One Critical Performance Output that Every Subscription Software Company Should Possess
There are many critical inputs and outputs that must be institutionalized and constantly monitored to ensure the proper operational and strategic decisions are being made throughout a company’s lifecycle and maturity. For software and SaaS businesses, finance and operational teams have a laundry list of KPIs and reporting standards that must be maintained (like any of these described in prior articles) to sufficiently address the requests and expectations of investors and other key stakeholders. Recurring revenue waterfalls stand at the forefront of these tracked measures, as the waterfalls convey the progress and growth (or lack thereof) of a company’s bookings and revenue streams. By instituting recurring revenue waterfalls as important reporting mechanisms, management teams can stay highly organized with internal reporting and ensure that external parties easily interpret and comprehend the company’s growth and health trends.
Walkthrough of a Recurring Revenue Waterfall and Details on Each of its Components
For SaaS businesses, a recurring revenue waterfall is a consistent output on the movement of a company’s bookings and revenue streams. It can take on two primary forms: one of which represents how much recurring revenue a company has booked / under contract and the other of which conveys the amount of GAAP revenue that is recognized in each period. In each of these cases, the buildup of a recurring revenue waterfall consists mainly of these components: a beginning balance, revenue gained from new bookings, revenue gained from upsells, revenue lost from downsells and revenue lost from churn, which collectively sum to the ending balance in each period displayed. Let’s explore the impact of each of these on the construct of a revenue waterfall.
The Impact of New Bookings
One of the major drivers of the period-over-period movement in a recurring revenue waterfall comes from new bookings. Typically, this is the case for companies that are successful in generating consistent new customer acquisitions, as these new bookings tend to have the largest value vs. the other components. In the example below, we walk through the isolated impact of new bookings on both the booked / contracted annual recurring revenue waterfall and the GAAP / recognized monthly recurring revenue waterfall:
Additionally, here is a 12-month view on the new bookings’ effect on the GAAP / recognized revenue waterfall:
In the examples above, Company ABC is able to successfully generate new bookings from both SMB and Enterprise customers over an illustrative 12-month period. If this trend continues, the company will continue to enjoy the benefit of an increasing booked and recognized recurring revenue balance (as long as the other components of the waterfall are managed accordingly), thus maintaining a healthy growth rate. One key difference to highlight between the two waterfalls above is the timing of revenue recognition. Booked SMB contracts are recognized as revenue in the same period as they are booked given they require less complex and arduous implementation. On the other hand, Enterprise contracts begin to be recognized as revenue in the third period following the booking, given the implementation of the product is longer and more complex for larger customers. This is important to understand, as it not only has an effect on the company’s reported revenue, but also on its cash flow dynamics. Therefore, it is a recommended best practice for companies to present both a booked revenue waterfall and recognized revenue waterfall, as this combination helps convey the financial impact of new customers in an accurate and timely manner.
The Impact of Upsells and Downsells
As was highlighted briefly in prior articles, upsells and downsells are two other important elements that every business owner and investor should consider when evaluating a company’s financial profile. Upsells represent the economic value gained / generated from selling into the existing customer base – normally through add-on modules within existing products, new products / services, user additions or via price increases. Downsells are the opposite, as they represent the economic value lost from existing customers. Typically, downsells come in the form of module reductions from existing customers, user reductions and price reductions / concessions for the company’s product / service.
Upsells and downsells have a contrasting effect on recurring revenue waterfalls, as upsells increase the total value of a period’s recurring revenue figure, while downsells decrease the value. Let’s continue the prior example for Company ABC:
The impact on the revenue waterfalls from both the upsells and downsells is immediate and there is no delay on the effect of each on the GAAP / recognized revenue base (i.e. ARR is converted immediately into MRR by dividing by 12). However, depending on the complexity of upsells (e.g. a new module upsold requires a long implementation), the revenue recognition can be delayed, akin to the new booking to revenue recognition delay from the Enterprise customers from the initial example. When constructing a revenue waterfall, upsells and downsells can be stated and forecasted on a percentage-basis (e.g. as a percent of beginning or ending ARR / MRR) or by multiplying total number of upsells and downsells by an average ACV (as was displayed in the example above). The selected approach is truly dependent on the level of data that is available and which approach is best representative of a company’s business model. Tracking both upsells and downsells in a revenue waterfall ensures business owners and investors can convey and understand the separate impact each has on a company’s growth and health.
The Impact of Churn
Other than new bookings, churn has the largest potential effect on a recurring revenue waterfall. This is due to the fact that at any given time, a company can lose any part of its customer base, small or large, thus causing the revenue waterfall to decrease. This is yet another reason why it is critical to monitor churn closely and ensure that it is included in each of the booked and GAAP revenue waterfalls, as it can provide timely insight on the health of a company’s customer base. Using Company ABC as the basis of our understanding, let’s complete our revenue waterfalls with the inclusion of churn below:
In the illustrative case above, I have forecasted churn off of a percentage that only considers ARR from Company ABC’s existing customer base (assuming no ARR from new customers churns in the first 12 months), building in an impact for seasonality (Company ABC has historically had higher churn % in months 6 through 10, thus using that trend as the basis for projections) that considers when the churn hits a company’s waterfalls. In reality, churn that is included in historical revenue waterfalls represents the economic value of cancelled customers. Monitoring churn closely on a historical basis in waterfalls helps identify and highlight key trends (e.g. if a company had numerous platform outages in a two-month period, one would expect higher churn in those periods, but lower churn following those two months), allowing a company to be better informed of the rationale and explanation of the trends. Moreover, this historical understanding can be used as a basis for projections and forecasting of financial performance.
Concluding Thoughts: A Critical Tool in a Software / SaaS Company’s Toolbox
The buildup of a revenue waterfall includes many components that a company is already monitoring closely – new bookings, upsells / downsells and churn. By combining these metrics into a recurring revenue waterfall (both on a booked / contracted and GAAP / recognized basis), the company can increase the usefulness of its financial reporting for internal and external stakeholders. Additionally, tracking revenue waterfalls vigilantly and consistently helps to quickly identify operational and financial issues, allowing management teams to make the necessary business decisions to improve these concerns. With the implementation of recurring revenue waterfalls as one of the most critical performance outputs, business owners and investors can possess a real-time, consistent view of a company’s health, growth and financial performance trends.