SaaS Metrics 2.0 – A Guide to Measuring and Improving what Matters

“If you cannot measure it, you cannot improve it” – Lord Kelvin

This article is a comprehensive and detailed look at the key metrics that are needed to understand and optimize a SaaS business. It is a completely updated rewrite of an older post.  For this version, I have co-opted two real experts in the field: Ron Gill, (CFO, NetSuite), and Brad Coffey (VP of Strategy, HubSpot), to add expertise, color and commentary from the viewpoint of a public and private SaaS company. My sincere thanks to both of them for their time and input.

SaaS/subscription businesses are more complex than traditional businesses. Traditional business metrics totally fail to capture the key factors that drive SaaS performance. In the SaaS world, there are a few key variables that make a big difference to future results. This post is aimed at helping SaaS executives understand which variables really matter, and how to measure them and act on the results.

The goal of the article is to help you answer the following questions:

  • Is my business financially viable?
  • What is working well, and what needs to be improved?
  • What levers should management focus on to drive the business?
  • Should the CEO hit the accelerator, or the brakes?
  • What is the impact on cash and profit/loss of hitting the accelerator?

(Note: although I focus on SaaS specifically, the article is applicable to any subscription business.)

What’s so different about SaaS?

SaaS, and other recurring revenue businesses are different because the revenue for the service comes over an extended period of time (the customer lifetime). If a customer is happy with the service, they will stick around for a long time, and the profit that can be made from that customer will increase considerably. On the other hand if a customer is unhappy, they will churn quickly, and the business will likely lose money on the investment that they made to acquire that customer. This creates a fundamentally different dynamic to a traditional software business: there are now two sales that have to be accomplished:

  1. Acquiring the customer
  2. Keeping the customer (to maximize the lifetime value).

Because of the importance of customer retention, we will see a lot of focus on metrics that help us understand retention and churn. But first let’s look at metrics that help you understand if your SaaS business is financially viable.

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The SaaS P&L / Cash Flow Trough

SaaS businesses face significant losses in the early years (and often an associated cash flow problem). This is because they have to invest heavily upfront to acquire the customer, but recover the profits from that investment over a long period of time. The faster the business decides to grow, the worse the losses become. Many investors/board members have a problem understanding this, and want to hit the brakes at precisely the moment when they should be hitting the accelerator.

In many SaaS businesses, this also translates into a cash flow problem, as they may only be able to get the customer to pay them month by month. To illustrate the problem, we built a simple Excel model which can be found here.  In that model, we are spending $6,000 to acquire the customer, and billing them at the rate of $500 per month. Take a look at these two graphs from that model:

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If we experience a cash flow trough for one customer, then what will happen if we start to do really well and acquire many customers at the same time? The model shows that the P&L/cash flow trough gets deeper if we increase the growth rate for the bookings.

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But there is light at the end of the tunnel, as eventually there is enough profit/cash from the installed base to cover the investment needed for new customers. At that point the business would turn profitable/cash flow positive – assuming you don’t decide to increase spending on sales and marketing. And, as expected, the faster the growth in customer acquisition, the better the curve looks when it becomes positive.

Ron Gill, NetSuite:

If plans go well, you may decide it is time to hit the accelerator (increasing spending on lead generation, hiring additional sales reps, adding data center capacity, etc.) in order to pick-up the pace of customer acquisition. The thing that surprises many investors and boards of directors about the SaaS model is that, even with perfect execution, an acceleration of growth will often be accompanied by a squeeze on profitability and cash flow.

As soon as the product starts to see some significant uptake, investors expect that the losses / cash drain should narrow, right? Instead, this is the perfect time to increase investment in the business. which will cause losses to deepen again. The graph below illustrates the problem:

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Notice in the example graph that the five customer per month model ultimately yields a much steeper rate of growth, but you have to go through another deep trough to get there. It is the concept of needing to re-enter that type of trough after just having gotten the curve to turn positive that many managers and investors struggle with.

Of course this a special challenge early-on as you need to explain to investors why you’ll require additional cash to fund that next round of acceleration. But it isn’t just a startup problem. At NetSuite, even as a public company our revenue growth rate has accelerated in each of the last three years. That means that each annual plan involves a stepping-up of investment in lead generation and sales capacity that will increase spending and cash flow out for some time before it starts yielding incremental revenue and cash flow in. As long as you’re accelerating the rate of revenue growth, managing and messaging around this phenomenon is a permanent part of the landscape for any SaaS company.

Why is growth important?

We have suggested that as soon as the business has shown that it can succeed, it should invest aggressively to increase the growth rate. You might ask question: Why?

SaaS is usually a “winner-takes-all” game, and it is therefore important to grab market share as fast as possible to make sure you are the winner in your space. Provided you can tell a story that shows that eventually that growth will lead to profitability, Wall Street, acquiring companies, and venture investors all reward higher growth with higher valuations. There’s also a premium for the market leader in a particular space.

However not all investments make sense. In the next section we will look at a tool to help you ensure that your growth initiatives/investments will pay back:  Unit Economics.

A Powerful Tool: Unit Economics

Because of the losses in the early days, which get bigger the more successful the company is at acquiring customers, it is much harder for management and investors to figure out whether a SaaS business is financially viable. We need some tools to help us figure this out.

A great way to understand any business model is to answer the following simple question:

Can I make more profit from my customers than it costs me to acquire them?

