A guide to revenue leakage: The “ultimate sin” in SaaS
This guide uncovers the basics of revenue leakage, a huge challenge facing nearly every SaaS company. You’ll learn what revenue leakage is, the impact it has, root causes, and how to fix it. Dive into the guide to stop committing the “ultimate sin” in SaaS.
What if we told you that nearly every SaaS company with complex pricing has revenue leakage, that most CFOs know they have it but can’t put a value on it, and that it could be costing you percentage points of revenue?
At a recent dinner with 15 CFOs in New York, SaaSonomics Managing Director Todd Gardner asked everyone to raise their hands if they thought their company had revenue leakage.
Everyone’s hands went up.
Some knew how much revenue leakage they had while others couldn’t put a value on it, but the market seems to agree that most estimates are conservative.
This seems to be a pertinent topic for SaaS leaders, with quite a bit of confusion around what it actually is and how to fix it. To dig deeper, m3ter CEO and Co-Founder Griff Parry recently hosted a webinar with Todd and Onfido Sr. Operations Manager Gordon Laing titled “UBP 101: Decoding Revenue Leakage.” The webinar is available on-demand, and this guide will walk through the key learnings shared by the group.
Contents:
- What is revenue leakage?
- Impact in SaaS
- Causes and types
- How to fix it
- Case study: Onfido
What is revenue leakage?
Revenue leakage occurs when a company under-bills for revenue that is owed according to customer contracts. It’s extremely costly and, according to Todd, the “ultimate sin” in SaaS.
Examples:
Company A uses a mix of seat-based and usage-based pricing (UBP) with annual and semi-annual prepayments. They're running billing in a master spreadsheet, but didn’t realize that the usage data tracking was incorrect for several of their customers. They leaked 5% of revenue on those customers for 6 months before the issue was caught.
Company B executed a heavily negotiated renewal with lower per-unit pricing but a higher monthly minimum. The Sales team updated Salesforce, and the pricing spreadsheet was updated with the new pricing. However, there was no automated way to track the minimums, and the customer was underbilled for over a year.
Company C has an internally developed system to track usage and the consumption of pre-paid credits. One of their large customers asked to see a detailed analysis of their usage and charges, but the system is a “black box” and they could not provide the customer any detail of their charges. The customer, rightfully, demanded more visibility or to switch to a flat fee.
There’s some confusion in the industry around the term itself, so it’s worth noting what revenue leakage is NOT:
Revenue leakage is not a collections problem or a churn problem.
The biggest area that revenue leakage gets lumped in with is collections, but they are not the same topic. While collection issues are definitely a concern for many businesses, collections are a cash flow and balance sheet issue, while revenue leakage is all on the P&L and more directly impacts valuation as we will see below.
This is about leakage of revenue that is owed but doesn’t even hit the top line – charges that should be on the bill but aren’t.
Impact of revenue leakage in SaaS
Revenue leakage isn’t just a lofty term used to scare finance execs. The negative impact can be significant across a number of areas. Todd says that revenue leakage hits the financial side of a SaaS company in four main ways:
1) Less revenue
This is the most obvious: whether your revenue leakage is 2%, 5%, or 10%, every dollar is one you earned but aren’t billing for. And since SaaS companies are valued based on a multiple of their revenue, every dollar of revenue leakage has an outsized impact on valuation.
2) Less profit
The impact of that decreased revenue works its way down the P&L. We’re talking about revenue from your existing customer base here: It's not churned revenue or revenue that you billed for but didn’t collect. These are customers that you're supporting, but you're just not charging enough.
That means you still have all the expenses associated with those customers – whether it’s the AWS bill or your Customer Success costs – and every dollar that you're not charging drops straight to the bottom line and pulls down your profitability.
Every dollar of leaked revenue is actually a dollar missing from operating profit. No other financial metric hits the P&L in that way.
For scaling SaaS companies that are unprofitable or hovering around breakeven, fixing revenue leakage can have a substantial impact on profitability: just think what could happen if you fixed a few percentage points of revenue leakage and it dropped straight to the bottom line. That could double or triple profitability.
3) Less value
Inefficient growth is no longer valued as highly as efficient growth in the current environment. That means revenue multiples are driven by both growth and profitability.
Here’s an example how the chain of events could go: A company identifies and fixes percentage points of their revenue leakage. That increased revenue drops straight to the bottom line and boosts profitability. The combination of higher profits and higher growth lead to an 8x multiple instead of a 7x multiple, which applies to all revenue, not just the incremental bit that’s recovered.
4) Less cash
At the end of the day, all that revenue leakage is cash you need to operate. Capturing those dollars means your cash accumulates faster – those are dollars that could allow you to delay a fundraise, develop new products, or invest more in Sales and Marketing.
I’ve started saying revenue leakage is ‘valuation kryptonite’. It really does have this unique impact both on the top line and the bottom line, and then ultimately on your valuation and your cash.
Todd developed a downloadable Revenue Leakage Calculator that can help you see the impact of even small amounts of leakage on revenue, profit, value, and cash:
In this example, a $10 million ARR company growing at 20% over five years – but with 3% revenue leakage – will end up with:
- $2.3 million less cash to reinvest
- $2.3 million less in profitability
- $5.1 million lower valuation (at least) in a sale or fundraise.
(This assumes no impact in the valuation multiple.)
