Friday Feb 19, 2010 by David Skok - General Partner, Matrix Partners
This blog post looks at the high level goals of a SaaS business and drills down layer by layer to expose the key metrics that will help drive success. Metrics for metric’s sake are not very useful. Instead the goal is to provide a detailed look at what management must focus on to drive a successful SaaS business. For each metric, we will also look at what is actionable.
Before going any further, I would like to thank the management team at HubSpot, and Gail Goodman of Constant Contact, who sits on the HubSpot board. A huge part of the material that I write about below comes my experiences working with them. In particular HubSpot’s management team is comprised of a group of very bright individuals that are all very metrics driven, and they have been clear thought leaders in developing the appropriate tools to drive their business. I’d also like to thank John Clancy, who until recently was President of Iron Mountain Digital, a $230m SaaS business, and Alastair Mitchell, CEO and founder of Huddle.
Let’s start by looking at the high level goals, and then drill down from there:
The above guidelines are not hard and fast rules. They are what I have observed to be needed by looking at a wide variety of SaaS startups. As a business moves past the startup stage, these guidelines may be relaxed.
In the next sections, we will drill down on the high level SaaS Goals to get to the components that drive each of these.
MRR is computed by multiplying the total number of paying customers by the average amount that they pay you each month (ARPU).
Our goal is to see a graph that looks like the following:
To achieve this, lets look at the component parts of each line, to see what variables we can use to drive the curves:
As mentioned earlier, customer profitability = LTV – CAC.
Drilling down into the factors affecting LTV, we see the following:
LTV = ARPU x Average Lifetime of a Customer – the Cost to Serve them (COGS)
It turns out that the Average Lifetime of a Customer is computed by 1/Churn Rate. As an example, if a you have a 50% churn rate, your average customer lifetime will be 1 divided by 50%, or 2 months. In most companies that I work with, they ignore tracking the average lifetime, but instead track the monthly churn rate religiously.
The importance of a low churn rate cannot be overstated. If your churn rate is high, then it is a clear indication of a problem with customer satisfaction. We will drill down later into how you can measure the factors contributing to Churn Rate, and talk about how you can improve them.
The formula to compute CAC is:
CAC = Total cost of Sales & Marketing / No of Deals closed
It turns out that we are actually interested in two CAC numbers. One that looks purely at marketing program costs, and one that also takes into consideration the people and other expenses associated with running the sales and marketing organization. The first of these gives us an idea of how well we could do if we have a low touch, or touchless sales model, where the human costs won’t rise dramatically over time as we grow the lead flow. The second number is more important for sales models that require more human touch to close the deal. In those situations the human costs will contribute greatly to CAC, and need to be taken into consideration to understand the true micro-economics.
I am often asked when it is possible to start measuring this and get a realistic number. Clearly there is no point in measuring this in the very early days of a startup, when you are still trying to refine product/market fit. However as you get to the point of having a repeatable sales model, this number becomes important, as that is the time when you will usually want to hit the accelerator pedal. It would be wrong to hit the accelerator pedal on a business that has unprofitable micro-economics. (When you are computing the costs for a very young company, it would be fair to remove the costs for people like the VP of Sales and VP of Marketing, as you will not hire more of these as you scale the company.)
When we look at how to lower CAC, there are a number of important variables that can be tweaked:
The metrics that matter for each sales funnel, vary from one company to the next depending on the steps involved in the funnel. However there is a common way to measure each step, and the overall funnel, regardless of your sales process. That involves measuring two things for each step: the number of leads that went into the top of that step, and the conversion rate to the next step in the funnel (see below).
You will also want to measure the overall funnel effectiveness by measuring the number of leads that go into the top of the funnel, and the conversion rate for the entire funnel process to signed customers.
The funnel diagram above shows a very simple process for a SaaS company with a touchless conversion. If you have a conversion process involving a sales organization, you will want to add those steps to the funnel process to get insights into the performance of your sales organization. For example, your inside sales process might look like the following:
Here if we look at the closed deals and overall conversion rates by sales rep, we will have a good idea of who our best reps are. For lower performing reps, it is useful to look at the intermediate conversion rates, as someone that is doing a poor job of, say, converting demos to closed deals could be an indication that they need demo training from people that have high conversion rates for demos. (Or, as Mark Roberge, VP of Sales at HubSpot, pointed out, it could also mean that they did a poor job of qualifying people that they put into the Demo stage.)
These metrics give you the insight you need into your sales and marketing machine, and those insights give you a roadmap for what actions you need to take to improve conversion rates.