This is effectively a study of the unit economics of each customer. To answer the question, we need two metrics:

  • LTV – the Lifetime Value of a typical customer
  • CAC – the Cost to Acquire a  typical Customer

(For more on how to calculate LTV and CAC, click here.)

Entrepreneurs are usually overoptimistic about how much it costs to acquire a customer. This probably comes from a belief that customers will be so excited about what they have built, that they will beat a path to their doors to buy the product. The reality is often very different! (I have written more on this topic here: Startup Killer: The Cost of Customer Acquisition, and here: How Sales Complexity impacts CAC.)

Is your SaaS business viable?

In the first version of this article, I introduced two guidelines that could be used to judge quickly whether your SaaS business is viable. The first is a good way to figure out if you will be profitable in the long run, and the second is about measuring the time to profitability (which also greatly impacts capital efficiency).

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Over the last two years, I have had the chance to validate these guidelines with many SaaS businesses, and it turns out that these early guesses have held up well. The best SaaS businesses have a LTV to CAC ratio that is higher than 3, sometimes as high as 7 or 8. And many of the best SaaS businesses are able to recover their CAC in 5-7 months. However many healthy SaaS businesses don’t meet the guidelines in the early days, but can see how they can improve the business over time to get there.

The second guideline (Months to Recover CAC)  is all about time to profitability and cash flow. Larger businesses, such as wireless carriers and credit card companies, can afford to have a longer time to recover CAC, as they have access to tons of cheap capital. Startups, on the other hand, typically find that capital is expensive in the early days.  However even if capital is cheap, it turns out that Months to recover CAC is a very good predictor of how well a SaaS business will perform. Take a look at the graph below, which comes from the same model used earlier. It shows how the profitability is anemic if the time to recover CAC extends beyond 12 months.

I should stress that these are only guidelines, there are always situations where it makes sense to break them.

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Three uses for the SaaS Guidelines

  1. One of the key jobs of the CEO is to decide when to hit the accelerator pedal. The value of these two guidelines is that they help you understand when you have a SaaS business that is in good shape, where it makes sense to hit the accelerator pedal. Alternatively if your business doesn’t meet the guidelines, it is a good indicator that there is more tweaking needed to fix the business before you should expand.
  2. Another way to use the two guidelines is for evaluating different lead sources. Different lead sources (e.g. Google AdWords, TV, Radio, etc.) have different costs associated with them. The guidelines help you understand if some of the more expensive lead generation options make financial sense. If they meet these guidelines, it makes sense to hit the accelerator on those sources (assuming you have the cash).Using the second guideline, and working backwards, we can tell that if we are getting paid $500 per month, we can afford to spend up to 12x that amount (i.e. $6,000) on acquiring the customer. If we’re spending less than that, you can afford to be more aggressive and spend more in marketing or sales.
  3. There is another important way to use this type of guideline: segmentation. Early-stage companies are often testing their offering with several different uses/types of customers / pricing models / industry verticals. It is very useful to examine which segments show the quickest return or highest LTV to CAC in order to understand which will be the most profitable to pursue.

Unit Economics in Action: HubSpot Example

HubSpot’s unit economics were recently published in an article in Forbes:

You can see from the second row in this table how they have dramatically improved their unit economics (LTV:CAC ratio) over the five quarters shown. The big driver for this was lowering the MRR Churn rate from 3.5% to 1.5%. This drove up the lifetime value of the customer considerably.  They were also able to drive up their AVG MRR per customer.

Brad Coffey, HubSpot:

In 2011 and early 2012 we used this chart to guide many of our business decisions at HubSpot. By breaking LTV:CAC down into its components we could examine each metric and understand what levers we could pull to drive overall improvement.

It turned out that the levers we could pull varied by segment. In the SMB market for instance we had the right sales process in place – but had an opportunity to improve LTV by improving the product to lower churn and increasing our average price in the segment. In the VSB (Very Small Business) segment, by contrast, there wasn’t as much upside left on the LTV (VSB customers have less money and naturally higher churn) so we focused on lowering CAC by removing friction from our sales process and moving more of our sales to the channel.

Two kinds of SaaS business:

There are two kinds of SaaS business:

  • Those with primarily monthly contracts, with some longer term contracts. In this business, the primary focus will be on MRR (Monthly Recurring Revenue)
  • Those with primarily annual contracts, with some contracts for multiple years. Here the primary focus is on ARR (Annual Recurring Revenue), and ACV (Annual Contract Value).

Most of the time in this article, I will refer to MRR/ACV. This means use MRR if you are the first kind of business, or ACV if you are the second kind of business. The dashboard shown below assumes monthly contracts (MRR). However in the downloadable spreadsheet, there is a tab that shows the same dashboard for the second kind, focusing on ACV instead of MRR.

SaaS Bookings: Three Contributing Elements

Every month in a SaaS business, there are three elements that contribute to how much MRR will change relative to the previous month:

What happened with new customers added in the month:

  • New MRR (or ACV)

What happened in the installed base of customers:

  • Churned MRR (or ACV) (from existing customers that cancelled their subscription. This will be a negative number.)
  • Expansion MRR (or ACV) (from existing customers who expanded their subscription)

The sum all three of these makes up your Net MRR or ACV Bookings:

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I recommend that you track these using a chart similar to the one below:

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This chart shows the three components of MRR (or ACV) Bookings, and the Net New MRR (or ACV) Bookings. By breaking out each component, you can track the key elements that are driving your business. The one variation we would recommend making to this chart is to show a dotted line for the plan, so you can track how you are doing against plan for each of the four lines. This is one of the most important charts to help you understand and run your business.

