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February 18, 2010

SaaS Metrics – A Guide to Measuring and Improving What Matters

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:

 

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Key SaaS Goals

 

  • Profitability: needs no further explanation.
    • MRR Monthly Recurring Revenue: In a SaaS business, one of the most important numbers to watch is MRR. It is likely a key contributor to Profitability.
  • Cash: very critical to watch in a SaaS business,
    as there can be a high upfront cash outlay to acquire a customer, while
    the cash payments from the customer come in small increments over a
    long period of time. This problem can be somewhat alleviated by using
    longer term contracts with advance payments.
    • Months to recover CAC: one of the best ways to
      look at the capital efficiency of your SaaS business is to look at how
      many months of revenue from a customer are required to recover your
      cost of acquiring that customer(CAC). In businesses such as banking and
      wireless carriers, where capital is cheap and abundant, they can afford
      a long payback period before they recover their investment to acquire a
      customer (typically greater than one year). In the startup world where
      capital is scarce and expensive, you will need to do better. My own
      rule says that startups need to recover their cost of customer
      acquisition in less than 12 months.
      (Note: there are other web
      sites and blogs that talk about the CAC ratio, with a complex formula
      to calculate it. This is effectively a more complicated way of saying
      the same thing. However I have found that most people cannot relate
      well to the notion of a CAC ratio, but they can easily relate to the
      idea of how many months of revenue it will take to recover their
      investment to acquire a customer. Hence my preference for the term
      Months to Recover CAC.)
  • Growth: usually a critical success factor to
    gaining market leadership. There is clear evidence that once one
    company starts to emerge as a market leader, there is a cycle of
    positive reinforcement, as customers prefer to buy from the market
    leader, and the market leader gets the most discussion in the press,
    blogosphere, and social media.

 

Two Key Guidelines for SaaS startups

 

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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.

 

Three ways to look at Profitability

 

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  1. Micro-Economics (per customer profitability):
    Micro-economics is the term used to describe looking at the economics
    of your business on a single customer level. Most business models (with
    a few exceptions such as marketplaces) are based around a simple
    principle: acquire customers and then monetize them. Micro-economics is
    about measuring the numbers behind these two essential ingredients of a
    customer interaction. The goal is to make sure the fundamental
    underpinnings of your business are sound: how much it cost to acquire
    your customers, and how much you can monetize them. i.e. CAC and LTV
    (cost of acquiring a customer, and lifetime value of the customer). In
    a SaaS business, you have a great business if LTV is significantly
    greater than CAC. My rule of thumb is that LTV must be at least 3x
    greater than CAC. (As mentioned elsewhere in this blog, your startup
    will die if your long term number for CAC is higher than your LTV. See Startup Killer: The cost of acquiring customers.)
  2. Overall profitability (standard accounting method):
    This looks a the standard accounting way of deriving profitability:
    revenue – COGS – Expenses.  The diagram also notes that Revenue is made
    up of MRR + Services Revenue. Since MRR is such a critical element,
    there will be a deeper drill down to understand the key component
    drivers.
  3. Profitability per Employee: it can be useful to
    look at the factors contributing to profitability on a per employee
    basis, and benchmark your company against the rest of the industry.
    Expenses per Employee is usually around $180-200k annually for
    businesses with all their employees in the US. (To calculate the number
    take the total of all expenses, not just salaraies, and divide by the
    number of employees.) Clearly to be profitable in the long term, you
    will want to see revenue per employee climb to be higher than expenses,
    taking into account your gross margin %.

 

Drill down on MRR

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MRR is computed by multiplying the total number of paying customers by the average amount that they pay you each month (ARPU).

