% discount = $240 |
| Sales & Marketing expenses | 15% of sales | 20% of sales |
| Customer service & warranty | 15% of sales | 15% of sales |
| New clients per month | 1,000 | 500 |
| Churn rate (clients cancellations) | 0% | 0% |
Figure 5
Total cash flow for the SaaS model is $643,395. Which is $207,395 more than the OTS model ($436,000). Our break-even point for the OTS has moved from May to July, taking one month longer to recover the investment than in our previous example.
Summary
While this post barely scratches the surface of Software Revenue Models, with these five (5) basic examples, we can visualize the differences between a subscription model or software-as-a-service (SaaS) and One-time Sales (OTS) models. It is important to understand how little changes in your cash inflow and cash outflow structure can completely change the profitability and risk of your project. After doing small tests within you sales organization, whether by asking your team, current customers, or prospective clients, and plugging them into your financial model; you can better assess which model will adjust better to your organization’s goal. One thing is for sure, the market is currently shifting towards the subscription-based model. Most clients will prefer to do a smaller investment in your product, while having the flexibility to cancel if they are not happy with the service or the service does not adjust to their organization’s needs. This shift is now obvious in most consumer software products. For the enterprise customers it is less obvious, as many of these developments are custom-tailored to the organization’s needs.
There are many issues that have not been addressed in this post. Our goal with this first post was to set the basis for comparison between OTS and SaaS models. In our second series we will address the metrics and other terminology frequently used within the software industry. We will also visit some of the benchmarks executives, entrepreneurs and investors are using when deciding in which software development to pour their money and energy.
Note: If you want me to send you the Excel with the formulas for this post, or if you have questions or comments, do not hesitate to contact us by clicking on the following link.
