B2B SaaS is a trend topic in venture capital these days as an increasing number of new funds is focusing on B2B startups. Especially B2B SaaS startups are doing their best to compete for the attention of venture capitalists and angel investors. Of course, investors are reciprocating because the segment shows unprecedented potential for capital efficiency, greater profitability as well as faster exits, mergers and IPOs.
A lot has been written about key business metrics of B2B SaaS startups and how to track and manage these KPIs. One of the most underrated factors for scaling your software startup are the payment terms you are offering to your customers. This article tries to shed some light on the implications of different payment options and why they could really make a big difference for building up your company.
The Case of a B2B software startup
I will focus on revenue, customer acquisition cost (cac) and cashflow and neglect all other operating expenses for the sake of this article. Let’s consider a (very) simplified version of a software as a service startup with the following unit economics:
- CAC @ 3.500 EUR
The company is spending 3.500 EUR for each new client subscribing to its software.
For simplification lets assume that the money is spent in the same month in which the client starting its subscription. A customer subscribing to the service in June will cost you 3.500 EUR in June and will generate revenue also from June on.
- Pricetag @ 500 EUR per month
Let´s assume the startup is targeting SMEs and has defined a price of 500 EUR per month per client (no pricing per seat) to use the software.
So, let´s asses the economic profiles of monthly, half-yearly and yearly payment options. Before we can do this, we need to clarify some basic terms relevant for all SaaS businesses.
Bookings vs. Billings and Revenue vs. Cashflow
Bookings are made by clients, who subscribe to your B2B SaaS product and represent an obligation to pay for using your service over the subscription period. They are comparable with the normal incoming orders in other businesses. E.g. a client might book a 4-year SaaS subscription. You cannot find bookings in the balance sheet as long as they are not billed to customer.
Revenues are recognized on a monthly basis over the subscription period and represent the portion of the booking that has already been “delivered” to the client. As an example, think of a one-year subscription period. Each month 1/12 of the contract value is recognized as revenue. The rest is shown as deferred revenue in your balance sheet. Whether or not the customer pays in advance, revenue is always recognized on a monthly basis as the software is delivered to the client.
Billings refer to the invoices the company issues towards the client for a certain period. The billing period might be yearly, half-early or monthly.
Cashflow is the actual payment made by the client. This can vary from doing monthly payments to paying a multi-year contract in advance. Advance payments need to be accrued as a liability in the balance sheet. It is then dissolved over time as revenue is recognized.
Revenue Recognition in B2B SaaS subscription businesses
SaaS companies require customers to subscribe, as opposed to software companies, for whom the transaction ends after the initial software delivery. Because the customer is still in a subscription period, the service cannot be deemed as (fully) delivered as delivery happens each period (e.g. monthly).
Accordingly, revenue is recognized in the companies Profit & Loss statement on a monthly basis. The rest is accrued. Revenue recognition happens over the time of the subscription.
As a starting point let’s take our simplified example startup with the following setup:
Subscription Period = monthly
Price per month = 500 €
Billing & Payment = monthly
Customer start date = 1st June 2020
Revenue is recognized over the 12 months of the contract in which the software is “delivered” to the client. The client receives a monthly invoice. Cash comes in on a monthly basis in the example.
How longer payment intervals change the picture
The picture changes whenever the subscription periods and payment intervals become longer. Then advance payments and deferred revenues have to be shown on the balance sheet. However, revenue is still recognized over the 12 months of the year.
Continuing our example from above, let´s see how this changes the company’s financial statements:
Subscription Period = yearly
Price per month = 500 € (6.000 € per year)
Billing & Payment = yearly in advance
Customer start date = 1st June 2020
While revenue recognition is not affected by the longer payment interval, balance sheet and especially cashflow look very different now. The advance payment received is recognized as a liability (deferred revenue) and dissolves over time.