  • Total Customers:  a key metric for any SaaS
    company. This increases with new additions coming out the bottom of the
    sales funnel, and decreases by the number of customers that churn. Both
    of these are key metrics, and we will drill down into them later.
  • ARPU – average monthly revenue per customer: (The
    term ARPU comes from the wireless carriers where U stands for user.) 
    This is another extremely imporant variable that can be tweaked in the
    SaaS model. If you read my blog post on the JBoss story,
    you will see that one of the key ways that we grew that business was to
    take the average annual deal size from $10k, to $50k.  Given that the
    other parts of the pipeline worked with the same numbers and conversion
    rates, this grew the business by 5x.  We will drill down into how you
    can do the same thing a little further on.

 

Drill down on Micro-Economics (Per Customer Profitability)

Our goal is to see a graph that looks like the following:

image

To achieve this, lets look at the component parts of each line, to see what variables we can use to drive the curves:

 

image

As mentioned earlier, customer profitability = LTV – CAC.

Drill down on LTV

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.

Drill down on CAC

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:

  • Sales Funnel Conversion rates: a funnel that takes
    the same number of leads and converts them at twice the rate, will not
    only result in 2x more closed customers, but will also lower CAC by
    half.  This is a very important place to focus energy, and a large part
    of this web site is dedicated to talking about how to do that. We will
    drill down into the Sales Funnel conversion rates next.
  • Marketing Program Costs: driving leads into the
    top of your sales funnel will usually involve a number of marketing
    programs. These could vary from pay per click advertising, to email
    campaigns, radio ads, tradeshows, etc. We will drill down into how to
    measure and control these costs later.
  • Level of Touch Required: a key factor that affects
    CAC is the amount of human sales touch required to convert a lead into
    a sale. Businesses that have a touchless conversion have spectacular
    economics: you can scale the number of leads being poured into the top
    of the funnel, and not worry about growing a sales organization, and
    the associated costs. Sadly most SaaS companies that I work with don’t
    have a touchless conversion. However it is a valuable goal to consider.
    What can you do to simplify both your product and your sales process to
    lower the amount of touch involved? This topic is covered at the bottom
    of a prior blog post:  Startup Killer: the cost of acquiring customers.
  • Personnel costs: this is directly related to the
    level of touch required. To see if you are improving both of these, you
    may find it useful to measure your Personnel costs as a % of CAC over
    time.

 

Drill down on Sales Funnel Conversion Rates

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).

 

image

 

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:

 

image

 

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.

Using Funnel Metrics in forward planning

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.

Drill down by Customer Type

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.

Drill down into ROI per Marketing Program

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.

image 

Since the conversion rates and costs per lead vary quite
considerably, it is important to also measure the overall ROI by lead
source:

 

image

 

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.”

Drill down into Churn Rate

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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:

  • How churn varies over time (the green call out below).
  • How churn rates are changing with newer cohorts, (the red call out
    below)  For example in the early days of your SaaS company, you may
    have serious product problems and lose a lot of customers in the first
    month. Over time your product gets better, and the first month churn
    rate will drop.

Cohort analysis will show this, instead of mixing all the churn rates into single number.

 

image

 

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.”

Two variables that really matter

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.

image

 

Drill down into ARPU (Average Revenue per Customer)

image

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:

  • Product Mix: adding products to the range, and using bundles, and cross-sell and up-sell
  • Scalable Pricing:  there are always some customers
    that are willing to pay more for your product than others. The trick is
    developing a multi-dimensional pricing matrix that allows you to scale
    pricing for larger customers that derive more value from the product.
    This could be pricing by the seat used (Salesforce.com), or by some
    other metric such as number of individuals mailed in email campaigns
    (Eloqua).
    If you are using scalable pricing, it will be valuable
    to measure what the distribution is of customers along the various
    axes. You could imagine taking an action to do after more seats inside
    of existing customers as a way to drive more revenue. etc.

 

Drill down into Cash

 

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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 Management and forecasting

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)”

Drill down into Growth

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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:

  • Improvement in the overall funnel conversion rate
  • Lead Generation Growth
  • Growth in Funnel Capacity

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.

Other Metrics

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:

image

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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.

Conclusions

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.