Customer Economics and FCF with Will Sheldon @ Accel

Looking Beyond The SaaS Income Statement

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🍻 Cheers to the end of 2022… $WCLD ended the year down 50%+ as rising interest rates drove investors to pivot from coveting growth to profitability. After years of focusing almost exclusively on topline, operators quickly pivoted to resilience and, in many cases, outright survival mode as multiples crashed and VC funding dried up basically overnight.

The theme of 2023: FCF > Growth at all costs 

Customer economics back in vogue. In under 12 months, the entire SaaS industry had to dust off their customer economics and FCF playbooks (and they were very dusty). From the start of BreakingSaaS, I have always been passionate about customer economics and my piece on FCF (Digging into SaaS FCF) was widely read and well received as a methodology to better understand key SaaS cash flow metrics and forecasting. 

That piece opened the doors to meeting other folks in the industry digging into SaaS customer economics. One of these is Will Sheldon, a software investor based in London who, like me, started his career in equity research. The following post is a summary of a wide ranging conversation we had on everything from FCF and customer economics to billings terms and commissions considerations. Hope you enjoy!

Intro to Will Sheldon

After cutting his teeth in software equity research, Will has spent close to a decade at growth equity and venture capital firms Summit Partners and Accel investing in high growth SaaS companies as they scale up from the early stages to $100M+ ARR. 

• Experience: Principal at Accel (current), formerly at Summit Partners and UBS

• Investment Stage: Multi-stage but typically early growth, i.e. Series A and B

• Exits: Calypso (acquired by Thoma Bravo for $3.75B), Darktrace (IPO, current market cap of $2.3B), Databand (acquired by IBM), Siteimprove (acquired by Nordic Capital)

• Recent Investments: Cyera (cloud data security software), Genesis Global (enterprise low-code software), Insify (B2B insurance platform)

Will’s investment philosophy: “The real magic of the best SaaS companies comes from a solution that customers simply can’t live without - and all of the great entrepreneurs I’ve been fortunate to work with have had a passion for the customer problem they are solving. Strong metrics and financials are important but are only ever the result of customer centricity and business building excellence.” 🎯

Eroding GTM Efficiency and Its Impacts for 2023

SaaS models depend on customer economics... All SaaS business models have at their core a relationship between the cost of acquiring customers and the high margin recurring revenue that these customers bring. ‘Customer Economics’ is the field of trying to understand and quantify this relationship.

One common methodology to measure customer economics and standardize across companies is CAC Payback:

[(Previous Q S&M Expense) / ((Current Q ARR) - (Previous Q ARR)) x Gross Margin] x 12

… but efficiency has now been declining for 3 quarters. Jamin Ball had a great post on Q3 SaaS earnings which, among other things, tracked the median CAC payback for all publicly listed SaaS companies. What’s evident from the data is that SaaS companies have generally been losing efficiency in their pursuit of growth, with the median CAC payback period drifting from <24 months in 2020 and 2021 to close to 40 months as of last reported quarter:

Source: Clouded Judgement @jaminball

Why? SaaS companies are getting hit from both sides: 

• Demand side: A challenging macro environment is leading buyers to hold back on committing to new spend, elongating sales cycles and cutting non-essential vendors.

• Supply side: An unprecedented number of well-funded SaaS companies have emerged over the past ~5 years (largely point solutions) going after the same customer budgets.

Result: Unprofitable SaaS gets squeezed. For growth-stage SaaS companies reliant on venture capital, this can create a painful squeeze: 

1. Less efficient customer acquisition means more capital must be consumed to reach the same ARR,

2. Driving shorter cash runways, and

3. Higher dilution for founders and teams.

How are top SaaS teams responding? Sales and RevOps leaders are pursuing multiple strategies including exiting unprofitable GTM channels, leaning into partner and platform distribution models, and targeted reductions in S&M teams. 

What to expect in 2023: Will believes that SaaS companies with best-in-class customer economics – perhaps underpinned by a unique distribution approach and/or growth flywheel – will be particularly in focus for investors in 2023. 

Customer Economics: Looking Beyond The Income Statement 

Not All CAC Payback Is Created Equal. Most SaaS efficiency analysis today (CAC payback, magic number, CAC ratio, etc.) begins and ends at the income statement. However, what these approaches miss is that two SaaS companies with the exact same CAC payback period can have remarkably different FCF profiles as they grow.

To demonstrate this, consider two fictional SaaS companies at $10M ARR scale, both adding $1M ACV per quarter with an 18-month CAC payback period, 75% gross margin and the same opex base. The company on the left uses monthly billing and the company in the middle uses annual, upfront billing. 

The two companies on the left have the exact same income statement but one is burning cash while the other is generating cash. You generate more cash when you bill upfront? Duh. So what? 

Skewing the billings mix can make a big difference: In practice, many SaaS companies typically have a mix of deal terms and billings timelines (often split between monthly subscriptions and annual contracts incentivised with a discount). While a company might not shift its entire business towards one pricing/billing strategy, gradually shifting towards one methodology or a few large contracts could have a meaningful impact on the shape of your FCF profile. 

