In SaaS businesses, the Rule of 78 is used to plan how much revenue is needed each month to achieve a certain target. The target number is divided by 78 to determine how much revenue needs to be generated each month. The requirements of contemporary accounting standards (ASC 606) mandate that revenue be recognized ratably as it is earned. This makes it hard to hit an annual goal when you have underperformance in the early part of a year. You simply can’t make up for lost time. There are several short and long-term tactics product managers can employ to recover from early misses and ensure long term success.
It’s the middle of March and you are looking at your Q1 revenue forecast. Things are not looking good. The 2021 plan you put together last November calls for $15,000,000 in 2021 and for $1,153,848 for Q1. You are forecasting $480,770 or 41.7% of plan. Has the Rule of 78 you used last year doomed your 2021 SaaS revenue plan? What are you going to do about it?
Several things contributed to Q1 performance problems. Primarily, the sales team failed to deliver new billable customers with sufficient revenue each month as planned. New reps hired the previous October failed to be as productive as planned, two competitors launched the New Year with very aggressive new pricing programs that undercut your prices, and the Pandemic shut down the major industry conference in New York in January which historically had delivered big wins and new billings. Finally, in February one positive case of COVID sidelined more than half the team. None of these events could have been predicted last year when the revenue plan was put together. What can be done to recover so that the full-year revenue plan can still be achieved?
The Rule of 78 and SaaS Revenue Planning
The Rule of 78 is “a term used in lending that refers to a method of yearly interest calculation. The name comes from the total number of months’ interest that is being calculated in a year (the first month is 1 month’s interest, whereas the second month contains 2 months’ interest, etc.). This is an accurate interest model only based on the assumption that the borrower pays only the amount due each month.”
In SaaS businesses, the Rule of 78 is used to plan how much revenue is needed each month to achieve a certain target. The target number is divided by 78 to determine how much revenue needs to be generated each month. For example, a $15,000,000 annual target would require $192,308 each month, as shown in the following table:
ASC 606 Changed the Game for SaaS Revenue Recognition
Revenue recognition is governed by the standards set by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). The specific policy is known as ASC 606 Contracts with Customers. ASC 606 mandates that revenue be recognized ratably as it is earned. For SaaS companies, this is usually monthly. For example, a customer signs up for a $7,500 monthly subscription. The company would recognize $7,500 a month in subscription revenue. Even if the company prepaid $90,000 for an annual subscription, the company could only recognize $7,500 a month. The balance of the $90,000 would be recorded on the balance sheet as deferred revenue. ASC 606 not only deals with revenue recognition but expense recognition. This impacts a company’s profitability. ASC 606 was initially launched in 2016 and all companies had to comply by 2020. If you need to brush up on your P&L basics check out Why Should Product Managers Care About Income Statements?
When Sales underperforms at the beginning of the year it is almost impossible for a product to catch up and hit its overall annual target. In the pre-SaaS days, software was sold on a license basis, with annual fees for maintenance and support. In those cases, the license fee could be recognized all at once. It was possible to make up any shortfalls on the last day of the quarter or year. Since SaaS revenues have to be recognized ratably, you can’t make up for shortfalls earlier in the year.
Impact of Missing Targets Early in the Year
Consider this example where Sales fell short in the first three months of the year, but overperformed in the next three months:
Even with great overperformance in April and May, the product will still fall far short of its goals. This is the nature of ASC 606 subscription revenue recognition and the curse of the Rule of 78.
How You Can Battle Rule of 78 Shortfalls
There’s a three-phased approach you can use to battle SaaS revenue shortfalls:
Quantify What Has Happened
When revenues fall short of plan, it is easy to calculate the scale of the miss. Experience has shown that there is significant value in drilling down into more detail. A good tool to use is the MoneyWheel. The MoneyWheel is a tool that you can use to discover and assess the repeatable patterns in sales transactions that occur in your business.
A MoneyWheel has two components: categories and spokes. A MoneyWheel category is a broad type of sales transaction. There are five broad categories:
- Net New Customers. These are customers that have not bought any of your products before.
- Add on Sales. These are sales of add on products to customers who have already bought a base product from you.
- Expansion Sales. Customers buying more units of a product they own, like more authorized seats or more transactions.
- Competitive Migrations. A special type of new sale where the customer is migrating from a competitive solution to your product.
