SaaS Metrics 101
Software-as-a-service is so commonplace today it’s hard to imagine an era where on-premise servers were the default, not the exception.
The era of on-premise enterprise software wasn’t that long ago, however. Players like SAP, Oracle and Siebel dominated the market for B2B software and customer relationship management for decades. It wasn’t until a little upstart called Salesforce came up with the novel idea of delivering software over the internet — no more hardware, no more change orders, no more painful implementations. The company, under the leadership of Marc Benioff, made their vision abundantly clear with a guerrilla marketing campaign in which employees staged a fake protest at the annual Siebel User Conference in 2000. Their message? The end of software!
Staged protest from Salesforce at Siebel User Conference (Source: Marc Benioff on Twitter)
Clever marketing earned them attention, but re-inventing the B2B software business model (and executing year over year) is what truly set Salesforce apart. They effectively re-wrote the rules of accounting for a recurring revenue business model and redesigned traditional org charts to optimize for user acquisition, growth and retention. Their radical move spawned a generation of new business to business SaaS companies targeting every aspect of the enterprise: Zendesk (customer service), Slack (internal communication), and our portfolio company Aircall (cloud telephony systems) to name a few. Since Salesforce gave way to the SaaS revolution, thousands of SaaS companies have come to market. In doing so, experts have developed key metrics to monitor the success of these organizations, which often behave counterintuitively to their predecessors. Today, I wanted to walk through SaaS Metrics 101, an introduction to the measurements that matter in today’s hyper-competitive software market.
“With the shift to the SaaS model, the connection between your customer’s success and your success is much more direct and felt more quickly. Smart companies have realized that customer loyalty is the most powerful sales and marketing tool that they have.”
— Bill Price, TPG Capital
What we’ll cover:
- Key Definitions & Unit Economics
- Why growth companies are different
- Adding fuel to the fire: methodologies to boost growth
- The holy grail of recurring revenue: negative churn
- Customer Engagement & Predicting outcomes
“You need to earn and maintain that customer’s trust every day, every transaction. The only way you can do that is measuring everything.”
— Lew Cirne, CEO of New Relic
One of the fundamental differences in the SaaS world is the subscription model. Instead of paying a one-time fee for software and implementation (and then recurring maintenance), you pay a monthly or annual subscription that earns your rights to future upgrades, bug fixes, and features, delivered seamlessly (and without breaking your instance) over the internet. This didn’t just change the pay structure, it had downstream implications across the entire business. A subscription makes it easy to sign-up, but easy to cancel or switch to another service. As a result, there is a major focus on customer-centricity, continual execution and constant innovation. Below is a cheat sheet that reflects the KPIs critical for understanding the health of your SaaS business.
Key Metrics for SaaS Businesses (graphic inspired by SaaS Metrics 2.0)
There are essentially three phases to the customer lifecycle in Saas:
- Acquisition
- Retention
- Engagement
If you can execute on these three pillars you have a shot at building and scaling a world-class company. In order to perform, however, you need to track the underlying business metrics reflected in the above formulas. The best companies have their finger on the pulse in real-time (or as close as humanly possible) with reports and dashboards that reflect targets and align incentives. It’s easier said than done. And since SaaS tends to be a “winner take all” market, some of the early growth strategies may be counterintuitive to a traditional executive.
“Those folks who are focused on customer development, they’re growing at 30% higher year-over-year growth rates than those who aren’t.”
– Patrick Campbell, CEO Profitwell
One of the most counterintuitive elements of an early SaaS company can be illustrated through the cash flow model of a single customer. Because it costs so much to acquire a new customer, you suffer early losses and negative cash flow. But due to the recurring subscription revenue, there is eventually a breaking point that pulls you into the black. This is why measuring CAC, payback period and LTV are incredibly important.
Source: For Entrepreneurs
The impulse for most investors (and executives for that matter) is to pull back when you cross over into positive cashflow. The reality, as proven by some of the most dominant SaaS companies today, is to do just the opposite. In the near term, the P&L and cash flow statements will dip deeper into the red, but the long run forecast accelerates growth even further. There is a risk tolerance here from investors because the model predicts that a winner in this scenario commands premium prices and the unit economics predict massive gains to outweigh the early losses in the long run.
