In a previous post Revenue Model Comparison: SaaS v. One-Time-Sales we talked about how a subscription revenue model (SaaS) differs from a one-time sales revenue model. This post will discuss the definition and some simple explanations of the terms: payback period, internal rate of return, modified internal rate of return and gross margin.
The first term to discuss is Payback period. It is defined by Investopedia as follows:
“The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.”
Calculated as: Payback Period = Cost of Project / Annual Cash Inflows
This is a very simple metric, but it is quite important to gauge risk of the project. Let’s say you invest $100,000 in a project that is expected to return $100,000 in the first year.
This example results in a payback period of 1 year. This means you will recover your investment during the first year. Notice that this metric does not calculate anything related to return on investment.
Now imagine that the same project will return $50,000 during the first year and $50,000 during the second year.
This example results in a payback period of 2 years. This means you will recover your investment during the once the second year is done. Which one would you prefer? All things equal, you should obviously go for the one that returns your cash quicker.
Now, in the third example, you invest $100,000, and have quarterly returns of $20,000. What’s your payback period?
Internal Rate of Return
The metric investors pay attention to the most is the Internal Rate of Return. Investopedia defines it as:
“The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.”
That sounds quite complicated, so let’s use the following example:
If you were to invest $100,000 in a project that renders an IRR of 15% in a five-year term, you assume that you’ll derive a 15% compounded return every year from this project. That’s technically true. One of the biggest confusions created with the IRR is that it provides a uniform set of cash flows. This cannot be farther from the truth. Let’s use the following examples to compare how under different cash flow scenarios you can still arrive at a 15% Internal Rate of Return.
In this case you invest $100,000 and receive no money back until the fifth year. In order to obtain a 15% internal rate of return you would need to receive back $174,901.
Focus only on the orange boxes. In this case you invest $100,000 and receive uniform payments of $15,000 annually plus your principal in year 5. Your full payback period is still in year 5, but you’re receiving $15,000 annually, so you at least get some cash during years 2-4, before receiving the principal with the last interest payment amount.
The light blue boxes are not used for the Internal Rate of Return calculations, but are there for a reason. They mean that the $15,000 you obtain in Year 2 – 4 must be reinvested at 15%, in order to obtain an IRR of 15%. (More on that later.)
Again, focus only on the orange boxes. In this case you invest $100,000 and receive uniform payments of $35,027 annually. That’s it: 4 payments of $35,027. Your full payback period is now in Year 4.
The light blue boxes are not used for the Internal Rate of Return calculations, but are there for a reason. They mean that the $35,027 you obtain in Year 2 – 4 must be reinvested at 15%, in order to obtain an IRR of 15%. (As mentioned in Example B, I will explain below the importance of this.
If you were to compare these three examples, which one would you pick. It all depends on your risk profile. Some investors prefer to see some cash up-front. So, Example C would return only $140,106 in total, but the investor might feel a bit more comfortable because by year 2 they at least have 70% of their investment back in their account. If the investor likes higher return and can bare the risk, they might prefer Example A, which sees no cash until Year 5, but receives $174,901.
The only problem with this metric is that it assumes that any cash you receiving during the term of the investment is reinvestment at the same rate. At this point we should discuss the importance of the light blue boxes; the Reinvestment Rate. The problem with the IRR formula is that it implies that the investor will deploy its capital through another investment that will yield the same rate as the one in discussion.
To illustrate this, I showed the blue boxes. If you look at the first payment, to the right you have three additional figures. Those figures are the “implied interest returns” at that “other investment” yielding that 15%. So, if you take the monies received in Year 2 ($35,027) and invest it in another instrument yielding 15%, by Year 5 you would have $53,271.
In real life that is hardly the case. In reality, you might have to rest the money in a bank account that pays 4% (if you’re lucky) and start looking for another investment. Because this is the norm, many investors prefer to use the MIRR, or Modified Internal Rate of Return formula.
