The most important SaaS Metrics and what you need to show investors to secure your next round of funding
Managing your subscription business with SaaS Metrics
Running a SaaS subscription business requires a different set of skills and business models. As a startup looking to grow and build a viable business, it’s imperative to understand the key drivers of success to show investors how well your company is performing.
By nature, your business model of charging a monthly fee means that additional revenue continues to come in each month a customer stays with you. If you can turn a profit with each customer, you may have a very successful business. But initially, at least, you are only taking in a portion of the total value of your product or solution, and if too many customers cancel their contract (churn) before you’ve made back enough to cover your sales and marketing costs, it’s going to be hard to convince people to invest in your business.
Investors have a specific set of SaaS Metrics they like to see CEOs present to demonstrate the health of their business. These are:
- ARR – Annual recurring revenue (and/or MRR – Monthly recurring revenue)
- CAC – Customer Acquisition Cost
- CLTV – Customer Lifetime Value
- CAC/CLTV ratio
- Cash Flow
There are different phases to a startup (including Early Stage, Growth Stage, and Private Equity), and in general, investors who provide Series A expect you to demonstrate Product Market fit because when it comes to raising your B round, investors are providing money for you to build your revenue engine.
SaaS Metrics and Product Market Fit (PMF)
Key characteristics of Product Market Fit include:
- Customers are buying the product
- Customers receive value from the product (and therefore stick with you)
- Your product spreads through word-of-mouth referrals (this may not be your only source of leads, but if you are overly dependent on paid ads and buying lists, your CAC will be too high)
- Customers engage with you, provide feedback on your product and evangelize your company to the market
- Usage is growing fast
How to demonstrate product-market fit with SaaS Metrics
Product market fit can be described as having identified a lucrative target market and serving it with the right product.
Let’s see how SaaS Metrics are critical to demonstrating product market fit.
- If you are selling well, then your monthly recurring revenue (MRR) will be growing month over month.
- But you also have to demonstrate how efficient your sales and marketing are at acquiring new customers. The higher your sales and marketing cost (CAC), the higher your lifetime value (LTV) needs to be, and therefore the longer you need your customers to stay with you (Churn).
- Great word-of-mouth growth reduces (and can eliminate) your need to spend more on sales and marketing (CAC).
- A good ratio to monitor is LTV to CAC.
- By choosing a subscription model and charging by month, you are only receiving a small portion of the total value of your product each month. And if your customer doesn’t stick with you long enough, you’ll actually lose money. (Churn, MRR, CAC)
- After a few months, if 5% of your customers decide they no longer want to continue paying for your product, they will cancel (Churn). And if churn is too high, this is a strong indication you do not have Product Market Fit because they are not finding value in your product, are not recommending it to their peers, and are not staying with you long enough where LTV > CAC.
These SaaS Metrics are key indicators of your startup’s health. Early-stage startups with the right subscription billing and accounting software can access these metrics in real-time.
Your ability to deliver attractive metrics is often the difference between getting your next round of funding and hitting the wall.
ARR (Annual Recurring Revenue) or also MRR (Monthly recurring revenue)
Most startups these days charge by the month, so we will focus on MRR. Plus, ARR tends to mask or hide monthly trends that could be valuable to know.
MRR is a key metric that measures the revenue coming in each month.
Investors will want to see that your overall MRR is growing but also that your month-over-month growth rates are increasing as well. A healthy MRR will show continued growth month over month.
With each successive customer you add, your MRR will continue to grow. The lower your CAC, the quicker you can become profitable, and the lower your churn, the faster your MRR will grow.
The nice thing about a subscription business is that the monthly revenue is relatively stable and predictable. You can therefore build models of future revenue that allow you to better perform scenario planning.
The right way to measure CAC (Customer Acquisition Cost)
CAC is defined as the cost across sales and marketing to close a new customer.
It’s important to know how much it costs your startup to acquire a new customer. To run a profitable business, you also need to know how much revenue to generate to cover your acquisition costs.
The basic formula to calculate CAC is “the cost of all sales and marketing divided by the number of new logos acquired”. However, how this is implemented varies. Many companies only look at programmatic costs – campaign spend, events, paid ads, and content creation (a video or eBook). This can be effective in understanding whether your growth is dependent on high marketing spend, or whether your company is growing more organically by word of mouth. Including sales costs in CAC helps to determine the sales efforts to close a deal. If you have a free trial that pulls in leads that then convert to paying customers without needing to talk to a sales rep, then the sales component of your CAC calculation will be much lower. The more dependent you are on sales reps engaging with prospects to close deals, the higher your CAC will be.
Keep in mind that CAC is not just your advertising or marketing program spend.
What you can learn from your CAC
Often, startup executives are surprised how much it costs to acquire a customer. But there are many ways to improve the efficiency of your sales funnel by learning how to improve conversion rates from leads to MQLs to Opportunities to booked deals. Improved efficiency in your sales funnel can drive your CAC lower.
You will also hear about CAC Payback period – the time it takes (usually in months) to cover the cost to acquire the customer. A good benchmark is 12 months. If your customer pays you $500 per month, and your CAC is $6000, then the CAC payback period would be 6000 / 500, which is 12 months. You can see in this example where a higher CAC of $12k would mean a CAC payback period of 24 months. And the higher your payback period, the longer it takes for you to make a profit.
Below is an example of $700 CAC where the customer is paying $100 per month subscription. From January to August is the payback period.
How to calculate CLTV (Customer Lifetime Value)
CLTV is defined as the net profit received throughout your relationship with a customer
Combined with CAC, it helps you understand whether you can make a profit relative to the cost it takes to acquire a customer. It, therefore, sets a limit on how much you can spend to acquire new customers.
