By Eric Mersch
There are many ways to classify SaaS companies, but differentiating companies based upon their customers presents the best approach for assessing and measuring your business. Using a customer-centric definition highlights the key operational differences that drive strategic decision making as well as the relevant key performance indicators.
We typically classify SaaS companies by customer segment, enabling us to better evaluate their needs:
- Small/Mid-Market (SMM)
- Business-to-Consumer (B2C)
In this article, one of three covering each of these SaaS customer categories, we will focus exclusively on Enterprise SaaS companies.
The Enterprise SaaS Company: Definition and Characteristics
Enterprise SaaS companies typically serve the largest customers, companies with revenues above $1B and an employee count above 10,000. We often reference the Fortune 1000 when describing Enterprise SaaS customers. These companies demand robust products designed for mission critical applications for use by hundreds or thousands of their employees. They require high-touch sales engagement and demand high quality services delivered through both customer support and customer success teams.
Enterprise SaaS companies have specific organizational structures designed to meet the demands of serving this customer segment:
- The go-to-market strategy for an Enterprise SaaS company requires a direct sales force consisting of account executives supported by both sales engineers and sales development reps.
- Account Based Marketing is typically the dominant strategy for communicating the value proposition.
- The customer success organization has a much higher profile and is increasingly led by a vice president or even Chief Experience Officer due to the role this function serves in driving expansion and lower churn.
Typically, the Enterprise SaaS product boasts robust functionality and requires extensive integration. To implement the product, the company staffs a strong professional services organization. Implementation time alone can take several months to complete; Time-to-Value will take even longer.
Financial Profile of Enterprise SaaS Companies
From a financial perspective, subscription revenues generate robust gross profits – at a 78% margin. The SaaS professional services profit margin may be 40% or less. In early stage SaaS companies, this line item may even be negative as companies subsidize implementation to acquire customers.
Value of Upfront Payments
A typical Enterprise SaaS client contract would be priced at a $100,000 Annual Contract Value (ACV), with a multiyear term that puts the Total Contract Value at 1.5 times ACV and is paid one year in advance at the start of each contract year.
Upfront payments create a negative working capital cycle and therefore help to fund operations. The faster the company grows, the greater its cash flow from operations. Such deals allow Enterprise SaaS companies to avoid the “working capital trough” that both small/midmarket and B2C companies face when earning revenue on a monthly basis.
Upfront payments also require one to look at the financials differently. When reviewing the financials, it is important to remember that the operating income is not a proxy for cash flow. Instead, bookings and billings activity drives cash flow. Therefore, it is important to view the entire financial plan including profit and loss statement, balance sheet, and cash flow statement.
Revenue Recognition in SaaS Companies
Enterprise SaaS revenue recognition has unique challenges, and these are mainly driven by the definition of satisfying the performance obligation. Typically, when we have a contract we understand the performance obligations of the contract. The price is stated in the contract and we have a pretty good idea that our customers have the money to pay us. But I’ve seen a wide variety of methods used to determine the point at which a SaaS company satisfies a performance obligation. On one end of the spectrum, companies begin recognizing revenue when the customer signs off on the implementation, therefore triggering a “Go Live” event. A more conservative view is to record revenue when all training and enablement have been completed. And the most conservative view is to recognize revenue when all licenses (seats) are actively used. Such differing approaches to revenue recognition require close evaluation.
Composition of OPEX
With regard to operating expenses, sales and marketing do consume the majority of OPEX and this is similar to profiles of non-Enterprise SaaS companies. However, Enterprise SaaS companies typically spend 70% of the sales and marketing expense on sales and 30% on marketing. The heavy labor cost required by a direct sales force team and its associated overhead, including sales commissions, drive this ratio.
Enterprise SaaS Metrics
Enterprise SaaS companies also require a specific set of SaaS metrics.
The metrics that demonstrate early indications of future revenue take on significant importance. As mentioned above, these are Bookings and Billings. Billings gives rise to Deferred Revenue, which represents all the future revenue you expect to earn and is a function of the total amount of Billings, net of revenue recognized.
Bookings and Billings are non-GAAP measures while Deferred Revenue is a GAAP measure. Therefore, providing reporting on all three is also important because it links your non-GAAP and GAAP measures.
Annual Recurring Revenue (ARR) is a standard metric for all SaaS companies. For Enterprise SaaS companies, the time to implement the product delays revenue recognition, and therefore ARR. So, we use a derivative called Contracted Annual Recurring Revenue, or CARR. If we have a high degree of confidence in successful implementation, then we use CARR and use the contract signature date to begin recording CARR. Use caution when reporting this though, because both the duration of the implementation and the revenue growth rate will create differences between CARR and ARR. I have seen this delta range from 5% to 40%. Larger variances will require that you define the drivers in your reporting.