So, our Example C.2, will use MIRR instead of IRR.
In this example, we used a Reinvestment Rate of 4% for the money received during Years 2, 3 and 4. Because we couldn’t find other projects with a 15% return, we had to put that money on a certificate of deposit yielding 4%; because of this, your real internal rate of return is 10.43%.
As you can see in the “actual return” line, the total $148,739 is lower than the “total implied return” of $174,901 in the other examples. While this is really not that important to the entrepreneur looking to raise money, it is important for the investor, in order to allocate capital efficiently throughout its portfolio.
Hopefully this primer in Internal Rate of Return did not confuse you more than it explained.
Gross margin is probably the easiest to explain, but not as easy to calculate, depending on your interpretation of what it should consider.
Investopedia defines Gross Margin as:
A company’s total sales revenue minus its cost of goods sold (or cost of service delivery), divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.
Gross margin is an excellent metric to understand if you are selling at the right price and/or your cost to produce x-amount of revenue is cheap or expensive. For example, in the professional services industries, benchmark for Gross Margin should be around 30%. If you are charging $75.00 an hour, your cost to deliver this service should not exceed $70.00 an hour.
If for example, you are in the product development SaaS sector, you’re benchmark could well be to achieve a Gross Margin of 65%. Thus your cost of service delivery should not exceed $35.00 if you’re charging $100 for the product.
How to use Gross Margin to identify if you’re charging too much, or too low, or paying too much to deliver service. Simple, market research. In other words, it’s time to start scouting competitors’ pricing structures, talking to your customers, and talking to your current and potential suppliers.
If you know that you’re paying the absolute cheapest for hosting, and you hired excellent employees at market rate, and you have a 25% gross margin rate; then you should look at pricing. Are you charging market rates? Yes, no maybe?
If they are charging the same amount, then you should take a long hard look at your volume. Maybe you have excellent hosting prices, and your employees are compensated well (and are happy), but you can take on 100% more clients without the need to hire an additional employee and raise hosting prices. This means you have idle capacity and you’re lagging in business development.
So, let’s say that you anticipate that getting 100 additional clients will be tough without any other adjustment. How about lowering your price by $5.00? Maybe doing that will bring in 100 clients easily.
Notice how decreasing pricing by 10%, gross margin decreases only 5 points from 62.5% to 58.3%. So, now you get excited and think that if you can bring an additional 100 with a $5.00 decrease, you might as well lower it 30% to $35.00 and bring in 400.
Not so fast there. Does your hosting provider charge for the additional traffic? Yes, actually it’s now going to cost you $500 a month. Can your employees handle the workload without burning out? Not really… So, you need to factor in additional support.
So, we’re back to where we started. Not really, in the first example gross margin stood at 25%, now gross margin stands at 46.4%, but the last calculation is a good example of how increasing revenue comes at a cost. Even fixed costs are fixed up to a certain point. This principle even applies to SaaS companies that depend more on technology than on personnel. All expenses, variable and fixed should be considered when projecting growth.
We’ve briefly discussed three important metrics related to financial modeling for startups (Payback, IRR/MIRR, and Gross Margin). These are important, because you need to know what investors are looking for, and/or if you should invest your time and money for a project that won’t really provide decent returns. Why would you go into it if it is not getting decent compensation for your efforts? You will learn a lot launch a new project, or startup, but will it be better than working for another company, and then trying to launch your startup?
There are other SaaS metrics like CAC, LTV, MRR, and Churn Rate; and more broad financial metrics like EBITDA, Net Profit Margin, etc. I hope to discuss them in a future post.
In the next post, I will focus on revenue and expense trends, and how it affects cash flow, internal rate of return and payback period. Hopefully, I tie the information in the first post of Revenue Models, with this post on metrics.
If you have a question, or think I missed something important in this post, shoot me email: email@example.com. I would love to hear your input. Also, if you want a copy of the Excel for these calculations, send me an email to send you a copy of the Excel.
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