Ron Gill, NetSuite:

This chart is really good. I also like to look at this data in tabular form because I want to know y-o-y growth rates. E.g. “Net new MRR is up 25% over June of last year”. The Y-o-Y % is a metric easily compared with increased spending, sales capacity, etc.

The Importance of Customer Retention (Churn)

In the early days of a SaaS business, churn really doesn’t matter that much. Let’s say that you lose 3% of your customers every month. When you only have a hundred customers, losing 3 of them is not that terrible. You can easily go and find another 3 to replace them. However as your business grows in size, the problem becomes different. Imagine that you have become really big, and now have a million customers. 3% churn means that you are losing 30,000 customers every month! That turns out to be a much harder number to replace. Companies like Constant Contact have run into this problem, and it has made it very hard for them to keep up their growth rate.

Ron Gill, NetSuite:  

One oft-overlooked aspect of churn is that the churn rate, combined with the rate of new ARR adds, not only defines how fast you can grow the business, it also defines the maximum size the business can reach (see graph below).

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It is an enlightening exercise to build a simple model like this for your business and plot where your current revenue run rate sits on the blue line defined by your present rate of ARR adds and churn. Are you near the left-hand side, where the growth is still steep and the ceiling is still far above? Or, are you further to the right where revenue growth will level off and there is limited room left to grow? How much benefit will you get from small improvements in churn or the pace of new business sign-up?

At NetSuite, we’ve had great success shifting the line in the last few years by both dramatically decreasing churn and by increasing average deal size and volume, thus increasing ARR adds. The result was both to steadily move the limit upward and to steepen the growth curve at the current ARR run rate, creating room for increasingly rapid expansion.

The Power of Negative Churn

The ultimate solution to the churn problem is to get to Negative Churn.

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There are two ways to get this expansion revenue:

  1. Use a pricing scheme that has a variable axis, such as the number of seats used, the number of leads tracked, etc. That way, as your customers expand their usage of your product, they pay you more.
  2. Upsell/Cross-sell them to more powerful versions of your product, or additional modules.

To help illustrate the power of negative churn, take a look at the following two graphs that show how cohorts behave with 3% churn, and then with 3% negative churn. (Since this is the first time I have used the word Cohort, let me explain what it means. A cohort is simply a fancy word for a group of customers. In the SaaS world, it is used typically to describe the group that joined in a particular month. So there would be the January cohort, February cohort, etc.  In our graphs below, a different color is used for each month’s cohort, so we can see how they decline or grow, based on the churn rate.)

In the top graph, we are losing 3% of our revenue every month, and you can see that with a constant bookings rate of $6k per month, the revenue reaches $140k after 40 months, and growth is flattening out. In the bottom graph, we may be losing some customers, but the remaining customers are more than making up for that with increased revenue. With a negative churn rate of 3%, we reach $450k in revenue (more then 3x greater), and the growth in revenues is increasing, not flattening.

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For more on this topic, you may wish to refer to these two blog posts of mine:

Defining a Dashboard for a SaaS Company

The following section should be most useful for readers who are interested putting together a dashboard to help them manage their SaaS business. To this, we created an excel file for an imaginary SaaS company, and laid out a traditional numeric report on one tab, and then a dashboard of graphs on a second tab (see below). These represent one view on how to do this. You may have a very different approach. But hopefully this will give you some ideas. I would recommend adding a dotted line with the plan number to all graphs. This will allow you to quickly see how you are doing versus plan.

There are two versions of the Dashboard: the one shown below, which is designed for companies using primarily monthly contracts (focused on MRR). And a second version that can be found here which is designed for companies using annual contracts, focusing on ACV (Annual Contract Value).

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Brad Coffey, HubSpot:

At HubSpot we obsess over these metrics – and watch many of them every day. Each night we send out a ‘waterfall’ chart that tracks our progress against our typical progress given the number of business days left in the month. Here is an example of what we look at to ensure we’re on track to meet our net MRR goals.

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By looking at this daily we can take action immediately if we’re tracking towards a bad month or quarter. Things like services promotion (for churned MRR) or sales contests & promotions (for new & expansion MRR) are adjustments we make within a given month in order to nail our goals. (In this model we combine expansion and churned MRR into one churned MRR line).

Detailed definitions of the various metrics used

Detailed definitions for each of the various metrics used can be found in this reference document:

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Revenue Churn vs Customer Churn – why are they different?

You might be wondering why it’s necessary to track both Customer Churn and Revenue Churn. Imagine a scenario where we have 50 small accounts paying us $100 a month, and 50 large accounts paying us $1,000 a month. In total we have 100 customers, and an MRR of $55,000 at the start of the month. Now imagine that we lose 10 of them. Our Customer churn rate is 10%. But if out of the ten churned customers, 9 of them were small accounts, and only one was a large account. We would only have lost $1,900 in MRR. That represents only 3.4% Revenue Churn. So you can see that the two numbers can be quite different. But each is important to understand if we want a complete picture of what is going on in the business.

