Essential Finance Concepts for Subscription Businesses
You are an entrepreneur. You are passionate, motivated, and confident. You know enough about a problem to believe you can build a successful company by solving that problem for the marketplace. Maybe better, faster or cheaper than someone else. Maybe by superior innovation, by pure muscle & force, or sheer perseverance. In the end, you will figure it out and be successful.
You spend wisely, probably tightly, and you always know exactly how much money is in the bank. You can enter expenses in QuickBooks, pay vendors and employees, issue invoices and get paid. You balance your checking account because cash is king and you always know how you stand. And, you know the right buttons to push in QuickBooks to see your income statement and balance sheet.
You manage cash flow, but “finance” is left to the accountant that prepares your taxes. If this is you, read on and be sure to watch the essential finance concepts video.
With exceptions, the end of life for a software company is pretty predictable. Precious few make it public One in a million will become a giant public company. In fact, most software companies either languish and die or are acquired (and still sometimes languish and die). Some remain profitably private for many years, but the economics of software development and the dynamics of the market usually require fast growth. Failure to keep up typically means the end. Fast growth draws interest, first from venture capital and eventually from other companies. If your growth isn’t fast, there is likely some company out there that thinks it can make your business grow faster with its channels, market presence, and expertise. Either way, as long as you aren’t languishing, you are bait!
Venture Capital money drives the software industry. It may not drive you directly, but it most likely will directly drive one of more of your competitors, and therefore drive the financial dynamics and economics in your segment. Inevitably, you will look to finance more aggressive growth, and while there is a nascent debt market for SaaS and subscription-based technology companies, the traditional approach is to sell a slice of the equity. Maybe you will prefer a loan, secured by your subscription contracts or maybe your house. Likely, you will end up selling some equity to a venture firm or to a private investor (corporate strategic investments are pretty rare for start ups). Your business will grow, with the market or leading the market. The market will consolidate, and if you aren’t on your deathbed, you will be acquired.
When you sell equity, you will likely meet the “finance people.” In the case of a “round,” it will be a financial analyst from the VCs or private investor. In the case of an acquisition, it will be a corporate finance team. The CEO and others will be interested in your product and company and be involved, but in the end, the acquisition process will be managed by finance people.
Finance people want the best deal. They do this by finding, managing, and exploiting risk. In the absence of information, they create their own information, and that information most assuredly will support their desire to reduce their risk. They reduce risk by negotiating a lower valuation, less up front payout/cash, and more in earn-out and escrow/hold back.
These finance people speak “finance” and it’s not like the checkbook balancing, taxes and bookkeeping finance you know. It’s public company finance. Remember, a company big enough to purchase you is either already public, is planning an IPO, or is looking to be acquired by a public company.
Finance is a very real and very defined language, one you speak after passing more than one test. This is the language they speak. The better you speak it, the better your deal!
What should you do?
Let’s go back to day one. In all businesses, expenses come before revenue. In most software companies, start-up mode means minimal money. You have neither the time nor the money to invest to set up your financial systems to speak the language you will need to speak in the end. You buy a copy of QuickBooks for $199 and you are off and running, tracking expenses and eventually sending some invoices. That is the right thing to do – it makes complete sense.
It will be quite some time before you can afford to hire the real finance person, a CFO who speaks the language of public finance natively, and one that can get your finance story in order and represent you when you sell the company. (Annual salary software CFO averages $180K, thanks Payscale). In fact, you will likely face that first round of funding without that person. You are on your own, facing a negotiation process and discussions that will largely take place in a language you don’t really understand.
VCs and private equity people don’t expect the CEO of an early stage company to be a CFO. They are looking for that entrepreneurial drive, passion, resilience and vision, not a couple of letters after your name. So, they will largely give you pass and “work with you” at your pace. But, they will want to know your business. The more you know your business and can explain it to them in THEIR language, the more your business is worth. Remember, all financial investments have a dimension of risk management. The absence of information means risk and puts the negotiation leverage in their hands. The more information you can communicate to them, the fewer the unknowns, the lower the risk, and the higher your valuation. So, what do you do? Explain your business to them in terms they understand – their terms! Finance terms! You don’t need letters on your business card to speak like a CFO. Invest some time and learn the basics. Be able to discuss finance terms like revenue, revenue recognition, revenue projections, and EBITA along with metrics terms like bookings, renewal rates, MRR, and churn.
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