Have you looked into financial models for your SaaS startup? Learn how they can give you a deeper understanding of your business.
Did you know that end-user spending at software-as-a-service (SaaS) companies is expected to grow by nearly 17% in 2023?
If you’re a SaaS entrepreneur, you can make sure your startup capitalises on this growing demand by testing your assumptions with a financial model.
In this article, we find out what a financial model is by comparing it to financial projections, and we will outline key metrics and approaches that you can use to create your own SaaS financial model.
Financial modelling is when you build mathematical models to represent the potential performance of your company.
It’s an abstract representation of your business that captures its financial position. The idea is to theoretically expose your business to several realities, such as changing prices or the number of new customers, and to estimate its performance under each.
These models are then used to evaluate investment opportunities, make business decisions, and communicate financial information to stakeholders.
The Difference between Financial Projections and Financial Models
Financial projections estimate the future performance of a company based on current business assumptions. This is done by analysing revenue and expenses, and including financial statements such as a cash flow statement or a projected income statement.
Let’s use an example to illustrate this. Imagine you have a SaaS company that helps freelance developers manage their workload.
Based on historical data, you expect to maintain an average of 20 subscribers each month and the average revenue per customer is £100 per month. This results in revenue of £2,000 per month, or £24,000 per year.
You then calculate your direct costs, such as your development costs and operating expenses, which may include items such as hosting fees, software subscriptions, and marketing expenses. This amounts to £1,500 per month or £18,000 per year. Your financial projection would then suggest an annual profit of £6,000.
Similarly, a financial model will also rely on business assumptions, such as the average number of subscriptions and average monthly revenue. However, modelling is when you bring uncertainty into your projections. It shows you how your business might perform under different circumstances.
There needs to be a variable change in the example, such as a change to your cost structure. If the interest rate rises and costs go up, how many clients will you need?
Let’s return to the above example. After meeting with your product team, you learn that your target market might benefit from new invoicing software. To justify including this in your product offering, you decide to create a financial model to determine its viability.
Your financial forecasting model assumes that the average number of subscribers remains constant, but they are willing to pay £50 more each month to use the invoicing service. This will lead to an additional £1,000 in monthly revenue or £12,000 in annual revenue.
However, building the invoicing software will increase your development costs by £500 each month, adding up to a total increase of £6,000 per year.
This means that you’re left with around £6,000 in additional annual profit if everything goes as planned.
From here, you might decide to model different scenarios based on assumptions around interest rate changes.
For example, you find that if interest rates increase, you might lose some clients, due to the fact that higher interest rates increase the cost of debt for consumers and cause them to decrease their spending. Conversely, if interest rates decrease you model that your subscriber base will increase.
With these–and other–results in hand, you’re able to decide whether it’s worthwhile to add invoicing software to your current product.
Note that both financial projections and financial models only lead to estimates, and they don’t represent actual results. You should regularly review and adjust expense projections so that your models are as accurate as possible.
Why Are Financial Models Important for SaaS Startups?
As a startup entrepreneur, you will face unique challenges such as attracting potential investors to launch your business and distinguishing your service from fierce competition in the market.
“Accurate and detailed financial modelling forms the backbone of any successful startup’s decision-making processes.”
Maarten Mantel – Director of Finance at MOHARA
A financial model can help you overcome these challenges by giving you insight into your service and an understanding of the environment in which it’s being launched.
Investors respond positively to financial models because it shows them that:
- 🏆 The business is in capable hands: By preparing a good financial model for your company, you will demonstrate that you have a solid understanding of your old and new customers, market, and revenue options. This will make investors feel confident in your ability to successfully run the business.
- 🏆 The risks have been considered: Financial models will also help you identify the potential risks that your company will face, such as high expenses or low customer retention. Once you’ve established this, you can outline ways in which to overcome them.
- 🏆 There’s evidence of future performance growth: Your startup’s financial model will outline numerous scenarios proving the financial viability of your business idea. It will show investors how it has the potential to expand and helps to guide the valuation of your business.
Your startup’s financial model will facilitate the negotiations you have with your investors. It will help you explain where their resources will go, and validate your business idea.
It will show them how you intend to secure your serviceable obtainable market (SOM), and even capture your serviceable available market (SAM), or total addressable market (TAM).
By presenting this, you will prove your business’s value in the market and encourage further investment.
However, the benefits don’t stop there. Financial models will help you steer your business in the right direction by allowing you to:
- 👍 Fine-tune your budget: By considering different financial models, you will get an understanding of where your money will go. This is particularly important when you’re starting, because you need to make the most of your limited resources.
- 👍 Validate key business decisions: Before you act on an idea, you can run it through a business model to find out whether it will work. This can protect you from making decisions that might sink your business in the long run.