Getting paid in advance

Getting paid in advance is really smart idea if you can do it without impacting bookings, as it can provide the cash flow that you need to cover the cash problem that we described earlier in the article. It is often worth providing good financial incentives in the form of discounts to encourage this behavior. The metric that we use to track how well your sales force is doing in this area is Months up Front.

Getting paid more upfront usually also helps lower churn. This happens because the customer has made a greater commitment to your service, and is more likely to spend the time getting it up and running. You also have more time to overcome issues that might arise with the implementation in the early days. Calculating LTV and CAC

The Metric “Months up Front” has been used at both HubSpot and NetSuite in the past as a way to incent sales people to get more paid up front when a new customer is signed. However asking for more money up front may turn off certain customers, and result in fewer new customers, so be careful how you balance these two conflicting goals.

Calculating CAC and LTV

Detailed information on how to calculate LTV and CAC is provided in the supplemental document that can be accessed by clicking here.

More on Churn: Cohort Analysis

Since churn is such a critical element for success in a SaaS company, it is an area that requires deeper exploration to understand. Cohort Analysis is one of the important techniques that we use to gain insight.

As mentioned earlier, a cohort is simply a fancy name for a group. In SaaS businesses, we use cohort analysis to observe what happens to the group of customers that joined in a particular month. So we will have a January cohort, a February cohort, etc. We would then be able to observe how our January cohort behaves over time (see illustration below).

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This can help answer questions such as:

  • Are we losing most of the customers in the first couple of months?
  • Does Churn stabilize after some period of time?

Then if took some actions to try to fix churn in early months, (i.e with better product features, easier on-boarding, better training, etc.) we would want to know if those changes had been successful. The cohort analysis allows us to do this by comparing how more recent cohorts (e.g. July in the table above) compared against January. The table above shows that we made a big improvement in the first month churn going from 15% to 4%.

Two ways to run Cohort Analysis

There are two ways to run Cohort Analysis: the first looks at the number of customers, and the second looks at the Revenue. Each teaches us something different and valuable. The example graph below simply looks at the number of customers in each cohort over time:

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The example graph below looks at how MRR evolves over time for each cohort. This particular example illustrates how the graph would look if there is very strong negative churn. As you can see, the increase in revenue from the customers that are still using the service is easily outpacing the lost revenue from churned customers. It is pretty rare to see things look this good, but it is the ideal situation that we are looking for. For those wondering if this can be achieved, one company in our portfolio, Zendesk, that has numbers that are even better than those shown in the example below.

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In the situation above, you will need a more complex formula to calculate LTV, as the value of the average customer is increasing over time. For more on that topic, you may want to check out the accompanying definitions document.

Predicting Churn: Customer Engagement Score

Since churn is so important, wouldn’t it be useful if we could predict in advance which customers were most likely to churn? That way we could put our best customer service reps to work in an effort to save the situation. It turns out that we can do that by instrumenting our SaaS applications and tracking whether our users are engaged with the key sticky features of the product. Different features will deserve different scores. For example if you were Facebook, you might score someone who uploaded a picture as far more engaged (and therefore less likely to churn), than someone who simply logged in and viewed one page.

Similarly if you sold your SaaS product to a 100 person department, and only 10 people were using it, you would score that differently to 90 people using it. So the recommendation is that you create a Customer Engagement Score, based on allocating points for the particular features used. Allocate more points for the features you believe are most sticky. (Later on you can go back and look at the customers who actually churned, and validate that you picked the right features as a predictor of who would churn.) And separately score how many users are engaged with specific scores.

Over time you’ll also come to discover which types of use are the best indicators of possible upsell. (HubSpot was the first company that I worked with who figured this out, and they called it their CHI score. CHI stands for Customer Happiness Index. It evolved to be a very good predictor for churn.)

Brad Coffey, HubSpot:

At HubSpot we had a lot of success looking at this metric – we called in Customer Happiness Index (CHI). First – by running the analysis we identified the parts of our application that provide the most value to customers and could invest accordingly in driving adoption in those areas. Second – we used this aggregate score as an early proxy for success as we experimented with different sales and onboarding processes. If a set of customers going through an experiment had a low CHI score we could kill the project without waiting 6 or 12 months to analyze the cohort retention.

NPS – Net Promoter Score

Since it is likely that customer satisfaction is likely to be good predictor of future churn, it would be useful to survey customer satisfaction. The recommended way to measure customer happiness is to use Net Promoter Score (NPS). The beauty of NPS is that it is a standardized number, so you can compare your company to others.  For more details on Net Promoter Score, click here.

Guidelines for Churn

If your Net Revenue Churn is high (above 2% per month) it is an indicator that there is something wrong in your business. At 2% monthly churn, you are losing about 22% of your revenue every year. That is nearly a quarter of your revenue! It’s a clear indication that there is something wrong with the business. As the business gets bigger, this will become a major drag on growth.

