Source: For Entrepreneurs, Jan 2013
(GREAT READ, with a downloadable excel file)
The High Level Picture: How to Run a SaaS Business
Hopefully what you will have gathered from the discussion above is that there are really three things that really matter when running a SaaS business:
- Acquiring customers
- Retaining customers
- Monetizing your customers
The second item should be first on your list of things to get right. If you can’t keep your customers happy, and keep them using the service, there is no point in worrying acquiring more of them. You will simply be filling a leaky bucket. Rather focus your attention on plugging the leaks.
SaaS businesses are remarkably influenced by a few key numbers. Making small improvements to those numbers can dramatically improve the overall health of the business.
Once you know your SaaS business is viable using the guidelines provided for LTV:CAC, and Time to recover CAC, hit the accelerator pedal. But be prepared to raise the cash needed to fund the growth.
SaaS Metrics 2.0 – A Guide to Measuring and Improving what Matters
“If you cannot measure it, you cannot improve it” – Lord Kelvin
This article is a comprehensive and detailed look at the key metrics that are needed to understand and optimize a SaaS business. It is a completely updated rewrite of an older post. For this version, I have co-opted two real experts in the field: Ron Gill, (CFO, NetSuite), and Brad Coffey (VP of Strategy, HubSpot), to add expertise, color and commentary from the viewpoint of a public and private SaaS company. My sincere thanks to both of them for their time and input.
SaaS/subscription businesses are more complex than traditional businesses. Traditional business metrics totally fail to capture the key factors that drive SaaS performance. In the SaaS world, there are a few key variables that make a big difference to future results. This post is aimed at helping SaaS executives understand which variables really matter, and how to measure them and act on the results.
The goal of the article is to help you answer the following questions:
- Is my business financially viable?
- What is working well, and what needs to be improved?
- What levers should management focus on to drive the business?
- Should the CEO hit the accelerator, or the brakes?
- What is the impact on cash and profit/loss of hitting the accelerator?
(Note: although I focus on SaaS specifically, the article is applicable to any subscription business.)
What’s so different about SaaS?
SaaS, and other recurring revenue businesses are different because the revenue for the service comes over an extended period of time (the customer lifetime). If a customer is happy with the service, they will stick around for a long time, and the profit that can be made from that customer will increase considerably. On the other hand if a customer is unhappy, they will churn quickly, and the business will likely lose money on the investment that they made to acquire that customer. This creates a fundamentally different dynamic to a traditional software business: there are now two sales that have to be accomplished:
- Acquiring the customer
- Keeping the customer (to maximize the lifetime value).
Because of the importance of customer retention, we will see a lot of focus on metrics that help us understand retention and churn. But first let’s look at metrics that help you understand if your SaaS business is financially viable.
The SaaS P&L / Cash Flow Trough
SaaS businesses face significant losses in the early years (and often an associated cash flow problem). This is because they have to invest heavily upfront to acquire the customer, but recover the profits from that investment over a long period of time. The faster the business decides to grow, the worse the losses become. Many investors/board members have a problem understanding this, and want to hit the brakes at precisely the moment when they should be hitting the accelerator.
In many SaaS businesses, this also translates into a cash flow problem, as they may only be able to get the customer to pay them month by month. To illustrate the problem, we built a simple Excel model which can be found here. In that model, we are spending $6,000 to acquire the customer, and billing them at the rate of $500 per month. Take a look at these two graphs from that model:
If we experience a cash flow trough for one customer, then what will happen if we start to do really well and acquire many customers at the same time? The model shows that the P&L/cash flow trough gets deeper if we increase the growth rate for the bookings.
But there is light at the end of the tunnel, as eventually there is enough profit/cash from the installed base to cover the investment needed for new customers. At that point the business would turn profitable/cash flow positive – assuming you don’t decide to increase spending on sales and marketing. And, as expected, the faster the growth in customer acquisition, the better the curve looks when it becomes positive.
Ron Gill, NetSuite:
If plans go well, you may decide it is time to hit the accelerator (increasing spending on lead generation, hiring additional sales reps, adding data center capacity, etc.) in order to pick-up the pace of customer acquisition. The thing that surprises many investors and boards of directors about the SaaS model is that, even with perfect execution, an acceleration of growth will often be accompanied by a squeeze on profitability and cash flow.
As soon as the product starts to see some significant uptake, investors expect that the losses / cash drain should narrow, right? Instead, this is the perfect time to increase investment in the business. which will cause losses to deepen again. The graph below illustrates the problem:
Notice in the example graph that the five customer per month model ultimately yields a much steeper rate of growth, but you have to go through another deep trough to get there. It is the concept of needing to re-enter that type of trough after just having gotten the curve to turn positive that many managers and investors struggle with.
Of course this a special challenge early-on as you need to explain to investors why you’ll require additional cash to fund that next round of acceleration. But it isn’t just a startup problem. At NetSuite, even as a public company our revenue growth rate has accelerated in each of the last three years. That means that each annual plan involves a stepping-up of investment in lead generation and sales capacity that will increase spending and cash flow out for some time before it starts yielding incremental revenue and cash flow in. As long as you’re accelerating the rate of revenue growth, managing and messaging around this phenomenon is a permanent part of the landscape for any SaaS company.
Why is growth important?
We have suggested that as soon as the business has shown that it can succeed, it should invest aggressively to increase the growth rate. You might ask question: Why?
SaaS is usually a “winner-takes-all” game, and it is therefore important to grab market share as fast as possible to make sure you are the winner in your space. Provided you can tell a story that shows that eventually that growth will lead to profitability, Wall Street, acquiring companies, and venture investors all reward higher growth with higher valuations. There’s also a premium for the market leader in a particular space.
However not all investments make sense. In the next section we will look at a tool to help you ensure that your growth initiatives/investments will pay back: Unit Economics.
A Powerful Tool: Unit Economics
Because of the losses in the early days, which get bigger the more successful the company is at acquiring customers, it is much harder for management and investors to figure out whether a SaaS business is financially viable. We need some tools to help us figure this out.
A great way to understand any business model is to answer the following simple question:
Can I make more profit from my customers than it costs me to acquire them?
This is effectively a study of the unit economics of each customer. To answer the question, we need two metrics:
- LTV – the Lifetime Value of a typical customer
- CAC – the Cost to Acquire a typical Customer
Two kinds of SaaS business:
There are two kinds of SaaS business:
- Those with primarily monthly contracts, with some longer term contracts. In this business, the primary focus will be on MRR (Monthly Recurring Revenue)
- Those with primarily annual contracts, with some contracts for multiple years. Here the primary focus is on ARR (Annual Recurring Revenue), and ACV (Annual Contract Value).
The Importance of Customer Retention (Churn)
Defining a Dashboard for a SaaS Company
The following section should be most useful for readers who are interested putting together a dashboard to help them manage their SaaS business.