Unit Economic Metrics
Unit economic metrics for Enterprise SaaS companies also differ. The LTV/CAC calculation is much more difficult for Enterprise SaaS companies. The standard components are Average ARR, Gross Margin, Customer Lifetime in the numerator and New Customers and Sales & Marketing expenses in the denominator. Let’s discuss each of these individually.
Average ARR and Gross Margin are easy. Customer Lifetime is more difficult. Enterprise SaaS service offerings typically have a much higher lock-in because of the high price of the product and the deep integration of the product throughout the enterprise. However, we typically will not have enough information to quantify this. We also cannot use churn because our contracts have annual and multiyear terms and most, or many, cohorts have not yet had the chance to terminate. In the “Land and Expand” model, we expect significant expansion, which would normally be included in the calculation.[i] However, similar to the churn calculation at this stage, we may not have accurate data upon which to project expansion rates since expansion typically occurs at contract renewal.
Additionally, due to the long SaaS sales cycle, it is very difficult to attribute sales and marketing expense in one period or periods to new customers in the period of the calculation. There is no standard way to solve this except to use your best judgment in picking a method for consistently allocating these expenses and reporting based this method.
Regardless, since customer count is small relative to bookings and sales seasonality, the LTV / CAC calculation will vary widely from one quarter to the next. You will see the same volatility in your CAC (Customer Acquisition Cost) Payback Period.
Unit economic measures for customer retention are the same as those for all other types of SaaS companies. For example, we use gross and net churn rates and retention rates. There are two main differences to note.
Enterprise SaaS companies typically have robust expansion activity, e.g., increase spending by their customers throughout the contract term. This increased spending can come from two sources. First, customers may add more users to their current product contract. This is known as “upsell expansion.” Second, customers may purchase additional products from the provider. This is known as “cross-sell expansion”. When reporting on expansion rates, we separate out upsell and cross-sell expansion for Enterprise SaaS companies. In contrast, small midmarket and B2C SaaS companies typically offer a point solution, which may have limited features and functionalities, (fewer cross-sell opportunities) or may only sell to an individual or small group of users (fewer upsell opportunities).
Enterprise SaaS companies have higher annual contract values and fewer customer accounts than other SaaS companies. Therefore, we base all customer retention rate reporting on dollars and not on customer count. The inverse is true for companies serving small and mid-market SaaS companies and consumers.
Enterprise SaaS Company Examples
Big Data company Splunk, Inc. serves as a good example of an Enterprise SaaS company. Splunk makes software for searching, monitoring, and analyzing machine-generated big data for large enterprise customers and markets the product as a “Data-to-Everything Platform.” In the company’s fiscal year 2020 third quarter, it signed 440 new enterprise customers including Airbus, Anaplan, Carnival Cruise Lines, Crowdstrike, Lloyds Banking Group, Takeda Pharmaceuticals, University of Bristol, the U.S. Census Bureau and Xcel Energy.[ii] Splunk’s financials reflect their Enterprise SaaS business model. The split of revenues between SaaS and professional services is 60% to 40% and the average Annual Recurring Revenue is $78,670.[iii]
In the private company universe, some notable Enterprise SaaS companies are cybersecurity company Kenna Security, AI-driven recruiting software provider Mya Systems, and mobile customer experience software company Swrve.
Building an Enterprise SaaS company is a unique challenge. You need to build a product that is robust enough to handle all the unique requirements of the enterprise. Then you need to be able to sell-in large corporations and convince them of your value. After you close the deal, you need to provide the high touch service levels that such customers expect. Upfront payments help with cash flow, but Enterprise SaaS companies typically do not reach scale until about $50 million in ARR. As a result, these businesses require a lot more capital to succeed. However, if they succeed, they are able to capture benefits in the form of lower working capital requirements and greater customer retention, leading to high growth rates and high valuations.
[i] We can include expansion rate in the formula either in the numerator as “1+ expansion rate” or in the denominator as net of churn.
[ii] Splunk Investor Relations website, Splunk Inc. Announces Fiscal Third Quarter 2020 Financial Results, November 21, 2019, https://investors.splunk.com/news-releases/news-release-details/splunk-inc-announces-fiscal-third-quarter-2020-financial-results
[iii] Sec.gov, Splunk Inc. 10-Q filed 12/04/2019, https://investors.splunk.com/news-releases/news-release-details/splunk-inc-announces-fiscal-third-quarter-2020-financial-results