Another key value of having these conversion rates is the ability to understand the implications of future forecasts. For example, lets say your company wants to do $4m in the next quarter. You can work backwards to figure out how many demos/trials that means, and given the sales productivity numbers – how many salespeople are required, and going back a stage earlier, how many leads are going to be required. These are crucial planning numbers that can change staffing levels, marketing program spend levels, etc.
If you have different customer types, you will want to look at all the CAC and LTV metrics for each different customer type, to understand the profitability by customer type. Often times this can lead you to a decision to focus more energy on the most profitable customer type.
My experiences with SaaS startups indicate that they usually start with a couple of lead generation programs such as Pay Per Click Google Ad-words, radio ads, etc. What I have found is that each of these lead sources tends to saturate over time, and produce less leads for more dollars invested. As a result, SaaS companies will need to be constantly evaluating new lead sources that they can layer in on top of the old to keep growing.
Since the conversion rates and costs per lead vary quite considerably, it is important to also measure the overall ROI by lead source:
Growing leads fast enough to feed the front end of the funnel is one of the perennial challenges for any SaaS company, and is likely to be one of the greatest limiting factors to growth. If you are facing that situation, the most powerful advice I can give you is to start investing in Inbound Marketing techniques (see Get Found using Inbound Marketing). This will take time to ramp up, but if you can do it well, will lead to far lower lead costs, and greater scaling than other paid techniques. Additionally the typical SaaS buyer is clearly web-savvy, and therefore very likely to embrace inbound marketing content and touchless selling techniques.
From Alistair Mitchell, CEO of Huddle: “Just calculating CAC can be extremely complicated, given the numerous ways in which people find out about your service. To stop getting too bogged down in the detail, its best to start with a blended rate that just takes your total spend on marketing (people, pr, acquisition etc) and split this across all your customers, regardless of type or source. Then, once you’ve got comfortable with that, you can start to break CAC down by the different customer types and elements of your inbound funnel, and start measuring specific campaigns for their contribution to each customer type.”
As described in the section on LTV, Churn Rate has a direct effect on LTV. If you can halve your churn rate, it will double your LTV. It is an enormously important variable in a SaaS business. Churn can usually be attributed to low customer satisfaction. We can measure customer satisfaction using customer surveys, and in particular, the Net Promoter Score.
If you are using longer term contracts, another key metric to focus on is renewals. From John Clancy, ex-President of Iron Mountain Digital: “
Non-renewals add to churn, but they can have different drivers. We spent a lot of time examining our renewal rates and found that a single digit improvement made a huge difference. Often times the driver on a non-renewal is economic – the internal IT department has mounted a campaign to bring the solution back in house. SaaS businesses need to identify renewal dates and treat the renewal as a sales cycle (it’s much easier and less expensive than a new sale, but it deserves the same level of attention) Many SaaS businesses make the mistake of taking renewals for granted.”
A good predictor of when a customer is about to churn is their product usage pattern. Low levels of usage indicate a lack of commitment to the product. It can be a good idea to instrument the product to measure this, looking for particular features our usage patterns that are correlated with stickiness, or a likelihood to churn.
Another measurement tool that can be very useful in understanding churn is to look at a Cohort Analysis. The term cohort refers to a group of customers that started in the same month. The reason for doing this is that churn varies over time, and using a single churn number for all customers will mask this. Cohort analysis shows:
Cohort analysis will show this, instead of mixing all the churn rates into single number.
Here’s a comment on Cohort Analysis from Alastair Mitchell, CEO of Huddle: “I actually think this is more important than churn, for the simple fact that churn varies over the lifetime of a customer cohort, and just looking at monthly churn can be very misleading. Also, given the importance of payback in a year – you really want to look at churn over the course of a 12 months cohort. For instance, in the first 3 months of a monthly paying customer you will see high churn (3 is a recurring ‘magic’ number in all of retail), then reduced churn (sometimes even positive churn) over the next 3 months less and then probably more stable spend over the next 6 months. The number you really care about is the % of customers spending after 12 months (not necessarily on a monthly basis) as that’s what matters for your CAC payback calculations.”
As we saw above, there are two variables that have a huge effect on a SaaS business: funnel conversion rate, and churn, and it is not a bad idea to graph them as shown below.