From an investors point of view, only looking at revenue does not give you the full picture. Especially for early stage startups liquidity is one the most critical business KPIs to follow. First, revenues recognized in the financial statement might not be representing future cashflows as they might have been prepaid. Second, as you cannot see the bookings from the balance sheet you need to understand whether there are future revenues and cashflows from existing (uncanceled) subscriptions.
Deferred revenues give you a concrete hint that longer-term contracts exist, which result in future revenues. However, you need to assess all the existing bookings (a.k.a. back-log) to fully understand the economic situation of the company.
As a startup trying to attract venture capital investors you need to communicate precisely your bookings, billings, revenues and cashflows. For your own interest build a reliable and transparent financial model around your business case.
Cashflow and Growth Financing in B2B SaaS
Billing and Payment terms are not only important for accounting and controlling purposes. They have a tremendous impact on scalability of the business and on capital efficiency.
Founders are well advised to carefully assess not only pricing but also their payment terms. Getting paid as early as possible will decide whether or not you need to raise a ton of money in exchange for precious equity.
I will continue the above example to demonstrate the implications different payment terms can have on your business. Remember the setup:
- CAC @ 3.500 €
- Pricetag @ 500 € per month, per client
Here is how revenue, customer acquisition cost and cashflow look like for monthly, half-yearly and yearly payment terms on a unit economic basis:
As you can see from this very simplified example it takes you 7 months to recoup the cash outlay for the customer acquisition cost if you go for monthly payments. So, the firm needs to pre-finance this period before a client becomes cashflow positive. With yearly payments on the other hand, the customer is cashflow positive the moment the company makes the sale. The shorter the payback period, the earlier the client is not consuming cash but yielding positive cashflows. The earlier cash can be reinvested into growth the better.
So, what does that mean on a higher scale for the company’s business?
Implications on fundraising for your B2B SaaS business
Consider the above unit economics at scale and you will see that payment terms have a huge impact on the need to raise funding for your B2B SaaS business. Building on the above example let’s consider this slightly adapted business case of a strongly growing company:
- Acquiring 25 clients per months with a growth rate of 10% month-over-month
- CAC @ 3.500 €
- Pricetag @ 500 € per month, per client
- Sales Cycle = 1 month
- Payment options to be considered = monthly, half-yearly and yearly
- For simplicity we neglect all other costs as well as customer churn
I will start with looking at Profit & Loss. Remember that revenues are recognized on a monthly basis and that this true for all payments scenarios as payment is independent from revenue recognition.
Looking at the cashflows resulting from the monthly, half-yearly and yearly payment terms you can see the significant differences:
The cash outlay for customer acquisition cost is the same in all three scenarios. While cash outflow is the same, the cash inflow as well as the total cumulated cashflow varies significantly.
Monthly payments force you to pre-finance your customer growth a lot more than the other options. In our example it takes 22 months to become cashflow positive with monthly payments. With half-yearly payments its only 11 months and with yearly payments only 3 months.
The total cumulated cashflow over a period of 24 months varies also significantly. After 2 years with monthly payments the total cumulated cashflow stands at 526.000 EUR. With half-yearly payments its ca. 5,5x times more and sums up to 2,9 Mio. EUR. With yearly cashflows the amount soars to ca. 6,15 Mio. EUR. Money that can be re-invested to fuel further growth or cover your operational expenses.
With monthly payment terms it would need ca. 603.500 EUR in cash to generate the revenues. The financing need reduces to ca. 231.5000 EUR with half-yearly payments. With yearly payments it boils down to 87.500 EUR in cash needed.
That’s why getting your money in advance is always a good idea. In any case companies should carefully think about the payment options they offer as they will have a direct influence on scalability, fundraising and valuation of the company.
So, entrepreneurs should create incentives for customers to go for cash advance payments (e.g. discounts)!
Benefits of advanced payments in B2B SaaS
It can be difficult for B2B SaaS businesses to walk the line between customer satisfaction and cashflow generation. They want to offer attractive payment terms to encourage people to choose them, but they also want to generate cash to invest in their day-to-day operations and future progress.