Source: For Entrepreneurs
“The second biggest cause of startup failure: the cost of acquiring customers”
– David Skok, Matrix Partners
There are two key benchmarks, rules of thumb so to speak, that indicate the health of your SaaS business. As a SaaS executive, you want your LTV : CAC ratio to exceed 3x and your Payback Period (CAC / ARPA) to remain below 12 months. To work towards these objectives, you need a pragmatic approach — not everything can be fixed with mathematical formulas! There are three common levers to pull:
- Fresh Fundraising
- New Lead Sources
- Customer Segmentation
The first strategy, we should all be familiar with — capital injection can be a useful method to support the inevitable cash burn associated with high growth. A non-trivial portion of any fundraising capital goes towards marketing (in addition to hiring talent, product development etc.), and marketing is always looking to optimize lead quality. Marketing channels tend to become saturated and ROI on marketing spend depletes. For example, LinkedIn and Instagram ads might not be performing as well as they used to, so it may be time to pivot to the new kid on the block: TikTok. The last tactic, customer segmentation, is an exercise I’ve been through many times as a Customer Success leader. In principle, it’s a simple concept: identify key personas across your customer base and tailor your approach to meet their respective needs. This could be a cross-section of your install base by size of business (SMB, Mid-Market, Enterprise) or by plan or spend (ARR or annual recurring revenue). Customer segmentation will impact your org structure across the board from Sales to Marketing to Customer Success and will dictate new playbooks for acquiring and retaining said clients. But no matter what, you’ll have to confront the nemesis of every SaaS business: churn.
“Customer relationships matter more than ever, because your future revenue depends on those relationships lasting well beyond a single transaction.”
— Mikkel Svane, CEO of Zendesk
In a traditional software business model, it’s enough to measure “bookings” — a snapshot of the one-off payments you expect to collect by month. In SaaS, recurring revenue requires a time variable to paint an accurate picture. Contract renewals are dependent on customer satisfaction, contract lengths vary from customer to customer, and while some customers will upgrade or expand usage, others will leave altogether. Thus, net new ARR is the formula that should be top of mind.
Source: For Entrepreneurs
In SaaS, 2% is considered a “good” churn rate. Now this obviously changes as you scale: 2% of 100 customers is much different than 2% of 50,000 customers. There are also two ways to measure churn: by customer and by ARR. So, for example, if you lost your highest paying customer, the former statistic wouldn’t look so bad, but ARR would inevitably take a serious hit. The lesson here is that metrics require context and analysis. Inherent to the SaaS model is the Leaky Bucket Theory: churning customers puts a drag on growth (see graph above). The strongest customer success organizations aim to counteract this through what is called negative churn. This is when expansion revenue (up-sells or cross-sells) outpace lost revenue due to churn. You can achieve this by empowering your customer success team to up-sell their existing customers or by creating a renewals team to prevent any unexpected outcomes. Ultimately, it comes down to a laser focus on customer success, generating feedback loops, improving the product, creating defensible moats against competitors, and building for your customers.
“I think customer service, new customer acquisition, word of mouth and the promoter economy are very tightly integrated.”
— Mikkel Svane CEO of Zendesk
Best-in-class companies become proficient at predicting churn through data and customer engagement. When I was at Salesforce, we had an “early warning system” to detect anomalous behavior from customers which dictated strategy for sales and customer success. Understanding SaaS fundamentals, executing on strategy quarter over quarter and building reporting infrastructure to monitor these key figures are critical for success. But that’s only one part of the equation. Company culture, customer obsession and best-in-class product are prerequisites to it all.
Sample Dashboard (Source: For Entrepreneurs)
Hopefully this gives you a glimpse into some of the fundamentals behind our analysis when evaluating SaaS companies. But also, the highly competitive nature of building a top-tier product in today’s software ecosystem. We assess potential portfolio companies on multiple axes and make decisions through a combination of unit economics viability, leadership and culture, and broader macro-trends in the market. Thanks for taking this journey with us!
For more details on SaaS metrics, review the details of the article that inspired this piece.