CLTV is the net present value of the recurring profit streams of a given customer less the acquisition cost (from Bessemer Venture Partners).
The lifetime of a customer can be calculated by 1/(churn rate). If your monthly churn rate is 5%, then 1/0.05 = 20 months. You can see how a smaller churn rate extends customer lifetime. A 1% churn rate translates to 1/0.01, or 100 months.
What’s a good CLTV / CAC Ratio?
To determine the viability and efficiency of your startup, investors want to know how your customer lifetime value compares to the cost of sales and marketing to acquire those customers.
Surprisingly, too many companies spend more to acquire a customer than they receive back over that customer’s lifetime and spend inordinate amounts of money to grab market share.
A 3 to 1 ratio (CLTV is more than 3X your CAC) is optimal, but most likely this ratio will be between 1 and 3.
If your ratio is less than 3, you need to look at these key factors:
- Increase CLTV:
- Extend the time (number of months) a customer stays with your startup by focusing on new product features, customer support and pricing.
- Improve your NPS (Net Promoter Score) as that’s a measure and a strong predictor of customer loyalty. And certainly, LTV is directly tied to Churn, so if you are focusing on reducing churn, your LTV will improve.
- Increase revenue (MRR) through additional add-on products, consulting or services revenue, increased product usage, or a higher number of users per account.
- Reduce CAC:
- There are numerous ways to improve your efficiency in sales and marketing, but one often overlooked area is whether you are selling to the right customer. Consider “unattractive customer segments” – those that might require an inordinate amount of support, or that fundamentally but unknowingly can’t afford your solution. And the good news here is that by eliminating these types of customers can also improve your churn.
The importance of Churn
This is often one of the metrics that gets ignored, but it is a crucial number to track as it is a strong indicator of the stickiness of your product.
Churn represents the percentage of customers that un-subscribe or do not renew their subscriptions.
High churn will bring up the dreaded words, “you have a leaky bucket”. Don’t fall prey to the notion that if revenue is growing, churn doesn’t matter, because a high churn rate means you do not have a strong product market fit.
High churn scares off investors as it directly lowers MRR and CLTV, and increases CAC (you have to spend more to keep up growth). Here you can see how a 5% monthly churn decreases MRR – if you are losing 5% of your installed base every month, after 12 months you could be losing almost 19% of the revenue you spent so much time, dollars, and resources to acquire.
It’s a good idea to track churn relative to both your monthly cohort of customers as well as a total number of customers.
A healthy annual churn is about 3%. But a 3% monthly churn means you’ll lose 30% of your cohort of customers after 12 months – not good!
Reducing your churn rate increases your LTV
Here’s a scenario worth understanding:
- Let’s start the year in January
- You have 100 customers
- Each month sales and marketing work hard to book 20 new customers
- But you have a monthly churn rate of 10%
- At the end of the month, instead of 120 customers, you have 110 because 10% of your 100 existing customers stopped doing business with you
- If you do a cohort analysis looking at January as your cohort where you added 20 new customers, with 10% monthly churn, at the end of February you have 18 customers (from your January cohort), and if you continue this trend, sometime between July and August, that January cohort of 20 customers will have dwindled down to half – only 10 paying customers
- In this scenario, churn drastically affects your lifetime value as you continue to lose paying customers.
- And think about your CAC. You are spending more on CAC to find and sign more customers to not only grow but to replace those that have churned.
In the above scenario, neither 10% nor 5% monthly churn is desirable. When you hear “churn” make sure you clarify if it’s annual or monthly. A 10% monthly churn means that 12 months later your cohort has shrunk by over 70%, or from 20 customers down to about 6. Ideally investors would like to see annual churn in the 5% range or less.
If you have a high churn rate, this is not necessarily fatal but is a strong signal of a problem (usually large) that needs to be addressed. And remember, reducing churn grows MRR.
Be honest with yourself when calculating this. You could game the numbers and make it a vanity metric, but you really want everyone in the company to know what it costs to find and earn the business of a customer.
What is negative churn?
The opposite of high churn is negative churn. And this is a very desirable state to achieve.
When your customers are spending more with your business through upgrades, additional users, increased usage, add-ons, and more services and the sum is greater than the amount of revenue lost due to customers who churned, then you’ll have negative churn.
This is typically achieved when your churn rate is low and your revenue per account is growing.
If you charge by the number of users, negative churn can happen when your customer is growing and adding more users (think Salesforce).
If you charge by usage or consumption, negative churn can happen when your customer continues to need more of your product or solution (think AWS).
What is Free Cash Flow
Measuring and managing cash flow is particularly important for subscription-based SaaS startups. By accepting payment in monthly increments, you are delaying the recovery of your profits. But you still have to make investments upfront to acquire your customers. And the faster you grow the wider your gap to recover your up-front investments. And this is where you may run into cash flow problems.
Free cash flow is what you have left over after paying operating expenses and capital expenditures – for example, employee salaries, rent, utilities, debt, advertising, marketing, office supplies, and taxes.
Positive Free Cash Flow is when your cash-in exceeds your cash-out. Note that your net burn rate may fluctuate month to month so it’s common to do a multi-month rolling average.
By tracking your MRR and burn rate you should have a good understanding of how well you are tracking to get to profitability, and therefore understand your runway – the number of months of cash you have until you run out.
Tracking and managing these key SaaS Metrics, will help you build a better company, make you a better leader, and help prepare you for your next round of funding.
It also helps all your employees know the key metrics that are driving your business and how they can help improve performance across the company and all touch points with your prospects and customers.
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