ARPU is often different for different customer categories, and should be measured separately for each category. It can usually be driven up by focusing on:
We already discussed Months to recover CAC as a key variable. There is another way to affect Cash: which is using longer term contracts and incenting your customers to pay for 6, 12, 24, or even 36 months up front in advance. This can mean the difference between needing to raise tons of venture capital and giving away ownership, or being able to grow the business in a self-funded manner. Given the cost of capital, you can often calculate what discount makes sense. (If capital is cheap and freely available, it doesn’t make sense to give much discount.)
If you do use longer term contracts, it will be important to measure “Discretionary Churn”. Since some of your customers are locked in and cannot churn, they could artificially lower your overall churn numbers. The way to understand what is really going on is to look at the discretionary churn, which is the churn rate for all customers that are at the point where they have the option to churn, removing those whose contracts would have prevented them from churning.
Cash is one of the most important items to get right in any startup. Run out of cash, and your business will come grinding to a halt regardless of how good any of your other metrics may be. One of the most important ways to run a SaaS company is to look at CashFlow profitability (not recognized revenue profitability). What is the difference: If your business only gets paid month by month, there will be no difference, but if you get longer term contracts, and get paid in advance, you will receive more cash upfront than you can recognize as revenue, so your cash flow profitability will look better than your revenue profitability, and is a more realistic view of whether you can survive day to day on the money coming in the door.
Here is another comment from Alastair Mitchell of Huddle on this topic: “SaaS companies tuning their model should think not just in terms of the months to recover CAC, but also the topline amount of cash required to get to cashflow profitability (or the next funding round). This is probably the single biggest mistake I see in early stage companies. They don’t look ahead, using these metrics, to figure out that if the time to repay CAC is 12 months, then in aggregate they are going to need 12 months of CAC spend PLUS the number of months required of further growth to cover their operating costs (mostly engineering) BEFORE they are even cashflow positive (let alone revenue profitability). Most businesses I see fundamentally miss this and end up short; frequently through under-estimating the time to recover CAC, and churn. The readers of this blog should be focused on cashflow profitability, not revenue profitability. (Hence why your point about annual/upfront contracts is so important)”
Focusing on Growth as a separate parameter can be highly valuable. It is the nature of a SaaS business to grow MRR month on month, even if you only added the same number of customers every month. However your goal should be to grow the number of new customers that you sign up every month. You can do this by focusing on:
The first two have been covered already. The last bullet: Growth in Funnel Capacity is an often overlooked metric that can bite you unexpectedly if you don’t pay attention to it. In my second startup, I had a situation where sales growth stalled after growing extremely rapidly for a couple of years. The problem, as it turned out, was that we had stopped hiring new sales people after reaching 20 people, a number that felt very large to me, and had maxed out on sales capacity. We started sales hiring again, and a couple of years later the business hit a $100m run rate. I witnessed a similar phenomenon at Solidworks, when after 2-3 years of phenomenal growth, their growth slowed. It turned out that their channel sales capacity had stopped growing. Solidworks started measuring and managing something that would later turn out to be a critical metric: channel capacity in terms of the number of FTE (Full Time Equivalent) sales people in their channel, and the average productivity per FTE. This has helped propel them to over $400m in annual revenues.
Another great way to grow your business is by adding new products that can be up-sold, or product features that can lead to a higher price point. Since you already have a billable contract, it is extremely easy to increase the amount being charged, and this can often be done with a touchless sale.
There are a series of less important metrics that can still be useful to be aware of. I have listed some of these in the diagrams below:
After posting the above, I received a note from Gail Goodman of Constant Contact, noting that they include the cost of on-boarding a customer in CAC, not LTV as I have shown. Given that they are a public company with significant accounting scrutiny, this is likely the right way to do things.
If you have kept reading this long, it likely means that you are likely an executive in a SaaS company, and truly have a reason to care about this depth of analysis. I would very much like to hear from you in the comments section below to see if I have missed out on metrics that you think are important.
The main conclusion to draw from this article, is that a SaaS business can be optimized in many ways. This article aims to help you understand what the levers are, and how they can affect the key goals of Profitability, Cash, Growth, and market share. To pull those levers requires that you first measure the variables, and watch them as they change over time.
It also requires that you implement a very metrics driven culture, which can only be done from the top. The CEO needs to use these metrics in her staff meetings, and those execs need to use them with their staff, etc. Human nature is such that if you show someone a metric, they will automatically work to try to improve it. That kind of a culture will lead to true operational excellence, and hopefully great success.
David Skok is a General Partner with Matrix Partners in Waltham, Massachusetts. This blog post was originally published on February 17, 2010. You can find this post, as well as additional content on his blog called For Entrepreneurs.