- Financial. Transactions that are specifically financially based and not on the features/functionality of your product. Enterprise-wide licenses are one example. Multi-year contracts are another.
Spokes are the specific types of repeatable sales transactions that occur within a MoneyWheel Category. They are often triggered by an event that occurs at a customer or in a marketplace. Spokes help explain why a customer purchased something. Spokes are unique to your product and market. While MoneyWheek categories are common across most SaaS companies, most spokes are context-specific.
For example, here are four spokes for the Net New Customer category for a Marketing Automation SaaS provider:
- New Marketing Vice President. When a new VP is hired, they often replace existing marketing automation solutions with vendors they have had success and experience with.
- Merger/Divestiture. When a merger occurs, the acquirer often replaces an existing marketing automation solution with the one the acquirer has standardized on.
- Bad Quarter. If the customer has experienced a bad quarter from a financial perspective, they will often consider a new marketing automation solution to boost revenues.
- Competition. If a customer’s competitors start performing significantly better, companies will often consider upgrading their marketing automation solution to match or exceed a competitor’s performance.
Here is a table that shows a MoneyWheel for a marketing automation SaaS provider:
You can extend this analysis to the sales region and even the sales rep level. Consider this table that describes Q3 for just the Midwest region:
The MoneyWheel allows you to quantify what has happened to your product’s sales. The next step is to determine why it happened. To learn more about the MoneyWheel check out Product Manager Intelligence on Steroids: The MoneyWheel & Win/Loss Analysis.
Understand Why It Has Happened
Quantitative analysis like the MoneyWheel only goes so far. There can be a lot of reasons why sales have fallen short. Was the plan too aggressive? Was the product priced and packaged effectively? Was there an economic downturn that impacted your industry or particular geography? Were some sales reps just better than others? Numbers tell you what has happened, but not why.
Win/Loss Analysis is a qualitative research technique to help you understand why you won or lost a particular deal. Interviews with people who participated in the decision-making process are the main focus of Win/Loss Analysis. During the interviews, a series of open-ended questions are asked. The goal is to understand why the prospect/customer acted the way they did. The MoneyWheel can tell you what happened, Win/Loss Analysis helps you understand why it happened.
Win/Loss is a Qualitative, Not Quantitative Analysis
Win/Loss is a qualitative type of analysis, not quantitative. In the case study for this article, there were 245 deals. To obtain a statistically relevant result (<5% margin of error) you would have to conduct analyze at least 150 deals. Here is a link to an online calculator for Student’s T-Test where you can calculate how many participants you would need out of a population of 245 deals to yield a statistically significant result (answer: 150). As we will discuss later, recruiting 150 Win/Loss interviews is a daunting task.
The Win/Loss Process
Win-Loss Analysis is a market research technique companies can use to discover key learnings from customers and prospects. These learnings can then drive improvements in marketing and sales, resulting in more revenue and profits. A typical Win/Loss project consists of five major steps:
The first step of the process is to do all of the preparatory work required to ensure the success of the project. An important first step is setting research objectives. Setting clearly defined Research Objectives will help you to both target your Win/Loss research as well as set expectations for the success of the program. And be sure to align your Research Objectives with the strategic goals of your organization. There is no sense chasing information from buyers that your organization has no interest in anyways. Research objectives may include:
- Your Product-Market-Price fit
- New market problems that your organization can solve
- Your service levels
- Persona refinement
- Buyer purchase-decision process
- Marketing channel effectiveness
- Sales process
- Communication style
- A better understanding of your place in the competitive mix
In addition to establishing your Research Objectives, you should also define the questions that will be asked during the interviews. The questions should be open-ended and designed to encourage a free-flowing discussion.
Finally, you will need to design the process you will use to recruit potential interviewees, conduct the interviews, analyze and report the results you have learned. The plan should lay out the roles and responsibilities of each participant in the project. You should also develop a schedule and a simple status reporting mechanism so everyone can stay up to date. Create a project charter that contains the research objectives, interview questions, roles, responsibilities, and schedule. Conduct a review meeting with the participants to approve and commit to the plan.
The next step in the process is to recruit people for the interviews. Most companies target a mix of net new customers and existing customers who have upgraded or expanded their use of products. You are looking for a mix of won deals and lost deals. Most Win/Loss Analysis projects with a single research objective try to get 15 to 20 interviews.