We recommend that you work on fixing the problems that are causing this before you go on to worry about other parts of your business. Some of the possible causes of churn are:

  • You are not meeting your customers expectations.
    • The product may not provide enough value
    • Instability or bugginess
  • Your product is not sticky. It might provide some value in the first few months, and then once the customer has that value, they may feel they don’t need to keep paying. To make your product sticky, try making it a key part of their monthly workflow, and/or have them store data in your product that is highly valuable to them, where the value would be lost of they cancelled.
  • You have not successfully got the customer’s users to adopt the product. Or they may not be using certain of the key sticky features in the product.
  • Your sales force may have oversold the product, or sold it to a customer that is not well suited to get the benefits
  • You may be selling to SMB’s where a lot of them go out of business. It isn’t enough that what you’re selling is sticky. Who you’re selling it to must also be sticky.
  • You are not using a pricing scheme that helps drive expansion bookings

The best way to find out why customers are churning is to get on the phone with them and ask them. If churn is a significant part of your business, we recommend that the founders themselves make these calls. They need to hear first hand what the problem is, as this is so important for the success of the business. And they are likely to be the best people to design a fix for the problem.

The Importance of Customer Segmentation

In all SaaS businesses there will likely come a moment where they realize that not all customers are created equal. As an example, bigger customers are harder to sell to, but usually place bigger orders, and churn less frequently. We need a way to understand which of these are most profitable, and this requires us to segment the customer base into different types, and compute the unit economics metrics for each segment separately. Common segments are things size of of customer, vertical industry, etc.

Despite the added work to produce the metrics, there is high value in understanding the different segments. This tells us which parts of the business are working well, and which are not. In addition to knowing where to focus and invest resources, we may recognize the need for different marketing messages, product features. As soon as you start doing this segmented analysis, the benefits will become immediately apparent.

For each segment, we recommend tracking the following metrics:

  • ARPA (Average Revenue per Account per month)
  • Net MRR Churn rate (including MRR expansion)
  • LTV
  • CAC
  • LTV: CAC ratio
  • Months to recover CAC
  • Customer Engagement Score

 

Brad Coffey, HubSpot:

At HubSpot, we started to see some of our biggest improvements in unit economics when we started segmenting our business and calculating the LTV to CAC ratio for each of our personas and go to market strategies.

As one good example – when we started this analysis, we had 12 reps selling directly into the VSB market and 4 reps selling through Value Added Resellers (VARs). When we looked at the math we realized we had a LTV:CAC ratio of 1.5 selling direct, and a LTV:CAC ratio of 5 selling through the channel. The solution was obvious. Twelve months later we had flipped our approach – keeping just 2 reps selling direct and 25 reps selling through the channel. This dramatically improved our overall economics in the segment and allowed us to continue growing.

We ended making similar investments in other high LTV:CAC segments. We went so far as to incentivize our sales managers to grow their teams – but then would only place new sales hires into the segments with the best economics. This ensured we continued to invest in the best segments and aligned incentives throughout the company on our LTV:CAC goals. It also allowed us to push innovation down to the sales manager level. Managers could experiment with org structure, and sales processes – but they knew that if they didn’t hit their LTV:CAC goals they wouldn’t be able to grow their teams.

Calculating LTV:CAC by segment can be challenging, especially on the CAC side. It’s relatively easy at the top level to add up all the marketing and sales expense in a period and divide it by the total number of customers (to get CAC). Once you try to segment down your spend you run into questions like ‘how much marketing expense do I allocate to a given segment’, ‘how much of the sales expense’?

We solved this by allocating marketing expense based on number of leads and sales expense based on headcount but it’s not perfect. For us the keys are: 1) Needs to account for all costs – no free lunch, 2) It needs to be consistent over time. Progress on improving the metric is more important than the actual value.

Funnel Metrics

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).

In the diagram above, (mirrored in the dashboard), we show a very simple three phase sales process, with visitors coming to a web site, and some portion of them signing up for a trial. Then some of the trials convert to purchases.  As you can see in the dashboard, we will want to track the number of visitors, trials and closed deals. Our goal should be to increase those numbers over time. And we will also want to track the conversion rates, with the goal of improving those over time.

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.

Sales Capacity

In many SaaS businesses, sales reps play a key role in closing deals. In those situations, the number of productive sales people (Sales Capacity) will be a key driver of bookings. It is important to work backwards from any forecasts that are made, to ensure that there is enough sales capacity. I’ve seen many businesses miss their targets because they failed to hire enough productive salespeople early enough.

It’s also worth noting that some percentage of new sales hires won’t meet expectations, so that should be taken into consideration when setting hiring goals. Typically we have seen failure rates around 25-30% for field sales reps, but this varies by company. The failure rate is lower for inside sales reps.

When computing Sales Capacity, if a newer rep is still ramping and only expected to deliver 50% of quota, they can be counted as half of a productive rep. That is often referred to as Full Time Equivalent or FTE for short.

Another important metric to understand is the number of leads required to feed a sales rep. If you are adding sales reps, make sure you also have a clear plan of how you will drive the additional leads required.

There is much more that could be said on this topic, but since it is all very similar to managing a sales force in a traditional software company, we will leave that for other blog posts.

Understanding the ROI for different Lead Sources

Our 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 we 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 we 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.

What Levers are available to drive Growth

SaaS businesses are more numerically driven than most other kinds of business. Making a small tweak to a number like the churn rate can have a very big impact on the overall health of the business. Because of this we frequently see a “quant” (i.e. a numbers oriented, spreadsheet modeling, type of person) as a valuable hire in a SaaS business. At HubSpot, Brad Coffey played that role, and he was able to run the models to determine which growth plays made the most sense.

