This blog is the first in a series of blogs dealing with SaaS metrics. This edition, the focus is revenue based metrics which often provide insight on customer unit economics and growth potential.
The use of ratios and metrics for evaluating SaaS based companies has taken on significant prominence, both for management and for investors. These metrics are determining whether more capital into the business will deliver the required return… whether more fuel on the fire will result in the expected positive outcome.
The metrics that management and investors rely upon to evaluate customer unit economics in SaaS businesses are subject to significant discontinuities in the early stages of revenue growth. The usage of these ratios in the first and second year of revenue growth should be carefully considered.
This blog is intended to provide guidance to those who are already familiar with SaaS metrics and is not intended to provide the basics on how to calculate these metrics. These resources are available elsewhere and we would be happy to point you in the right direction, just reach out.
In the first few years of revenue growth, SaaS companies can easily grow at 200% per year, as measured in both customer numbers and revenue dollars. Calculating the stickiness of a business (via its churn percent) during periods of significant growth can be difficult and misleading.
Correcting for this error requires an understanding of the underlying customer contract structure. When did the churning customers originally sign up? Last year or last month? The construction of the churn percent formula should mirror the source of the churn in the most recent months.
Month to month contracts, where churn can come from contracts that are 2 months old, should calculate churn as a percent of the current month’s opening balance. Annual contracts, where churn is coming from last year’s customers, should be based upon the year’s opening customer balance.
Calculating churn as a function of both customer numbers and revenue dollars provides important insight into the evolution of the customer base of the company.
LTV / CAC Ratio
This commonly used calculation requires four metrics:
- Revenue per customer
- Gross margin percent
- Churn percent
- Sales and marketing costs per customer
During the first two years of revenue growth, there is a much higher degree of variability in the last three metrics (gross margin percent, churn percent, and sales and marketing costs per customer). This results in a correspondingly high level of variability in the LTV / CAC ratio, making the metric unworkable.
One common approach is to smooth the data over a period of months. For example, smoothing all four metrics over a rolling 3 or 6 month period will help offset variability. However, this can mask changes that are occurring in the business over the most recent quarter.
Another option is to use the Months Payback ratio.
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A simpler method is to calculate Months Payback on a contract by contract basis — how much did any given contract cost to acquire, and how many months of gross margin dollars (revenue * gross margin percent) does it take to recover those acquisition costs.
This eliminates the need for churn percent but still requires revenue per customer, gross margin percent, and a sales and marketing cost per customer. Again, smoothing can be used to eliminate month to month variability at the cost of month to month granularity.
Average Revenue per Customer
This is an easy and useful statistic that maintains its usefulness even in the early stages of growth. It highlights changes in the customer mix and/or contract pricing over time.
Next edition, we will look at more profitability related metrics, such as gross margin, net loss/income percent and the Rule of 40.
- Churn % — Customers lost during a specific period. Can be monthly, quarterly or annual.
- Gross margin % — Gross Margin $ = Revenue less Cost of Goods Sold. Gross Margin % = Gross Margin $ divided Revenue, expressed as a %. Future blogs will deal with acceptable ranges for this %.
- Cost of goods — All direct costs of sale. In the case of most SaaS companies, this is web services costs, product support costs, and other preserve costs.
- LTV / CAC Ratio — Lifetime Value / Customer Acquisition Costs. 3X is a normal threshold.