However, going for longer payment intervals has some striking benefits:
Catalyst for growth
A startup’s growth opportunities increase when it has a stable cash flow. An advanced payment allows the startup to accept the entire billable amount in one go and reinvest it into the company.
It will take away your need to seek further investment, which will increase your value.
If you offer discounts, it may further ease the burden on your customer as they would pay less upfront, as compared to if they paid per month or per quarter.
Customer commitment and lower churn rates
Customers agreeing to longer payment periods show more trust in your company and commit to the service you are offering because they have to justify their money spent. Asking for an annual upfront payment is also a good test how valuable your B2B SaaS product is in the eyes of your clients.
The longer they use your service, the more dependent they will become and the more time they have to perceive the value your product is delivering. The time they spend working with your software is irreplaceable and decreases your client’s will to look for a replacement unless you have provided inadequate service.
This will result in less churn and help the customer extract maximum value from the service.
Protects Equity and Enables other forms of financing
Venture Capital firms offer investment in return for equity or revenue. Most B2B SaaS startups leverage their equity for initial investment and growth opportunities. Longer term customer contracts will allow you to look for revenue-based investment.
Revenue-based financing allows you to acquire funds in exchange for a share in your future revenues. This will protect your company’s equity and still allow you to raise finances. For further information see:
Limits Renewal Intervals
An enhanced commitment to the company will keep your customer from contemplating hiring another service. An advanced payment on an annual plan means restricting your customer to one decision point, which will be at the end of the subscription period. Any other payment plan would offer the customer multiple intervals where the board could review and find your service inadequate.
An advanced payment would have been a massive incentive for growth for the case study mentioned earlier. However, there are a few obstacles on the way to receiving advanced payment and using it to your advantage:
- Higher Sales Hurdle
To convince your customers to sign off on a large one-time payment, your sales representative must be persuasive. They have to offer incentives while protecting your long-term finances.
- Trust Issue
Customers might not want to pay a large amount to a new startup as they do not trust in the company or are afraid that the startup goes bust in the course of the contract, not delivering what it has promised. The closer your B2B SaaS product is to the core business process the more relevant this question will become. Don´t underestimate that the person you are selling to needs to justify the decision to hire e startup.
Key take aways
Don’t be afraid to negotiate payment terms
It is important to offer different payment options to various clients, depending on when you need financing:
B2B SaaS clients of different size need different payment options
- Small Clients: Negotiate for monthly payments with smaller clients. In case you ask for an advanced payment, they should have the liquid capability to pay you. The more you churn, the higher your CAC; thus, do this smartly.
- Small and Medium-Sized Enterprises: Because their capabilities are higher than those of a smaller company, negotiate a quarterly or half-yearly payment plan with them. A more extended period of association with them may also be beneficial for your company.
- Large-Scale Enterprises: Begin negotiations with them on an annual payment method because of the value of retaining a client of this size. The large lump-sum is also something they can afford and would be a monumental addition to your liquid capabilities at the start of the year.
Deciding on a longer payment interval will give you more of a cash flow to work with while giving you more time to execute the deliverables and invest in other resources for growth.
Communicate with clients
Discuss the payment options with your client. Bring them in on the conversation, educate them on the pros and cons. It is crucial for you to help them make the best decision for them and you.
Build assumptions around each payment option on your financial model to understand the implications on your fundraising needs.
Get your payments in Advance as and when possible
Advanced payments are essential for the growth of a SaaS business – exercise your company’s diplomatic strengths to ensure that you can secure them.
The best incentive is a discount. To convince a company to pay you a large lump-sum amount upfront, it has to be lesser than what they would pay you on a monthly basis.
It might also be a good idea to work with a trustworthy business development representative to communicate with customers because they can help you build trust.
If you’re a SaaS business focusing on growth, it would be beneficial to incentivize various payment options and negotiate advanced payments, boosting your growth by increasing your cash flow!