It’s a ubiquitous trend in the world of software: service-based consulting companies transitioning to subscription-based SaaS product companies.
Sometimes founders realize that they’re essentially solving the same problem over and over again for their customers and decide to capitalize on that demand by creating a product solution. Other times, founders have a SaaS product in mind from the start but decide to generate a steady stream of income from consulting in order to build the product and start scaling.
In the long run, if you’re successful, a subscription-based SaaS business can be far more lucrative than a consulting company could ever be. But even in the best of circumstances, success is not guaranteed.
If you’re thinking of making the leap from the bread-and-butter business of consulting company to a SaaS company, it’s good to understand the pros and cons. If you are already committed to the switch, and in the middle of this transition, you may want to read this post on how to transition from a service to product company successfully.
Pros of starting a SaaS business
Scalability
Once your product is built out, you can add a lot of users without a significant increase in cost. Not only can this lead to substantial profits, but it also makes it possible for you to secure investment capital as you grow.
Cash up front
The longer your subscriptions are for, the more usable cash you’ll have to redeploy towards further growing your business. This is the exact opposite of consulting, where you need to do the work first, and then get paid 30, 60, or 90 days out.
Predictability
With a subscription model, you can easily get a handle on recurring revenue, baseline growth, and customer churn. Combining those key data points will enable you to make a reasonable prediction about your company’s future revenue. This is in sharp contrast to a consulting business, where customers come back only as needed, and on whatever timeframe meets their needs.
Financing
More predictable future revenues will make it easier to market your company to providers of outside capital to keep growing.
Cons of the SaaS business model
Development costs
Unlike a consulting company, which is profitable almost immediately, SaaS companies take a long time to get into the black. Unless your consulting business is generating significant excess cash flow, getting your product off the ground might require outside capital. And startup business loans can be hard to get if you're a new tech business without hard assets that isn't making a profit.
Complex budgeting
Even if your SaaS product is built out and profitable, you’ll need to be sure that you reserve some subscription revenue to provide ongoing service and updates for your customers during their billing period. If you don’t budget and manage cash flow adequately, you could find yourself in a position where you can’t afford to deliver on something that your customers already paid for.
Less revenue per customer
The upside of offering a high-touch consulting service is that you can generally charge a higher amount per customer than you can when offering a monthly subscription product. This means you’ll need a lot more customers for your SaaS business than you did for your consulting business.
During the transition period, you may find that your gross income is actually lower than before, because your lucrative consulting clients have moved to a less expensive subscription, while you don’t yet have enough new customers to make up for the loss. Even if your gross income goes up, without a significant customer base for your product, you may not earn enough during the transition to make up for the cost of effectively running two business — both a product business and a service business.
Differences in accounting for revenue
Before you make the transition from a service to a product company, you should understand how to properly recognize the accounting differences between the two and ensure that you’re financially prepared to make that transition, as well.
Let’s review the differences in accounting for both types of revenue under accrual accounting.
Recognizing revenue in a services business
Your consulting revenue consists of the stand-alone purchases of services. Your clients will likely pay after completion for a smaller project, and then they may or may not choose to renew for another contract.
In this instance, you recognize revenue and an associated cost of service at the time of purchase.
If you offer delayed payment terms, you recognize an account receivable as a result of this transaction, but generally your clients are billed at the project's completion for cash.
If it's a longer-term consulting contract, you will probably charge progress billings, which essentially divide a large contract into smaller pieces. With progress billings, you usually collect payment at certain milestones determined by your contract — the associated accounting recognizes an asset called unbilled revenue, which operates similarly to accounts receivable (A/R).
Revenue recognition for a subscription product
When you move to the SaaS subscription model, your clients will be paying a recurring fee for access to your product offering. In turn, you agree to keep your software up to date, and provide ongoing support to your subscribers.
As a matter of payment, you provide access to your software and immediately charge the client for that access upfront, for the entire billing period.
This results in unearned revenue, which is a liability under accrual accounting that recognizes someone has paid you for something that you haven’t fully delivered yet.
Read more about how to record deferred revenue.
A good move for some businesses, but not all
In the long run, there can be a huge payoff to switching from a service business to a product business; but the going can be tough, especially if your consulting clients transition to your SaaS product before you have enough new customers to make up for the lost income.
This strategy works best for companies that think they can either:
Get their clients to adopt the new SaaS product quickly enough to ditch the consulting side of their business entirely; or
Entice enough new clients to the SaaS product so they can afford to run both businesses at once.