A portfolio approach to soliciting interviews works best. The tactic that has the highest success rate is when a salesperson makes a personal outreach to a potential interviewee. Generally, 25% to 40% of these contacts will convert to an interview. The second most common approach is email. Organizations pull a list of candidates from their CRM or sales force automation system and then email them asking for participation in the project. This approach performs like most email campaigns – a 20% open rate and a 2% to 5% click-thru rate. 50% of those who click-thru convert to interviews. The final tactic is to do phone follow-up with contacts that opened the email but did not click thru. This tactic performs like telemarketing campaigns – a 1% to 2% success rate.
Most Win/Loss Analysis programs use incentives to encourage targets to commit to doing the interview. Companies offer a $25 or $50 gift card. This provides the interviewee with something tangible in exchange for their valuable time.
The biggest challenge many Win/Loss Analysis projects face is recruiting enough quality interviewees. Sending cold non-personalized emails to all of the CRM contacts associated with a customer tends not to be successful. What happy customer wouldn’t want to do a short interview and get a $50 VISA gift card? A lot fewer than you would expect. Experience has shown that a portfolio approach that combines warm introductions, multiple emails, and phone call follow-ups works best.
Sometimes when a Win/Loss Analysis project has problems in getting sufficient interviews to reach the research objectives. Teams will then increase the interview incentive to $75 or even $100. While this may spur more people to respond to the solicitation, often these individuals are only interested in the incentive payment. These individuals may only have limited exposure to the product and may not have been involved in the actual sales process. This risk can be reduced by selecting the best candidates to target with the solicitation. Sending an email blast to every contact from a company in your CRM system will not produce the quality results you are looking for.
The core activity of the project is conducting interviews. Most interviews take 20 to 30 minutes to complete. Companies use internet meeting services that facilitate the interview scheduling process, but also allow the discussion to be recorded. This enables the interviewer to focus on the discussion instead of trying to listen and take notes at the same time. There are services that will transcribe the recordings for you into a Word document for about $1 minute.
Experience has shown that interviewees are more comfortable talking to an independent third party instead of a representative from the company. This results in a free and easy discussion. It also avoids making embarrassing or disparaging comments about their experiences or opinions.
A critical aspect of the interview process is asking why a customer believes certain things they say. Surveys and checklists are one way to get customer feedback, but they lack the ability to follow up on interesting statements. The real value of using experienced interviewers is that they can follow up and explore why a customer believes specific things. Often this is the most valuable outcome from the interviews.
After the interviews are completed, the recordings are transcribed. Next, the team reviews the transcripts to identify common themes. These themes are analyzed and documented in a final report. The report contains a summary of the interviewees – company size, interviewee title, transaction type (new/upgrade and win/loss). For each theme or finding, specific quotes from the interviews are included. This lets the report’s reviewers hear, from the customer’s perspective and in their voice, the exact point they were trying to make. A meeting is held with all of the interested internal organizations to review the report’s findings and conclusions.
The final step is to take action on the recommendations. Effective Win/Loss Analysis programs are really part of a cycle to drive improvements in the business. Win/Loss Analysis is a variant of the Six Sigma DMAIC (Define, Measure, Analyze, Improve, and Control) methodology. If action is not taken based on the recommendations from the interview analysis then an opportunity to fundamentally improve your business will be missed.
Themes are the learnings distilled from the Win/Loss interviews. Here are some examples from the Marketing Automation Saas provider: For reference, the Marketing Automation SaaS provider had been in business for over eight years. They had over 3,500 active customers. Top line revenue was around $50 million. They were VC-funded, having recently raised over $20 million in a Series C round. Most of their inbound leads came from the web. Their product was considered to be a market leader in terms of functionality.
Fifteen interviews were conducted from ‘win’ transactions. 5 were from net new customers, 10 were from existing customers.. 6 were from mid-market organizations with less than $100 million in revenue. * were from enterprises with revenues between $100 million and $2 billion. The major themes included:
Positive Themes from Interviews
Thought Leadership. The vendor was considered to be a thought leader in the industry. Almost all interviewees cited the quantity and quality of thought leadership articles the vendor published. The readers liked that the vendor did not push their products in these articles.
Functionality. All the interviewees cited the depth and quality of the product’s features and functions. Many felt that competitors fell short in a few key areas.