Understanding these SaaS metrics is a key step towards seeing how you can drive your business going forward. Let’s look at some of the levers that these imply as growth drivers for your business:

Churn

  • Get Churn and customer happiness right first (if this isn’t right, the business isn’t viable, so no point in driving growth elsewhere. You will simply be filling a leaky bucket.)

Product

  • You’re in a product business – first and foremost: fix your product.
    • If you’re using a free trial, focus on getting the conversion rate for that right (ideally around 15 – 20%). If this isn’t right, your value proposition isn’t resonating, or you may have a market where there is not enough pain to get people to buy.
    • Win/Loss ratio should be good
    • Trial or Sales conversion rates on qualified leads should be good

Funnel metrics

  • Increase the number of raw leads coming in to the Top of your funnel
  • Identify the profitable lead sources and invest in those as much as possible. Conversely stop investing in poor lead sources until they can be tweaked to make them profitable.
  • Increase the Conversion Rates at various stages in the funnel

Sales Metrics

  • Sales productivity (focus on getting this right consistently across a broad set of sales folks before hitting the gas)
  • Add Sales Capacity. But first make sure you know how to provide them with the right number of leads. This turns out to be one of the key levers that many companies rely on for growth. We have learned from experience how important it is to meet your targets for sales capacity by hiring on time, and hiring the right quality of sales people so there are fewer failures.
  • Increase retention for your sales people. Since you have invested a lot in making them fully productive, get the maximum return on that investment by keeping them longer.
  • Look at adding Business Development Reps. These are outbound sales folks who specialize in prospecting to a targeted list of potential buyers. For more on this topic, click here.

Pricing/Upsell/Cross Sell

  • Multi-axis pricing
  • Additional product modules (easier to sell more to existing customers than it is to sell to brand new customers)

Brad Coffey, HubSpot:

Turns out the pricing your product right can have a huge impact on the unit economics. Not simply by getting the average MRR right, or by providing upsell opportunities – but also by signaling what pieces of the product are most valuable.

At HubSpot we changed our pricing in 2011 to be tiered based on the number of contacts in the system – and actually saw an increase in adoption of the contacts application after we made the change. This is counter-intuitive but makes sense given that we sell through an inside sales team. After the pricing change, sales reps now could make a lot more money by selling the contacts. And they quickly become much better at positioning that part of the product, as well as finding companies with a contacts-based use case. Product quality will remain paramount – but it’s remarkable how much impact pricing, packaging and sales commission structure can have on product adoption and unit economics.

Customer Segmentation

Customer Segmentation analysis will help point out which are your most profitable segments. Two immediate actions that are suggested by this analysis are:

  • Double down on your most profitable segments
  • Look at your less profitable segments and consider changes that would make them more profitable: lower cost marketing & sales approaches, higher pricing, product changes, etc. If nothing seems to make sense, spend less effort on these segments.

International Markets

Expansion internationally is only recommended for fairly mature SaaS companies that already have honed their business practices in their primary market. It is far harder to experiment and tune a business in far off regions, with language and cultural differences.

Brad Coffey, HubSpot

  • One of the biggest challenges we face is the trade-off between growth and unit economics (specifically churn).  Many of the things that we have done to reduce churn have (potentially) come at the expense of lowering our growth rate. Those have been some of our hardest decisions:  e.g. requiring upfront payments, requiring customers buy consulting, holding sales reps accountable for churn, etc. We are always looking at things that give us growth without the tradeoff of lower growth. For example product improvement is an obvious one – a better product is easier to sell and provides more value to the customer. Services promotions actually work well too. Many of the options that SaaS companies have to adjust their business are not simply a win-win but are still worth exploring. Too many companies think that every problem is a product problem and every solution is that the product must get better.
  • The other thing that’s really important is that companies don’t try to spin these numbers.  There is so much pressure to dismiss a bad customer (who hurt your churn number) or exclude costs (only count marketing ‘program’ spend – not headcount).  If you can get the accounting close enough to right it actually frees management from needing to make every decision.  If the accounting is right management can obsess over setting goals (growth, LTV:CAC), hold people accountable to those goals and then give autonomy to their team on how to achieve those goals.

Plan ahead

It takes time for most initiatives to have an impact. We’ve learned from some tough lessons that planning has to be done well in advance to drive a SaaS business. For example if you are not happy with your current growth rate, it will often take nine to twelve months from the point of decision before the growth resulting from increased investment in sales and marketing will actually be observed.

The High Level Picture: How to Run a SaaS Business

Hopefully what you will have gathered from the discussion above is that there are really three things that really matter when running a SaaS business:

  1. Acquiring customers
  2. Retaining customers
  3. Monetizing your customers

The second item should be first on your list of things to get right. If you can’t keep your customers happy, and keep them using the service, there is no point in worrying acquiring more of them. You will simply be filling a leaky bucket. Rather focus your attention on plugging the leaks.

SaaS businesses are remarkably influenced by a few key numbers. Making small improvements to those numbers can dramatically improve the overall health of the business.

Once you know your SaaS business is viable using the guidelines provided for LTV:CAC, and Time to recover CAC, hit the accelerator pedal. But be prepared to raise the cash needed to fund the growth.

Although this article is long and occasionally complex, we hope that it has helped provide you with an understanding of which metrics are key, and how you can go about improving them.

