Growth or Profit ?— What VCs look for in a SaaS Business
As I prepare for SaaS North, I wanted to share a few thoughts on growing and funding a SaaS businesses. SaaS has been widely written about and so rather than write some of the same, I’ve linked to some of my favorite blog posts that do a deep dive on each of the topics below.
A SaaS company is a unique kind of business as it invests upfront to acquire a customer, but only recoups that investment over a period of time via subscription revenue (typically monthly). Ideally, customers stick around long enough (lifetime value) to outweigh the cost of acquiring them.
The interesting thing with a SaaS business is that the faster the business wants to grow, the faster it can lose money. On the other hand, investors and board members often pressure a business to stop burning cash when actually it may be time to increase spend. As a VC with Inovia Capital, I’ve seen a lot of companies raising large rounds to fuel growth, but showing steep hockey stick loss curves to fuel that growth. So what’s better…. “Growth or Profit?
To answer that question, let’s first make sure we all understand the 3 fundamentals of a SaaS company:
1) Acquiring customers.
2) Retaining customers.
3) Monetizing customers.
1) Acquiring customers: Calculating Customer Acquisition Cost (CAC).
Simply put, CAC is the average amount of sales and marketing dollars spent to get a new customer. The cost includes sales headcount, marketing, infrastructure overheads, PR etc. To calculate CAC, a business must take all those related sales and marketing costs over time and divide by the number of customers it acquired. To be on the conservative side, I would suggest that one should remove organic customer acquisitions originating from channels such as free press, as those elements have a zero cost and often cannot be accelerated with funding.
Customer Acquisition Cost = Total sales + marketing costs / # new customers acquired
Clearly understanding CAC is the first step in finding out whether the business has a scalable acquisition model. This calculation should be done for each type of customer acquisition channel (ex: SEM, direct sales, partners). For a great tool to accurately calculate ROI of marketing spend, check out Allocadia.
It is also important to understand the business’ dependence on salespeople to convert leads. Great businesses that scale fast have succeeded in reducing human intervention to a minimum. “How sales Complexities Impact your Startups Viability” provides some good tips on reducing cost of sales.
High CAC can make or break a SaaS company. For some good tips on reducing CAC, read this post by David Skok: “Startup Killer: the Cost of Customer Acquisition”.
2) Retaining Customers: SaaS Churn
SaaS churn is the percentage rate at which SaaS customers cancel their recurring revenue subscriptions. There are a number of ways to analyze churn: dollar amount; number of customers lost (monthly, yearly, and by type of customer — SME, large) and gross vs. net churn.
Gross Churn vs. Net Churn: Gross churn does not take into consideration customer increase in spend during the period (ex: upgrades or more users per customer). It is possible to have 8% gross churn and 4% net churn because of the dollar volume. This is also why negative churn is possible. Understanding also what type of customers churned can be enlightening. For example, losing smaller customers is not as bad as large higher revenue customers. It may also demonstrate product market fit with one type of customer over another. Churn by number of customers is likely less informative.
What is normal Churn?
Churn can vary by industry or customer type. SaaS providers selling into the enterprise market typically experience less churn than those selling into the SMB market. For example, Workday sells to the enterprise customer with an average deal size of $680k and has a renewal rate of more than 95%. Conversely, Constant Contact sells email-marketing solutions to SMBs with an average deal size of $454 and has a renewal rate of less than 80%.
5% churn may be normal for some, but rates should be compared to others in the industry. As a rule of thumb, the longer the contract, the lower the churn. Point Nine Capital did a survey of 306 SaaS companies and their churn, which was an average of 6%.
Churn is normal especially for smaller companies however understanding and strategizing around it can separate winners from losers. Clement Vouilon of Point Nine Capital analyzed the churn of 1500 SaaS companies and goes into details here.
3) Monetizing Customers
Knowing how much a customer returns in net revenue or Lifetime Value (LTV) as it is commonly called, dictates how much a business can afford to spend to acquire that customer. We call this the LTV: CAC ratio.
Formulas:
Customer Acquisition Cost (CAC)= Total Sales + Mktg Cost/ # New Customers
LTV = Average recurring per account (ARPU) — Churn
CAC Ratio = LTV/ CAC
As an example, if it costs a company $200 to acquire the customer and the customer pays $50/ month and they remain on average 20 months (including churn) then the LTV:CAC is 5X ($50X20 months) / $200.
In general, LTV:CAC must be >3 for a SaaS business to be viable, otherwise it could take too much money to grow the business. Companies like Salesforce.com, ConstantContact, Hubspot have multiples that are > 5 x CAC.
Payback Period: As the title implies, this is the time period it takes to get a payback on customer acquisition. The below graph from Alex Layton of Spark Capital in his blog post on Sales Efficiency compared 20 leading public SAAS companies and graphed their payback period. The average is 16.3 months. For venture backed companies I would say the ideal should be between 6 and 12 months.
If you’re unsure how to measure user growth check out Jonathan Hsu from Social Capital who wrote this two-part piece on Accounting for Revenue Growth.
Conclusion: Growth or Profit ?
The great thing about a SaaS business is its measurability which can help validate if a model is scalable. The longer a company has been in business, the more accurately it can measure CAC, churn and LTV, which unfortunately startups may not have enough history to do. I would advise very early stage companies to just focus on growing as quickly as possible, while keeping churn to a minimum to prove they have product market fit (before running out of money). By Series A, a company should have enough data to demonstrate how capital efficient it can be: this is key to investors.
If the market appears to be a land crab and the company has a positive acquisition model (> 4 or 5 X), then it should raise more money and accelerate. Under that, they should make sure they find way to increase marketing efficiency before raising too much money and suffering unnecessary dilution. Companies that can grow at 10% month over month are usually considered outperforming. We could write a whole post on calculating MRR, but here is a good read on the subject.
Bessemer prepared a detailed report on valuation multiples of some of the most well-known SaaS companies, which highlights that the market is paying a premium for companies that are growing quickly yet still have free cash flow. I respect companies that can scale quickly without massive burn but I also realize that a rocketship takes rocket fuel to go FAST.
In closing, at some point a company must be cashflow positive or investors will lose patience, but until that time comes my advice is:
GROW!…GROW!… GROW!
PS: If you’ve read this blog post to this end point, here’s a little gift. A priceless list of about 150 fantastic SaaS readings by Tomasz Tunguz, a well respected VC at Redpoint.
Thanks
David
@VentureBuilder