Sales Team Effectiveness. Many interviewees cited the professionalism, responsiveness, and courtesy of the sales teams. They did not feel pressured or subjected to typical software sales techniques (buy before the end of the quarter to avoid a price increase).
Analyst Reports. Many interviewees cited the inclusion the Leaders Quadrant in Gartner Group’s Marketing Automation Magic Quadrant as being important.
User Reviews. Some prospects/customers cited the multitude of reviews on user review sites like G2.com and Capterra
Negative Themes from Interviews
Price. Most interviewees considered the price for the SaaS solution to be among the highest in the industry. Many competitors had better pricing.
The majority of the ten existing customers cited dissatisfaction with the product packaging. Most were satisfied with the entry-level offering but were very dissatisfied with upgrade options. Many felt that the upgrade packages included add-on products that they saw little to no value in. The pricing was based on the number of modules purchased and a transaction limit. The entry-level offering had three modules and 10,000 transactions a month. Transactions above 10,000 were billed at $0.05 a transaction. The smallest upgrade was four times the cost of the entry-level package. The upgrade included six additional modules and 25,500 transactions a month. Customers rejected the upgrade 80% of the time. They saw little value in the extra modules and rejected the effective per-transaction price increase. Many customers moved to a solution that offered significantly lower transaction costs but also had lesser functionality. They accepted the trade-off.
Change in Priorities. Many loss transactions were due to a change in customer business priorities. The need to focus on another issue was more important than investing in the vendor’s solution.
No Perceived Differentiation. The prospect was unable to see a real difference in value between competing solutions. While competitive solutions had clearly lower levels of features/functions, the prospects were unable to see any real difference. Lower prices trumped what appeared to be better functionality.
Disruptive Events. Events like mergers, acquisitions, divestitures, or departures of key executive sponsors often delayed or canceled planned purchases.
No Decision. The most common reason cited fr lost deals was No Decision. Either the prospect/customer never made a decision or the vendor was unable to determine why the sales process stopped.
Drive New Revenue Streams
These tactics may bring some short-term benefit but probably won’t drive so much improvement that you’ll make your bonus targets this year. The math of subscription revenue recognition is tough. You can’t make up for poor performance early in the year by a blitz at the end of the year. But you can lay the foundation for next year’s success. Here are three tactics you can consider.
Optimize Demand Generation Programs
Armed with the knowledge gained from Tiering, Money Wheel and Win-Loss Analysis re-examine your current demand generation programs. Look at the segments of the market where you are succeeding and double down on the investments you are making to target them. Add more ad spend, more webinars, more events/conferences, more thought leadership blog pieces. Conversely, look at areas where you are not succeeding. Experiment with eliminating investments in demand generation that target those segments. The risk is not too high – those segments are not producing significant revenues for you anyways.
Re-evaluate Pricing & Packaging
In a mature business, a significant part of MoneyWheel transactions will involve Expansion and Add-on sales. Pricing and packaging can have a major impact on sales in these areas. Win-Loss Analysis can help confirm customers’ acceptance or rejection of your pricing and packaging policies.
In mature SaaS businesses (>7 years old or in the Late Majority stage of Technology Adoption Life Cycle) pricing becomes a critical strategy to drive revenue growth. You should condition your customers to expect regular price increases. The increases should be explainable in terms your customers will relate to. People costs are the majority of SaaS companies operating ex[enses. Labor, benefits, and tax costs rise over time. Customers can understand and relate to that. As long as your price increases are less than the prevailing rate of inflation they can be explained. You should raise your prices at least once every 18 months
In most mature markets price eventually becomes an issue. Solutions that address the same business problem usually end up with prices that are at least in the same order of magnitude as each other. Assuming that the cost of migrating from a competitor’s solution to yours is not too cost-prohibitive, you can use price as a tool to steal away your competitors’ customers. Almost all markets commoditize eventually. Some examples are the cost of long-distance telephone calls or mobile phone minutes. CPU processing power is another example. The impact of Netflix on cable TV subscriptions is a third example.
For SaaS companies, you need to understand the unit economics of delivering revenue on your platform. Most companies have a lot of surplus capacity in their infrastructure. The costs of adding another ten, twenty, or hundred customers are minimal. You can use the same infrastructure and same enablement, support, and operations personnel that you use to service your existing customers. Therefore, adding incremental revenue is almost cost-free. You can continue to do this until you hit an inflection point where you need to add material amounts of new costs to service the revenue.
