March 23, 2016 | 5-minute read (979 words)
This is a guest post from Zach Hoene, Associate, Underwriting, Lighter Capital.
A big trend in the software world today is service-based consulting companies making the move to a subscription SaaS product offering. Founders can sometimes find that they end up solving the same issues repeatedly for their clients, and in turn decide to capitalize on that demand by creating a much needed product solution. In other instances, entrepreneurs start with a SaaS product in mind, but decide to scale by generating a steady stream of considerable income from consulting.
A SaaS business can be much more lucrative compared to a consulting company in the long run - if you are successful. As always, however, success is never guaranteed. If you think you are ready to make the jump from consulting to SaaS, it is important you know the pros and cons going in. If you are reading this and have already made the commitment to switch, you may want to learn more on transitioning from service to product company successfully.
Moving To Saas: The Upside
- Ability to scale - Once the product is built out, adding a significant number of users doesn’t require a large increase in cost. This can lead to impressive profits, as well as securing investment capital needed to grow.
- Subscriptions = cash up front The longer the subscriptions, the more usable cash is available to commit to growth of the business. This is the exact opposite of consulting, where the work comes first, and then payment 30, 60, or 90 days out.
- Tracking growth - and predicting future revenue - is much easier Subscription models allow you to easily get a handle on recurring revenue, baseline growth, and customer churn. This is key information that will enable you to make a realistic projection about your company’s future revenue. This is very different for consulting companies, where customers come back only as they need to, and on whatever time-frame meets their needs.
- Securing financing is easier Predictable future revenue makes it easier to position your company for receiving investment from outside capital.
Moving To Saas: The Downside
- Large development costs Consulting businesses become profitable almost immediately, but with the SaaS model there is a significant upfront investment in development and scaling. In the event your consulting business is not generating significant excess cash flow, moving to a SaaS product could require outside investment. Keep in mind that obtaining debt capital can be tough if you are just starting out.
- Budgeting for future costs Even if the move to SaaS has been profitable for your business, you will still need to reserve some subscription revenue for regular maintenance and updates for your customer base. Not budgeting properly could leave you in a position where you are unable to deliver on what your clients have already paid for.
- Lower income per customer Billing for consulting services is usually higher per customer than with a monthly subscription. This ultimately means needing more customers for your SaaS model versus consulting. You may even find a significant dip in revenue as you make the switch to SaaS, as your high-paying consulting clients make the move to the lower cost monthly model. Even if gross income increases, with an initially small customer base for your product, you may not be earning enough during the transition to make up for the cost of effectively running two business—a product business and a service business.
There are accounting differences that you should keep in mind when it comes time to make the switch from consulting to SaaS. Make sure you are aware of those differences and that you are financially prepared for the transition. Here we will take a look at the accounting differences between these types of revenue under accrual accounting.
Consulting revenue is made up of the stand-alone purchases of services. Clients normally pay after completion of a smaller project, and then choose to renew or not renew your contact. If this is the case, revenue and an associated cost of services is recognized at the time of purchase. In the case of delayed payment terms, you would recognize an account receivable as a result of this transaction, but generally your clients will be billed at completion for cash. Additionally, if it were a longer term consulting contract, you would probably charge progress billings, which essentially divide a large contract into smaller pieces. With progress billings, you usually collect payment when pre-defined milestones are met. The associated accounting would recognize an asset called unbilled revenue, which operates similarly to accounts receivable.
In the SaaS model, your clients will be paying a recurring fee for access to what you have to offer. In return, you agree to keep the software updated, as well as to provide ongoing support for subscribers. As a matter of payment you would provide access to your software to a client and immediately charge them for that access upfront for the entire billing period. This will result in unearned revenue - a liability under accrual accounting that recognizes the fact that you have been paid for something that you have not fully delivered, which is a certain time frame of access to your service.
A Good Move - For Some Businesses
Over the long run, moving from a consulting model to a Saas model can be a huge payoff. It’s not going to be easy, however, especially if your consulting clients are transitioning to your service before you have enough new SaaS customers to make up for the lost income. This is why the transition is ideal for businesses that can either (a) get adoption of the SaaS product quickly among their clients, enabling them to ditch the consulting side of their business entirely; or (b) bring in enough new business to their SaaS offering that they can afford to run both companies simultaneously.