About the Podcast
Orbit Shift is a podcast from the Freshworks team. Jayadevan, the host interviews Tyler Sloat on this episode. Tyler joined Freshworks in 2020 as CFO. Previously he served as CFO of Zuora Inc., which provides billing and analytics software to help companies create and run subscription businesses effectively. He joined Zuora in ’10 when it had $4m ARR and was CFO as it IPO’d in ’18.
This is a good podcast to bone up on your SAAS (Software as a service) / subscription fundamentals. It covers everything from basic concepts such as ARR and churn, to even more complex topics as GEI or Growth Efficiency Index and the ‘Rule of 40’ and through these, dissects the SAAS business model well.
Takeaways
- The building blocks of any subscription business - be it a physical product, software or content you are selling - is a) what you are serving up to the consumer. Whatever you serve up, the customer has to find value in that. So you need to think about what you are serving up, and b) how you are serving up - that is the pricing and packaging - that helps the customer use your product to draw utility from it.
- The sweet spot in SAAS pricing according to Tyler is neither 100% fixed pricing, where you ended up leaving a lot of money on the table, or the other extreme, 100% usage-based, where you ended up having high churn, but a combination of fixed and usage-based pricing.
- Your decision to spend money on growth should be tied closely to what your Growth Efficiency Index or GEI is. The GEI is expressed as spends on numerator and revenue on denominator. The lower the GEI the better, as it tells you what you need to spend to get a $ of revenue.
- The higher the churn, the lower the GEI needs to be. Typically consumer utility software (productivity apps) with high churn need to spend efficiently in acquiring consumers whereas enterprise software that becomes the system of record for corporates (Salesforce, SAP etc) and see low churn could have a high GEI, i.e high customer acquisition cost.
- Tyler explains how startups should think about the CFO’s role. The CFO’s role today is not as much accounting as much as governance and complying. At the early stage of a startup, get a Controller who will make sure your back end is in shape. The ideal CFO will be a strategic business partner - he or she is more like a COO than CFO, helping the CEO think through strategic aspects of vendor management / pricing / operations etc. He or she can come in at a later stage once the basic systems are up. The CFO should own accounting, financial planning, data compliance etc.
Notes
- Subscription businesses put the customer at the centre of the business model, as opposed to other businesses that put the product at the centre of the business. For subscription / SAAS business, Iterative pricing and packaging, go to market and speed matters.
- The building blocks of any subscription business - be it a physical product, software or content you are selling - is a) what you are serving up to the consumer. Whatever you serve up, the customer has to find value in that. So you need to think about what you are serving up, and b) how you are serving up - that is the pricing and packaging - that helps the customer use your product to draw utility from it.
- ARR or Annual Recurring Revenue is the umbrella that fits over the entire subscription business. Revenue is typically backward looking; ARR instead is future looking. It is the revenue that you expect to get from your customer base in the next 12months, if nothing else changed. Sum up the expected next 12months revenue from your customer base and you have ARR. Of course, if your business has churn (customers drop out), then factor that in your ARR, by subtracting expected churn.
- Pricing and Packaging: Pricing is a 2-way relationship - the price you charge has to match with the utility that the customer expects to derive from the use of your product. The sweet spot in SAAS pricing according to Tyler is neither 100% fixed pricing, where you ended up leaving a lot of money on the table, or the other extreme, 100% usage-based, where you ended up having high churn, but a combination of fixed and usage-based pricing. The other input Tyler provides is to track how your customers are using the product and see where they are deriving utility from, so that you can direct your innovation focus there, create new feature sets and aim to monetise that through higher prices.
- Jayadevan and Tyler look at frameworks for understanding SAAS businesses
- Looking at ARR = COGS (cost of goods sold) + G&A (general & admin expenses) + R&D expenses + growth expenses. Now COGS, G&A and R&D expenses are your recurring expense. Growth spends are a choice.
- ARR minus (COGS + G&A + R&D) = recurring profit margin. You can spend all of your recurring profit margin in growth, or even more, especially if you have raised money in venture. But your decision to spend money on growth should be tied closely to what your Growth Efficiency Index or GEI is. The GEI is expressed as spends on numerator and revenue on denominator. The lower the GEI the better, as it tells you what you need to spend to get a $ of revenue.
- Your GEI is essentially what do you get back for every $ you put in to the growth engine. Now the growth engine is sales, marketing and customer success, and you ask yourself what will I get back in revenue if I give the growth engine a $. This ratio of rev to moneys put in the growth engine is the GEI. The GEI is analogous to the LTV - CAC ratio.
- The higher the churn, the lower the GEI needs to be. Typically consumer utility software (productivity apps) with high churn need to spend efficiently in acquiring consumers whereas enterprise software that becomes the system of record for corporates (Salesforce, SAP etc) and see low churn could have a high GEI, i.e high customer acquisition cost.
- Rule of 40 - which says your growth rate + profit margin percentages should add up to 40%
- Churn is the cancer of the subscription business. It can be full churn (loss of customer) or downsell (reduction in the contract value). You need to be very cognisant of your churn and hence set marketing spends accordingly. Churn can be managed through tracking how your customers are using your products and whether they are deriving utility from it
- Best to have annual contracts paid annually in advance. This gives you 12months to ensure your customer success teams get a year to drive usage
- 5-12% churn for enterprise businesses and 10-15% churn for consumer / D2C businesses are common benchmarks
- Tyler explains (this section starts ~37:00) on how startups should think about the CFO’s role. The CFO’s role today is not as much accounting as much as governance and complying. At the early stage of a startup, get a Controller who will make sure your back end is in shape. The ideal CFO will be a strategic business partner - he or she is more like a COO than CFO, helping the CEO think through strategic aspects of vendor management / pricing / operations etc. He or she can come in at a later stage once the basic systems are up. The CFO should own accounting, financial planning, data compliance etc.
- How should unlisted co CFOs communicate numbers? (42:30 - 44:30)
- Never provide forecasts but only report what has happened
- Look at what public cos in your domain are declaring and select a few of those metrics to report on. Ideally those where your performance looks favourable
- His one advice to founders is to build products with the vision of what it means to be 10 years later, i.e., the biggest risk for companies is that they build products without knowing what it means to scale a few years hence. They get stuck on a monolithic code base or some feature set built for a set of companies, and find it hard to innovate. Instead, he says stay true to why you founded the company, and put in the building blocks on your product that make it easy to continually innovate over time.
- Books / Articles mentioned in the podcast