Acknowledgements

I would like to thank Ron Gill, the CFO of NetSuite, and Brad Coffey & Brian Halligan of Hubspot for their help in writing this. I would like to thank the HubSpot management team without whom none of this would be possible. Most of my learnings on SaaS have come from working with them. I would also like to thank Gail Goodman, the CEO of Constant Contact who also taught us many of the key metrics in her role as board member of HubSpot.

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  • http://www.forentrepreneurs.com David Skok

    Hi Christina, you are 100% right. That is a spreadsheet error. The formula should point to Row 35 (total customers) not Row 33 (new customers). Thanks for pointing this out. I will upload a corrected version.

  • http://www.forentrepreneurs.com David Skok

    I have now uploaded a corrected version of that spreadsheet.

  • http://www.forentrepreneurs.com David Skok

    I have now uploaded a corrected version of that spreadsheet. It fixed a second error as well as the one you pointed out.

  • Jeff Nelson

    Excellent article. Lot of high level principles and lots of details. Well done.

  • Christina Choi

    David, are you sure that the Excel sheet is corrected? When I just checked the Excel file in the section of “The SaaS P&L,” I still see the same old one. Anyway I thank you for answering my question.

  • Lasse

    Hi David,

    Amazing update it helped us a lot. I have two questions:

    1. Looking at the spreadsheet why is MRR Expation or MRR Churn so low? If we look at ARPA at U$ 550 it seems that is should be higher if we also look at the churn rate or new customers. I think I’m misurdestanding this concept.

    2. I 100% agree about looking first at churn rate, but I found almost nothing about good customer support/retantion strategies. Do you have any reference about that?

    Thanks for your time

    Bests,

  • http://www.forentrepreneurs.com David Skok

    Hi Christina, the old version was cached, causing the problem you saw. If you check now, you will get the corrected version. Thanks for your help diagnosing the problem!

  • Phil

    Hi David,

    Great article! I was curious if you may any benchmarking data in what best in class SaaS vendors have for these conversion rates:

    Visitor to Trial Rate
    Trials to Purchase

    Thanks,
    Phil

  • http://www.forentrepreneurs.com David Skok

    Hi Phil, that’s a great question. Unfortunately I don’t have benchmarking data to answer your question. However I can tell you that the trial to purchase conversion rates that I have seen for successful companies vary from 5% to 50%, with the majority in the 10-20% range. Below 10% is an indication that there may be something wrong with your product or service. Getting above 20% is rare, and is a really strong indication of a great product.
    For Visitor to Trial, I haven’t been tracking that as well, so can’t give you the same data.

  • Mateus

    Awesome post David! Thanks!
    I have a doubt: how do I get to the Gross Margin % number in the Spredsheet for a SaaS company? I saw that you allocated 83% for each month but didn`t understand where this number came from. Thanks!

  • http://www.forentrepreneurs.com David Skok

    The 83% is just an example number that should be replaced with your own number. To get the right number you’ll need to compute your cost of service which is typically cloud server costs, operations people, and support people. Your Gross Margin % is 1 – Cost of Service/Revenue.
    Best, David

  • Mateus Maciel Rabello

    Thanks again David!

  • ben smith

    Hi David

    Really helpful post.

    Can you throw light on sales & marketing spend as a percentage of annual revenue. Assuming the percentage spend doesn’t decrease year on year, CAC is going to increase substantially because its being pegged against revenue generated from the previous years customers. For example i’m calculating marketing spend as 40% of revenues for year 1, 2 & 3 & my CAC is increasing 60% year on year. Is this how you would calculate it & what you would expect or should marketing spend be pegged against new annual revenue? Thanks

  • Z

    Hi David,
    Two questions:
    1 – We currently have a partner referral business where we pay a recurring partner commissions of 20% over the lifetime of the customer. Do we include the LTV of the commission payment in CAC or do we factor the 20% commissoin into the gross margin?
    2. We have one line of business that has low client churn (1.5%) which translates to 67 months. This line of business has been around for less than 2 years. Because of the low churn, our LTV/CAC and LTM/CAC ratios look phenomenal. Is there anything we should be doing to discount or sensitize the churn or metrics given lack of historical information to valide the LTV of customer.
    Your input is greatly appreciated!
    Thanks,
    Z

  • http://www.forentrepreneurs.com David Skok

    Hi Z, for 1: on the assumption that you are paying that commission because they helped you with the sale, I would prefer to see it in CAC. Gross Margin should more reflect things that are costs after the sale in delivering the service.
    For 2: This would depend on whether you felt there were any reasons to believe that your short term churn numbers are not reflective of the risks that they stay the same going forward. Five years is a long time, and there are things like potential competition, changes in the market, etc. Depending on your level of confidence, you might decide to discount LTV.
    The thing I would point out is that the value of knowing the LTV:CAC ratio is business decision making. So spending too much time trying to over think it would be a mistake, unless there is some critical decision that needs you to be ultra-accurate. For most people there are a few key decisions to take:

    1. Is our business viable and looking good – which should lead to the decision to invest heavily
    2. Does one customer segment look better than another customer segment – which would mean invest more in that one, and look to see if there are ways to improve the laggard.
    3. How much money can we afford to invest in sales and marketing to acquire these customers? This last question is easily answered by taking the rule of thumb that you can spend one year of their customer value to acquire them. Anything below that is really great, and anything between one year and two years spent on CAC is still viable, but is going to burn a lot of cash.
    There may be others as well, but hopefully this gets the point across: these metrics are only valuable if they are helping you make useful business decisions. So no need to spend too much energy on making them ridiculously accurate.

