A 4-step guide to your first SaaS financial forecast.
Any entrepreneur, regardless of background or expertise, needs to understand the financial plan. In the earliest stages of your company (the first year or two), you likely don’t have a dedicated head of finance to build detailed models and track analytics, so that responsibility falls to you. Cash reigns, and you need a plan to manage it, but what are the right cost estimates to set, revenue goals to target, and how do you predict when you’ll need to raise your next round?
At High Alpha, we provide studio services for the finance function for several of our early-stage portfolio companies. Most notably, this involves creating financial plans to forecast performance and cash flows, and providing insight on past performance. We are continually developing and refining how we create financial plans — there isn’t a simple, standardized method. But if you’ve never created a detailed forecast before, knowing where to start can be daunting. This post is meant to provide a starting point, and walk you through several of the key pieces of financial forecasting you’ll need to understand. I’ve included a sample financial model template here to demonstrate how these pieces flow together, based on the accrual method of accounting. Some forecasting software tools have started to emerge, but for the sake of this exercise and for flexibility, I’ve used an old-fashioned spreadsheet.
Creating a forecast is one of the most beneficial exercises you can walk through in the early stages of starting a company, because it forces you to think about all aspects of the strategy behind the business, from pricing to hiring, and it helps you identify areas of your business that require purposeful decisions, but otherwise will be dictated by convenience. It’s also one of the best ways to understand the mechanics of the business. This exercise involves four key aspects of a financial model, and I’ll walk you through each.
Tackle the forecasted income statement first. In an early-stage, high-growth company with investment capital, this will no doubt be a “loss statement”, with high expenses. Companies with physical inventory may focus their efforts on forecasting expenses based on materials, production, and inventory management. For SaaS companies with high gross margins, almost every expense is some function of your employee count, so bring a hiring plan to this exercise with the expectation that you’ll adjust it as you see the numbers play out.
Salaries will likely be your largest expense line item in a SaaS business. You can then group other expenses as correlated with employee count, relatively fixed, or discretionary. Items like payroll taxes and benefits are directly correlated to your headcount. Items like meals and entertainment, travel, software, and general office expenses, although somewhat discretionary, will also naturally correlate with your employee count — we’re still looking for the perfect formula to forecast LaCroix consumption. Your office rent will likely be fixed in the short-term. And expenses like contract labor and marketing-related items are more discretionary. Don’t forget to include in the budget expected legal costs associated with starting your company.
2. Sales and Revenue
Forecasting sales and revenue is especially difficult in the early days of a new company, as the product and sales cycle are unproven and unpredictable. At some point, you need to make your best estimates based on your current pipeline. One of the hardest parts about creating a good financial model is balancing setting ambitious goals while also being realistic and conservative so that you aren’t caught off-guard. For this reason, it can be beneficial to create two models — one that is ambitious in goals around new sales and one that is more conservative and realistic around sales and expenses.
After the initial few customers, if your go-to-market strategy relies heavily on salespeople, forecast your new sales and ARR as a function of salespeople, remembering to factor in ramp time for new hires and employee churn rate. Ramp time, number of deals, and quota will all depend on the nature of the business, but each of these details are important to define as part of the overall strategy of the product and business. Don’t forget to include commission expense as a function of new sales. Also realize that if you delay a sales hire, you’re either delaying your revenue growth or putting that burden on other members of your team.
As you forecast your sales, think about how this translates into revenue recognition. MRR/ARR and recognized revenue are not the same. SaaS is all about ARR, so focus on setting goals around this metric, and model proper revenue recognition as a function of ARR. Refer to the template to see how this works in its simplest form — recognized revenue in one month should be the prior month ending MRR, or ending ARR divided by twelve. But if your deals vary between monthly, quarterly, and annual, this modeling can get complex quickly.
3. Cost of Sales and Gross Margin
Cost of sales (cost of goods sold in a physical product business) is simply the cost associated with the actual product being provided to your customer — things like hosting, licensing costs, and the costs of any employees providing services to your customers. Gross margin is your revenue minus cost of sales. There are many good articles explaining SaaS gross margins, and it’s important to understand how they impact good unit economics.