- 👍 Offer alternative data: Since SaaS startups have recurring revenue streams rather than one-time sales, it can be difficult to create accurate financial projections. By using a good financial model, you can ensure that your business is still able to test difficult assumptions and multiple scenarios.
Key financial metrics you should track to create a SAAS financial model
Before you create a financial model for your SaaS business, you need to gather data that can be used to draw your assumptions from.
Early-stage startups in the SaaS industry function differently from traditional businesses, which means that you will need to track metrics that are relevant to this business model.
One thing to note is that you only need to start tracking metrics when they become relevant to your business, for example, you won’t need to start tracking your customer acquisition cost (CAC) when you are just starting out, as you probably won’t yet be spending on marketing or sales.
These are some of the most important financial metrics that SaaS startups should track:
- 📊 Monthly Recurring Revenue (MRR): This is the amount of revenue your business earns each month from its services, such as subscriptions from monthly customers.
- 📊 Annual Recurring Revenue (ARR): This is the annual revenue your company makes. Calculate this by multiplying the MRR by 12 months.
- 📊 Customer Acquisition Cost (CAC): This is the cost of winning over new customers. It may include the cost of your marketing efforts or sales team expenses.
- 📊 Average Revenue per User (ARPU): If you have different subscription tiers, then you can calculate the average amount of revenue your company earns from customers.
- 📊 Lifetime Value (LTV): New customers can only spend a finite amount of money on a product during their lifetime. This is their lifetime contribution to your business.
- 📊 Churn Rate: This is the rate at which old or new customers cancel their subscription to your services, or decline to renew their contract with you.
- 📊 Burn Rate: As a startup company, your business might rely on funding. Burn rate is the rate at which your company “burns” through its funding in an effort to accumulate market share and grow its revenue. On the surface, it might look like a loss, but it’s an investment in your company’s long-term profit.
Approaches to Financial Modeling for SaaS Startups
Once you have calculated the financial metrics that are most relevant to your business, you can start creating your startup’s financial model.
There are many methods and techniques you can use to achieve this. The route you choose will depend on the kind of business you have, the stage it’s in, and what you’re trying to achieve by creating a model.
For example, if you know that the investor you’re about to pitch your business idea to is interested in startups with high growth potential, you might lean towards an approach that will demonstrate this.
Here are three effective approaches to financial models for startups:
💡 1. Sensitivity analysis
Sensitivity analysis determines how responsive your business is to change. You can do this by making changes to your assumptions, such as your MRR or churn rate, and seeing how this might impact the financial outcome of your business.
Let’s return to our example where you have a SaaS startup that helps developers manage their workload. After continuing to work on your financial model, you determine that at an interest rate of 10%, you’d need at least 25 customers in order to make your new invoicing software profitable.
By applying sensitivity analysis to this, you might test how your model will respond to slight changes in this interest rate. For example, you might calculate whether your new product will continue to be viable if the interest rate is 9% or 11%.
Taking note of the sensitivity to these changes will give you valuable insight into your business. It allows you to see how a single assumption impacts your business as a whole.
💡 2. Scenario analysis
Scenario analysis is when you test multiple scenarios against your assumptions. This may include comparing a best-case, worst-case, and base-case scenario of implementing a new idea.
For instance, if you’re feeling confident about implementing the invoicing software to your product offering, it might be helpful to consider the possible outcomes.
Your best-case scenario might be that all 20 subscribers will sign up for this additional service, while your worst-case scenario might be that none of them will be interested in it.
Before you green-light the invoice software, you should have a contingency plan for your worst-case scenario. For example, to help mitigate the costs, you might be able to form a partnership with another company that would be interested in making use of the software if your subscribers don’t take to it.
💡 3. Break-even analysis
Break-even analysis is when you determine the minimum amount of revenue or sales you require to cover all your variable and fixed costs to break even.
Your goal is to calculate the point where your total revenue equals your total expenses. This will help you determine the bare bones of what you need to do before you can start earning a profit.
When we first calculated profit for our SaaS startup example, we determined that your expenses added up to £18,000 per year.
This means that when the revenue you earn from subscribers equals £18,000, you will have reached your break-even point. This amounts to having at least 15 subscribers per month before you will start making a profit.
This is an important calculation for startup companies, because it will help you set out performance metrics for your business.
“In summary, financial modelling is essential for SaaS startups to plan for growth, manage cash flow, make informed decisions, and secure investment. It is a critical tool that can help startups achieve long-term success in the highly competitive SaaS industry”.
Maarten Mantel – Director of Finance at MOHARA
MOHARA Can Help
Creating a financial model for your early-stage startup is no easy feat. It takes time and dedication. However, it can also pay off in the form of increased investment in your idea.
At MOHARA, we use a sweat equity model to invest in up-and-coming startup companies, and we would love to learn more about you and your business.
Our team has over 10 years of experience in the SaaS startup space, and we have helped many businesses successfully launch and grow their products.
Get in touch and let us know how we can help you.