Capex vs Opex in SaaS
What do these terms mean. Why and when do customers prefer one vs the other
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As SaaS startups start maturing, they inevitably encounter this question from their customers — Can we structure this SaaS contract as capex?
Many SaaS founders never had to deal with this before, so it becomes a bit puzzling. I decided to tackle that question in this post. We’ll talk about:
What exactly do the terms "capex" and "opex" mean
Why does it matter?
Why do customers prefer capex? And under what conditions?
How to structure a SaaS contract as capex?
I asked DALL-E to generate an image of two accountants evaluating a SaaS contract in ancient Rome. This is what it came up with:
Let's say your company offers a SaaS product. And you bill your customers on a recurring basis every month. You've been running a pilot with a large customer and now they are ready to sign a multi-year commercial agreement with you. You get a request from them asking you to structure the contract as capex as opposed to opex.
But how do you do that? Isn't capex meant for buying large physical equipment? How is it relevant to SaaS? It's a great topic that doesn’t get enough attention, so I decided to tackle it in this post.
What exactly do the terms "capex" and "opex" mean?
Capex stands for CAPital EXpenditures. They are purchases made by companies to be used over the long term. It's usually for fixed assets such as equipment, vehicles, manufacturing plants, or owned software licenses.
Opex stands for OPerating EXpenses. These are day-to-day expenses to run the operations for a business. This can include rent, salaries, utilities, travel, and other recurring expensess.
Why does it matter?
Let's say your business needs to print paper on a daily basis to run its core operations. If you have to go to a printing shop to print every time, the printing expenses are counted as opex.
Now you realize that instead of going to the printing shop every time, you can just buy a printer. It's easier and faster, but you do need spend money upfront to buy the printer. The cost of buying the printer is counted as capex.
Due to wear and tear, you may have to replace this printer in 3 years. But if printing is a core part of your business, it's preferable to invest capital upfront and buy the printer.
If the capex vs opex ever comes up in SaaS, it’s a good sign for a startup. It means the customer is looking for an efficient way to make you an integral part of their business. As you sign longer term deals in SaaS, the capex vs opex conversation becomes increasingly relevant because it's beneficial for a company to treat it as capex. Let's see why that's the case.
Why do customers prefer capex? And under what conditions?
Capex is part of the balance sheet, but not the P&L statement. What does that mean? It means that the company doesn't have to show that they're spending money out of the revenue that's coming in.
Now let's compare this to opex. The opex has to be accounted for in the same year. And companies can deduct opex from their taxes for the year in which the expenses were incurred. But it has an impact on the profit margin (obtained by calculating the difference between revenue and expenses).
The key feature of capex is that these purchases benefit the company for longer than a single tax year. These assets have a parameter associated with them called "useful life" and they depreciate over this time period. This is helpful for companies to spread out the cost of the asset over this useful life.
If an item is critical for long-term success, making an upfront investment and moving it to capex effectively increases their profit margin for the year. If expenditure goes down, the margin goes up. This tends to have a direct impact on the stock price of the company.
If they're doing a short term contract, it usually goes into opex. If they want to sign a multi-year contract, it usually goes into capex. Multi-year contracts are great for startups.
How to structure a SaaS contract as capex?
SaaS payments come under opex by default. You need to spend this money every year to run the operations. But if the customer sees this product as a core part of running their business, it's usually beneficial for them to move it to capex. And then allow this asset to depreciate over time. It usually means signing a multi-year contract.
The way to structure this contract is to show that your SaaS product has been customized for this particular customer and has a useful life of 'n' years. This means that the product can't be dramatically changed during this time period (except for minor changes related to software maintenance).
This piece of software will be treated as an asset that was purchased upfront and has a useful life of 'n' years. After that, they will buy a new asset from you. This new asset could be an improved version of your SaaS product with new features.
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