If you look at the impact over ten years as opposed to five, revenue leakage will depress the valuation of this hypothetical company by $12 million.
You can download the Revenue Leakage Calculator here.
Causes and types of revenue leakage
The rise of revenue leakage is really driven by the complexity and billing of today’s SaaS companies. With more businesses moving toward UBP – or creating a hybrid model by marrying UBP with existing subscription-based pricing – complexity has gone up. In traditional SaaS businesses with simple subscriptions, sending out a bill once per year wouldn’t have been as complicated, and there was likely very little revenue leakage.
But as custom deals become more frequent and UBP gets folded into other pricing models, complexity and errors start to snowball into leaked revenue.
We see three main types of revenue leakage:
1) Capability constraints with usage data
A significant type of leakage happens when a company isn’t systematically capturing and rating product usage data (i.e., they don’t have the capability to track and calculate bills according to the contracted pricing).
Example: A business offers a subscription product with a usage allowance. If the customer exceeds that usage allowance, they should pay overages. But many businesses lack the capability to measure that usage, leaving them unable to work out whether they should be charging overages – so they just don't. The value of those uncharged overages is revenue leakage.
2) Errors and manual processes
Another cause of revenue leakage is when the source of truth for pricing gets out of sync with the actual pricing being used to calculate bills. This is especially common in cases where manual processes are still running the show and errors are easily introduced.
Example: A customer renews their contract and prices have increased, but for some reason that change doesn't filter down to wherever the bill calculation is happening (e.g., in a master spreadsheet). This means the bill is being calculated with pricing that is outdated and too low.
3) Unknown revenue leakage
Revenue leakage can also be a “known unknown,” which in this case means the CFO can sense complex pricing is leading to leaked revenue, but they can't figure out how it’s happening, why, or how much leakage there is. Or, perhaps it’s a “blissfully ignorant unknown,” and the CFO thinks they don’t have revenue leakage when they actually do.
How to fix it
The bad news: companies with any form of usage-based pricing almost certainly have revenue leakage, whether their CFOs want to believe it or not. The good news: no matter the type or cause of revenue leakage, it is fixable.
According to Griff, there are three main solutions that fix revenue leakage and give you confidence going forward:
- Automation of bill calculation
- Automation of the integration with the sources of truth for product usage and pricing
- Creation of a visibility or data management layer, so you can see what's going on and identify anomalies or potential problems
Case study: Onfido
The team at Onfido – an established SaaS provider of state-of-the-art identity verification – knows the struggles of revenue leakage firsthand.
Onfido’s pricing and billing:
- Usage-based pricing
- Bill up front
- Customers prepay an annual commitment
- Everything is a drawdown deferred revenue position
- Bespoke pricing for every customer
Senior Company Operations Manager Gordon Laing says his team’s impulse to find and fix their revenue leakage stemmed from audit questions. During revenue audits, external auditors would ask questions like, “How did you calculate this customer’s bill for this day or month?” But as Onfido would go through their billing and aggregating platform that was built in-house, they could see that the data didn’t always match when they retested it.
“We knew we had a problem there,” says Gordon. “We couldn't always identify what that calculation was doing and why it wasn't consistent.” While it seemed to be working most of the time, certain complex use cases with bundled products were clearly introducing problems.
A note from Todd:
It’s fascinating that [Onfido’s] auditors caught this. Because of their credit system, it absolutely mattered in RevRec that it be accurate.
But in a lot of cases, companies are billing in arrears. So RevRec starts with the bill, and when that happens, auditors are much less likely to actually identify this issue.
So if you've been through a few audits, and you think, ‘Oh, the auditors say it's fine,’ that’s not necessarily the case. It's not that revenue leakage is not a problem - it's just a problem that the auditors don’t catch.
Onfido enlisted a 3rd party provider to try and size the problem based on all of their Salesforce, billing, and pricing data. That provider’s conservative estimate was that Onfido’s revenue leakage was between 0.75% and 1.5%.
Beyond the revenue leakage issue, Onfido was dealing with capacity challenges in its legacy billing platform, other instances of painful data reconciliation, and engineers spread thin.
How Onfido fixed their revenue leakage
Onfido was able to finally plug the revenue leakage and produce reliable calculations once they started using m3ter’s usage-based billing platform. Gordon says he and his team knew within about 30 seconds of a demo call that m3ter was exactly what they needed.
Since then, the team has been able to see the full scale of their revenue leakage thanks to the accuracy of the billing information. As it turns out, there were a number of customers who weren’t being billed – the old system would never send them an invoice as there wasn’t specific pricing linked to their account. Total leakage was estimated at up to 1% of total revenue.
The impact has been substantial: m3ter is helping Onfido prevent tens of thousands of dollars of revenue leakage each month. m3ter’s seamless integration with Salesforce means Onfido has just one source of truth for contract and usage data. And auditability is significantly improved, allowing the team to go in and see the calculations on any given day and any given product with just a few clicks.
These insights come from our recent webinar featuring Todd Gardner, Gordon Laing, and Griffin Parry. Want to hear more? Watch it here.
Watch our webinar on "Decoding Revenue Leakage"
Join SaaS finance expert Todd Gardner, Onfido’s Senior Operations Manager Gordon Laing, and m3ter CEO Griffin Parry for an essential webinar. Designed for Billing and Finance operations teams, this session addresses the critical issue of revenue leakage and its potential threat to your business.
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