SaaS & Minimizing Buyer Risk

Andreessen Horowitz had a podcast recently on software company valuations. All of their podcasts are excellent by the way and definitely worth listening to when you have some time. This one discussed the fact that, traditionally, big enterprise software deals were sold as "perpetual" licenses. This meant that the enterprise would pay big money upfront for software that could be used forever. This was a nice thing for the seller from an accounting point of view. You'd get big bucks on day one that you could use to pay your engineering team and sales force. Your financials would look really good in that period. The software as a service model (SaaS) is much different. With SaaS, the license is sold as a subscription and revenues and costs are spread out over the life of the agreement. At first glance, the SaaS model doesn't make a seller's financials look so good. When the deal is closed the seller has to pay their engineering team and sales force upfront. All that cash is out the door but the revenue is collected and realized over several years. This is why Castlight Health was called the most overpriced IPO of the century when they went public a couple months ago at a valuation of $1.4 billion on only $13 million in revenue (an outrageous 100x revenue multiple). I don't have a strong opinion on the company or their valuation but what many people in the media missed is the fact that most of that multiple was being driven by the company's "deferred revenue" -- or deals that have been closed but not yet realized from a revenue recognition perspective. Deferred revenue is a critical measure of a SaaS company's health.

I say all of this to make a related point. One of the challenges in selling enterprise software is the buyer's concern about risk -- e.g. a buyer might say "what if we make a big investment in your product and we find that it doesn't work for us, do you provide a guarantee?" When you're selling SaaS (as opposed to a perpetual license) it's important to explain to your buyer that you are totally aligned on risk. The entire SaaS model is built around getting renewals. During the initial contract period, the cost of selling the software likely exceeds the revenue collected so it's critical for the seller to get the buyer to renew. The good news for the seller is that over time the costs are amortized and when the client renews the relationship becomes quite profitable. So the entire model is setup to drive customer renewals -- in many cases, most of the risk is actually on the seller. It's worth explaining some of this simple accounting to a buyer when they push back on risk.

Unlike a perpetual license, the buyer and seller's interests are completely aligned: the buyer needs great software and the seller needs a renewal.