The benefits from a FCF perspective are particularly relevant in 2023:

• Reduces outside funding requirements: If you’re starting or growing a SaaS business, you’ll need less external capital (and shareholder dilution) if your customers are partially funding your operations.

• Increases investment potential: Now look at the scenario on the far right. Instead of banking the upfront cash from upfront annual payments, you decide to increase growth investment and drive faster ARR. (Note: this is a simplified example that does not take into account collection timing, AE hiring/ramp schedules, etc.)

Pushing it further: multi-year, upfront? The holy grail of SaaS FCF is if you can get customers to pay multi-year contracts upfront. This is historically how on-prem contracts were priced and billed with smaller maintenance payments made into perpetuity. It's also how many scrappy, resourceful start-ups have gotten their early adopters to fund their product development. The challenge is whether customers will want to make such a big upfront commitment.

What discount rate makes sense when incentivizing long term contracts, paid upfront? It depends on what you are optimizing for (higher near-term cash vs higher long-term total value) and is also partially a function of the risk-free rate, which at around 4% is now the highest it’s been for over a decade. That said, here are some discounts used by a few SaaS leaders with publicly disclosed pricing to incentivise annual billing (vs monthly) for their mid-tier plans:

SaaS Price Discount for Annual Billing vs Monthly Billing

Align Your Operations and Metrics

Metrics aren’t for vanity. They should be designed to reflect economic reality and help with managing the business, making strategic decisions, and forecasting outcomes. 

When you’re in customer economics and FCF mode it's important you’re not cheating, fudging, etc. to impress someone. If you do? You’ll just end up further from the truth when forecasting. 

Besides billings terms, here are a few other things to watch out for when trying to get closer to the true picture on customer economics from a FCF perspective:

Sales commissions GAAP accounting: For contracts longer than one year, ASC 606 / IFRS 15 requires companies to capitalize and amortize sales commission expense for individual sales reps over the length of the contract. Using GAAP S&M in a typical CAC payback calculation would therefore capture smoothed expenses instead of the direct FCF impact. Finance teams with full internal data can build a ‘Cash CAC Payback’ metric which looks at the payback time of ‘cash sales expense’ with the associated customer cash collections. While the data isn’t available to build a full public comp set, I presented a methodology for estimating cash commissions paid for public companies in Digging into SaaS FCF.  

Keep your ARR metric tight. Many SaaS companies like to report CARR or ‘Committed ARR’ which captures signed contracts but can have long lead times or implementations with revenue and cash collections quarters into the future. While CARR can be useful to track, a cleaner ARR metric which includes only live, paying customers will be most useful for getting a good handle on customer economics. 

Aligning sales commissions paid with customer cash collections. One methodology for companies to reduce the impact of the spread between ARR and CARR is to align commissions paid to customer collections. Some companies have found the hold and release structure makes sense. 

Allocating customer success and support correctly. Per the formula above, CAC payback as a metric should be weighted by gross margin, rather than just including top line revenue in the payback calculation. This serves to capture the economic benefit that flows to the company from the acquired customers and also to normalize between companies with different gross margin structures. Industry best practice is generally to allocate ‘customer support’ to COGS and ‘customer success’ across COGS and S&M according to whether the customer success team is focused more on technical support or on driving retention and upsell.

Are Longer SaaS Contracts Better?

If SaaS companies should technically want more cash upfront from their customers, why doesn’t every SaaS company push for long term deals, paid upfront? 

Will pointed to Clearwater Analytics (NYSE:CWAN) as a SaaS company which counterintuitively decided to offer monthly contracts as a strategic decision from inception. This was a differentiator vs. legacy vendors in the space and aligned the company better with their customers. The company operates on a philosophy of ‘deserve to win the customer every month’ and consequently sports an NPS of 60+ and gross retention of 98%.

Jason Lemkin also recently posted on the topic of why annual deals (vs. monthly) can have downsides as well as benefits. Potential drawbacks of any longer, ‘cash-upfront’ contracts include difficulties with cash collections, legal & procurement delays, friction with customer preferences for shorter deals, sizable discounting required to lock in more upfront cash, and tensions with usage-based services which more intuitively would get billed in arrears. 

Longer contracts can be a double edged sword for churn: on the one hand, retention initially looks higher as customers (and revenue) are contractually locked in for longer. However, by masking the ‘underlying’ churn of customers who would prefer to leave mid-contract, SaaS companies risk having dissatisfied customers out in the market damaging their brand, and also losing out on product signals from ‘at risk’ or churned customers which could better inform roadmap and ICP. 

Net / Net

SaaS companies and investors need to adjust their toolkit to unpack customer economics and FCF as we enter the new normal of 2023. The best SaaS companies will keep focused on delighting customers but will likely also adjust tactically to make precious cash go further.

With Blessings of Strong NRR,

Thomas

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