While you are in this zone the price you charge for the service is almost irrelevant. This gives you an opportunity to commoditize and decimate your competition. You can lower your price by 50% and steal your competitors’ business. Customers that use a solution only switch to a competitive solution for a few reasons. One reason is that there has been a serious performance issue such as frequent and prolonged outages. Another reason is cost. If the cost of a comparable competitive solution is a fraction of the current solution, there can be a compelling economic reason to make a change. The risk of making the change, however, has to be minimal. There can be no hiccups or surprises during the migration.
This is a radical solution to your stalled revenue growth challenges. Changing the price economics carries both significant risks but opportunities as well. This strategy works best when your agreements with customers are not month-to-month but have some fixed term, like 12 or 24 months. In this type of situation, your existing customers are locked into their contracts and pricing. You can pillage your competitor’s customer base while not risking too much damage to your own customer base. Eventually, your existing customers will come up for renewal and they will expect to get price concessions similar to what you offered the ‘steal away customers. But you will have enjoyed the benefit of the incremental revenue in the interim which was the goal of the exercise.
Price commoditization eventually comes to all competitive software markets. History has shown that the first market player to commoditize pricing can enjoy outsized benefits..
Focus on Repeatable, Scalable Sales Transactions
Money Wheel Analysis when combined with sales region and sales rep quota performance can give you insights into why the most successful reps are winning and why the lowest-performing reps are struggling. Sales management and sales rep performance are complicated topics. Most sales teams have top performers, average performers, and low performers. Performance can vary across territories and countries. Some sales reps are innately more talented than others. You can use the information you developed in your baseline analysis in two ways. First, you can understand why specific reps are having significantly more success in selling certain types of transactions than others. Is their territory richer in prospects that respond to these types of sales transactions? Or do they have an approach and process that resonates especially well? Understanding how to replicate the success of the best sales reps across the entire sales force. This is one of the most productive investments you can make.
The first strategy is to consider developing a new add-on product that complements your core product. Through the use of open-source software components and Agile development techniques the time and cost to deliver a Minimal Viable Product is a fraction of what it was five years ago. While a new product will not solve your bonus problems this year, it can lay the foundation for long-term success. New product development always is risky. Companies with a portfolio of existing products are often loathe to take the risk of new product development. Past experiences that have failed are often a barrier as well.
The paradigm of Minimal Viable Products is a potential game-changer for mature organizations. It can also provide a boost of energy for marketing, sales, and development teams. Given the relatively low cost of developing an MVP that can be cross-sold into your existing customer base, it is a risk worth taking.
New Geographic Markets
Beginning international expansion or moving into new geographies is not a short-term proposition. While it is easier today to internationalize a SaaS application in comparison to the old days of on-premise software, there is a lot more that is required to be successful. Your company needs to build marketing, sales, enablement, and support infrastructure to serve international customers. In certain geographies like the U.K., India, and Australia/New Zealand you can get away with an American English version of your product and English-speaking marketing, sales, and support personnel. In other geographies like Germany, France, Spain, Italy, and Russia you will eventually have to take the plunge and build a business infrastructure with people that can speak the local language. Again, international expansion is important, but it is a long-term strategy.
A third strategy is to focus on competitive steal away. In most mature markets (Early/Late Majority in the TALC) there are multiple competitors chasing the same customer opportunities. Your competitor’s customer bases are prime opportunities for you. These customers have already seen the value of investing in solutions like yours to address their business needs. If they saw value in a competitor’s solution, they should see value in your solution as well. A radical strategy is to consider commoditizing the price of your offering to steal away your competitor’s customers.
In SaaS businesses, the Rule of 78 is used to plan how much revenue is needed each month to achieve a certain target. The target number is divided by 78 to determine how much revenue needs to be generated each month. The requirements of contemporary accounting standards (ASC 606) mandate that revenue be recognized ratably as it is earned. This makes it hard to hit an annual goal when you have underperformance in the early part of a year. You simply can’t make up for lost time. Product managers should first quantify what has happened, understand why it happened, and use short and long-term tactics to achieve annual SaaS product revenue goals.
Also published on Medium.