Modeling gross margin is more important for understanding the scalability of your business and what it takes to deliver your product than for predicting cash flow. In an early-stage (one-year-old) company, accurately forecasting cost of sales is difficult; your product is unproven and you’re likely using more time and energy to service your first few customers, so your real gross margin may not be very high. For purposes of predicting cash flow, it’s most important to forecast expenses like hosting and 3rd party apps that are part of your product; your people-related service costs should be accounted for in your hiring plan.
4. Balance Sheet
If you’re using the accrual method of accounting, as opposed to the cash method, it’s important to understand the relationship between the balance sheet and income statement. After mapping out all the expenses you’ll incur each month and the revenue you’ll recognize, you now have a picture of the healthy net loss that you’ll build up as your company gets going. Your total net loss, though, is not necessarily the cash you’ll need to make it so far.
Map out your basic balance sheet: cash, accounts receivable, prepaid expenses, accounts payable, deferred revenue, equity, and retained earnings. Your cash will be a function of how the rest of these accounts move, which are in turn all influenced by items on the income statement that you just created. Reference the balance sheet in financial model provided above for a better look at how the pieces come together.
How quickly and frequently do you expect to collect payment from your customers? This requires thought about your deal structure; one of the best ways to cash flow your business is by selling annual subscriptions and getting payment up-front, so keeping your Accounts Receivable balance relatively low will help your cash balance.
Your deal structure will also drive your deferred revenue balance. If your business relies on annual deals, your deferred revenue balance will increase each month by new sales and decrease by the the monthly amount of revenue recognized. A healthy, growing SaaS company should see their deferred revenue balance increase each month, as it continues to add sales. If your company is built on annual subscriptions, don’t forget to include renewals, less some churn, in year two and beyond.
Prepaid expenses and accounts payable are more difficult to forecast, as they can vary widely from month to month depending on the business’s expense activity. It’s not worth spending much time forecasting these in the first year. Use a percentage of your monthly expenses as an estimate for accounts payable. If you know of any big expenses, like conference fees, that you may have to pay several months in advance, include that number in the prepaid expense balance for the months in between.
Finally, set your retained earnings equal to your cumulative net income and your equity equal to the capital invested thus far (or capital you hope to receive), and calculate your cash to balance that balance sheet. You’ll now be able to see the dynamics of your cash flow over time.
One of the most difficult parts about creating that initial forecast is that you have no historical data to go off of. For this reason, it’s pretty useless to try to forecast with any accuracy more than a year out from day one. Do your research around expenses, make reasonable estimates, and adjust. Compare your budget to your actual expenses monthly, and revisit your forecast at least quarterly to make adjustments based on trends in your actual expenses and sales. Not only will you have a better chance of avoiding the surprise of running low on cash or missing your targets, but this discipline will help you make better data-driven decisions.
If you complete this exercise and realize you don’t like how much cash you’re burning and how quickly you’ll need to fundraise again, one of the quickest ways to cut down on cash burn in your model is to slow down your hiring. Most of your costs relate back to people. But be realistic by looking at ratios like customer count to client success employees and new ARR per salesperson. Also be sure to give your product the R&D talent it needs.
I’ve outlined the process that we go through at High Alpha with our companies in building initial forecasts, but there are certainly other ways to come at the financial model. A different perspective is to start with an ARR goal and work backwards, calculating how many sales reps with a certain quota you’ll need, and the expenses around supporting them and the product. I prefer to work forwards, starting with the costs around your MVP and adding on go-to-market costs, as it tends to be more realistic — although keeping the big picture in mind and hitting certain milestones are important.
A Final Note
Keep in mind that a financial forecast will never be correct. It’s a plan, but you can’t perfectly predict the numerous variables that will affect the business going forward — from one month to five years. But it does provide a chance to compare how you’re doing now against where you hoped to be, and illuminates a path to hitting your goals and scaling your business. If you have other tips and suggestions for forecasting the financials of an early-stage SaaS company, leave a comment below!
Big thanks to Blake Koriath, the source of much of my SaaS finance knowledge.