The higher my recurring revenue percentage, the more predictable my revenue, and the more likely my investors are to fund my company’s growth. Right?
Wrong. This mindset can have dangerous consequences! Let me illustrate why service revenue is important, by using some real-life examples from Papirfly.
First: what exactly is RR%?
Recurring revenue percentage (“RR%”) is defined as:
RR% = Recurring revenue / Total revenue
Total revenue at Papirfly, similar to most SaaS companies, includes recurring revenue (including software recurring revenue and other recurring revenue) and services revenue (including onboarding, managed services, and projects). RR% is simply recurring revenue divided by the sum of recurring revenue and services revenue. Turning this reasoning on its head:
The higher my RR%, the lower my services revenue %
Sounds obvious! But why exactly would I want to minimize my service revenue? Let’s explore that argument for a moment before we dismiss it. We will put on three different hats: first Product, then Customer, and then Finance.
The Product hat
The point of the SaaS model is building a product that can be sold as beautifully pure, high-margin, software recurring revenue rather than lesser, lower-margin services revenue.
So, the better my product, the higher my RR%? Not necessarily! Note these nuances:
1: A product with excellent features and integrations removes the need to sell services to bridge my product gaps.
It’s easy to see a perfect product would mean no need to provide additional services, however in the absence of perfection SaaS companies may be tempted to resort to manual quick-fix solutions to work around limitations in the product. This can be a good solution in the short term, or for a limited / reducing number of customers but unless addressed in a proper way can have a snowball effect, increasing human effort and causing serious structural inefficiencies.
At Papirfly, we have had instances of our support team pulling together manual reports for our customers. This is low-margin, manual work: not efficient. So when we introduce our automated reporting module, our RR% will in theory increase, but this is not the case. In our efforts to serve our customers we were often doing this additional manual effort for free, so we received zero services revenue before automation, and will receive zero service revenue after – no effect on RR%, but a clear win for us and the customer.
High service revenue can be a symptom of significant product gaps. But product gaps can exist even with zero services revenue if those services are not packaged as one-off fees, as we have learned the hard way at Papirfly. This is why it’s important to have a functioning setup for charging one-off fees, i.e. services revenue.
2: A product that is self-serve means my customers can effortlessly find what they need in the product or e-learning material without the help of humans.
Some SaaS platforms are truly self-serve, and good for them! Those companies can put all of their human efforts into marketing and product-led growth and not waste any human time on individual customers. But I would challenge even the most ardent self-serve enthusiasts to really take a look at their processes. For example, is their onboarding process truly self-serve or do they assist their customers with this? If the latter, I would advise them to review the time spent onboarding and consider a scenario in which they charge separately for these services.
It is very much possible to have 100% recurring revenue whilst plugging product gaps with human effort. We must go deeper to understand the ideal boundary between products and services. Each company, product, and market is different, and I would urge SaaS professionals to make sure they really understand what their ideal scenario is, and act accordingly.
The Customer hat
Customers don’t really care about the product, but they want the best tools and resources to do their jobs properly. When we put our Customer hats on, we consider that each customer has different and varying needs in navigating change management and adoption challenges on their end to ensure optimal use of the product.
Services, whether it’s onboarding, managed services or projects, are a crucial part of ensuring that the software sold by the sales team becomes embedded in the customers’ workflow. This in turn increases stickiness, which drives net retention and ultimately recurring revenue.
At Papirfly, we find that the more our customers invest upfront in our services, the higher their net revenue retention. Particularly intriguing is the interest from our customers in co-funding innovation. For example, with our Papirfly AI Lab, we are generating service revenue from some of our most loyal customers whilst also driving innovation.
The above suggests that services drive recurring revenue growth via a twofold feedback mechanism:
- Lack of available services puts customers at risk of churn, reducing RR
- Investment in services increases adoption, increasing the likelihood of upselling RR
Services are an integral part of most successful B2B SaaS companies: if services were not important, no successful SaaS company would have service revenue.
The Finance hat
As a SaaS CFO, I need to understand which revenue streams are contributing to my overall gross margin. Splitting my margins by revenue category helps me drive budget and planning sessions to map resource requests against forecasted margins. It’s hard to make decisions without knowing revenue stream margins and understanding the impact of certain investments on my business.
At Papirfly, we came to the painful realization that we could not properly differentiate our revenue streams, impacting decision-making. This is one of the reasons we decided to clarify the boundary between services and software at Papirfly and appointed a separate services leader. This enables us to have an understanding of not just our overall gross margin but also our services margin and software margin. Data-based decision-making is only as good as the data going in.
In the current macro environment, high-interest rates and high inflation is causing many SaaS companies to look for profitability rather than growth at all costs. According to an analysis by ABG of Swedish-listed SaaS companies per Q1-23, companies on average sacrificed 9% of annualized growth to gain 7% in profitability.
One of the most capital-efficient ways to improve profitability is via one-off customer projects, due to the low cost of customer acquisition. Although some SaaS companies are seeing a drop in their services revenues this year, as customers look to delay projects, on the other hand, a downturn causes people to look inwards. With large-scale transformative trends such as AI and the green revolution, there could be an opportunity to look for co-funded innovation opportunities together with our customers. In this way, we can earn money through services whilst increasing stickiness and RR growth.
Key Takeaways
- It is not as simple as going for as high a recurring revenue percentage as possible. Rather than maximize, think to optimize RR% for your business, your market, and your product.
- It is tempting to plug product gaps with human effort, and this is ok as long as the boundary between product and services is well defined, it is a temporary fix, and this human effort is charged for as a separate services revenue stream.
- Services revenue drives recurring revenue growth in a beautiful symbiotic way, through improvement in adoption and customer satisfaction, which increases the stickiness of the product.
- Consider how to capitalize on the current market conditions by selling appropriately tailored services, which can in turn increase RR.
Further reading:
https://www.thesaascfo.com/how-to-calculate-saas-gross-margin/
https://www.precursive.com/post/the-role-of-professional-services-in-saas-companies
