The systemic shocks caused by the current crisis have destabilized traditional macroeconomic assumptions and scenarios to forecast market demand and long-term revenue. Will stock markets remain resilient? Will the historic fall in global trade rebound? Will embattled business sectors revive? Will unemployment ease?
The answers to these and other questions typically can be found in historical and real-time economic data trends. But the shifting nature of economic data in the current crisis weakens the reliability of macroeconomic models. This risk is evident in the more than half of companies in the S&P 500 that either withdrew or reduced their earnings guidance at mid-year.
Given these impediments, it is not surprising why CFOs in a recent survey cited planning and forecasting as their most pressing concern. Drawing assumptions from the organization’s pre-pandemic results in a highly uncertain economic environment that could mark the beginnings of a permanent shift in demand, many CFOs were forced to prepare multiple forecasts, each one positing a different long-term recovery scenario, according to a mid-September report by Deloitte.
There is one group of CFOs, however, that has not been encumbered with the same forecasting difficulty. Software companies that generate recurring revenue on a software-as-a-service (SaaS) subscription effectively dodged the planning and forecasting ambiguities confronting other industry sectors. My company fits this profile. In conversations with other CFOs whose organizations also provide enterprise-focused mission-critical software, the “stickiness” of subscribers made projecting revenues and earnings a walk in the park, by comparison.
Preliminary findings from the latest Subscription Economy Index affirm that recurring revenue models increase customer stickiness: While S&P 500 companies experienced a 10% annualized decline in sales through the first half of 2020, subscription revenue expanded at a 12% rate. A late-July report by Gartner came to a similar conclusion, projecting that SaaS revenues would reach more than $140 billion in 2022, up from $102 billion in 2019.
A factor in the SaaS industry’s resilience during the crisis is the mass migration of employees from offices to homes. The appeal of software tools available in the cloud anytime, anywhere, has long been a key marketing strength. Suddenly, everyone at once demanded this access and flexibility, lifting the fortunes of many SaaS providers.
While CFOs in several other industry sectors (and tech companies that sold software products on a one-off basis) struggled to interpret the impact of demand curves on revenue, the predictable flow of customer income at regular intervals made such analyses vastly simpler for CFOs of SaaS businesses.
At my company, a provider of finance and accounting automation software, we used our tools to close the books and issue the earnings guidance in less than three days — on a remote and entirely virtual basis. By virtue of having automated our data flows and closing process, the finance team can focus more of their time on forecasting and managing uncertainties. Like other SaaS businesses, we’re confident recording our future revenues, given the near-certainty of recurring payments over the duration of our subscription contracts.
My interest in subscription-based services on a recurring revenue basis derived from SaaS legend Steve Cakebread, the CFO that created the model at Salesforce and took the company public in 2004. If Steve hadn’t done the hard work developing some of the first subscription accounting and finance systems, Salesforce wouldn’t be the company it is today — a new member of the Dow Jones Industrial Average.
In reviewing CFO job offers early in my career, my number one requirement was a recurring revenue model. The pandemic’s impact on planning and forecasting has validated the wisdom of narrowing my options.
Managing the Downsides
Like all things that appear too good to be true, subscription-based models have their drawbacks. There is no guarantee that recurring revenues will continue indefinitely. Unlike power and water utilities that also provide mission-critical services on a recurring revenue basis, SaaS customers have alternatives.
SaaS businesses also have significant cash flow and gross margin risks, especially in the early years following their launch. Whereas on-prem software providers are paid a lump sum upfront for multiple years of a product license, SaaS businesses are paid incrementally. Since payments are delayed over time, this produces what is referred to as a “SaaS cash-flow trough.”
This trough can be deep, given the time it takes to recover the investments made in the quality of the services provided. The solution is twofold. SaaS businesses need to be highly capitalized, especially at the outset of launching the recurring revenue model. And since the pricing reflects the lifetime value of the product, providers must continually introduce new or improved product features that increase customer retention and subscription renewals.
Assuming adequate capital, appropriate pricing, and continuous product improvements, CFOs of SaaS businesses can effectively manage the risk of sales attrition to generate a consistent stream of revenues. Armed with this knowledge, they will have a direct line of sight into long-term market trends to posit a single forecast that can be relied upon.
Mark Partin is the CFO of BlackLine, a publicly traded company that provides finance and accounting automation solutions in the cloud.