  • Joshua

    Hi David – great article and content.

    Could you comment on the following article:

    http://www.bothsidesofthetable.com/2011/12/22/the-amazing-power-of-deflationary-economics-for-startups/

    We are considering a SaaS startup to compete with an incumbent in a market that was once diverse (5-6 years ago), but is now ruled by one large, public company (that still has basically the same product they started with). Once upon a time, having this software gave you a competitive advantage, but now it is a permission to play (you almost have to have it to compete). Our thought is that there might be an opportunity to challenge the incumbent according to the strategies in the above article.

    I would love to hear your thoughts on the concepts of deflationary businesses in SaaS, and any insights into a strategy one could take against an entrenched, high-priced incumbent.

  • http://www.forentrepreneurs.com David Skok

    Sounds like the market may have potential for disruption. The place I would start is with the customers:

    - Are they happy with what they have today?

    - What would it take to get them to switch? (Price, Features, or both Price & Features)
    - Is the product entrenched with high switching costs?

    - Is there a segment of the market that you can find that would have liked to buy this product, but didn’t because the price is too high?
    - What is the trigger point that would get someone to consider making a change. (Change is hard for companies once something is working.)
    The strategy will evolve out of those conversations. But one clear option you have is to sell at a lower price, and make sure you have a lower CAC to allow you to do that profitably.
    I hope that helps.

  • Brett

    David
    We are just going through due diligence with an investment house and a debate has ensued about LTV and run-off revenues. Our churn per year is around 14% giving a LT of just over 7 years. Our ARR is $6m. Thus, our LTV is around $40m.
    So far so good.
    The DD guys argue that in a run off situation – where no new customers are added and you need to recoup all cash, then the LTV should be halved.
    The argument goes that at the run-off point (when you decide to stop acquiring new customers – not that you’d ever do this) although the LT is 7 years, 50% of them on average are already 3.5 years old. Hence halving the LTV as a measure of future incomes.
    Our opposite point of view is that the snapshot measure of churn that leads to LT, has no knowledge of the age of a customer and hence LT is a measure of the FUTURE years remaining i.e. 7.
    Another way to argue these points is that the DD guys would say churn is arithmetic (in a run off only, the 14% is lost off the original value of revenue), whereas I would argue it’s geometric in nature (where the 14% is lost off each years declining revenue).
    I am sure I am correct, but do not appear to be able to persuade them.
    Who is correct and what’s the best logic?
    Kind Regards
    Brett

  • http://www.forentrepreneurs.com David Skok

    In your situation, I believe that the idea of LTV is less applicable, as it is mostly a way to value NEW customers. But what you are able to ascertain is the value of your current recurring revenue stream because you have a predictable churn rate. Unless the churn rate goes up for some reason (e.g. because of an announcement made that you are ending the life of the product), then the remaining revenue should continue to erode at the same rate as in the past. That would allow you to determine the value of that current set of customers.
    I may have missed something here, as I am not a math wiz. But does this make sense to you?

  • Z

    Hi David, thanks for the response. This is really helpful. There seems to be a lot of back and forth in our company on how we should account for the LTV of the commission payment and impacts the metrics significantly.

    Here is what is not making sense:

    Scenario 1 –

    Assumptions:
    LTV of customer = $1000
    Recurring commission = 20% so LTV of commissions = $200.
    Sales CAC (sales rep) = $100
    So LTV = 3.3:1

    Scenario 2 –

    Assumptions:
    LTV of customer = $1000
    Recurring commission = 20% so net LTV of customer = $800
    Sales CAC (sales rep) = $100
    So LTV = 8:1

    You can see the metrics looks drastically differently. Your insight is

  • Joshua

    Have you found any correlation between CAC and the size of the businesses you are pitching to?

  • Brett

    Hi David

    we are try to get the future revenue stream for the entire base as of today. I believe that in fact is the same as the LTV. The bank (it’s a debt investment) who is looking for ability to repay, argues differently. They say that you must halve LTV to get the figure for future revenues from the current base because ‘on average’ half of the current base us half way through its average LT.

    This makes no sense to me. I believe LT is a metric for the remaining years of tenure, not total years, depending on when they happen to have started?

  • http://www.forentrepreneurs.com David Skok

    No. There is a more likely correlation between the selling price and CAC, as it takes more people and proof points to get larger deals done.

  • http://www.forentrepreneurs.com David Skok

    I can see where they are coming from, but that argument seems to me to be the wrong way to look at the problem. I believe the right way to look at the problem is via the churn rate, as covered in my previous reply.

  • http://www.forentrepreneurs.com David Skok

    Hi Z, I see the big difference. The right answer is to use Scenario 1, as the commissions are part of your costs to acquire the customer. (The only exception to that would be if your channel partner had nothing to do with sales, but was only being given the commission because they were providing some kind of support or other service to enable product delivery. But if that is the case, the use of the word “commission” is wrong.)

  • Brett

    Many thanks…

  • Yasha Podeswa

    If anything, your churn rate for your overall customer base would likely decrease over time if your acquisitions were to die. For almost all SaaS companies, new customers churn a lot, as many either aren’t onboarded properly or aren’t good fits for your product, but established customers tend to have much lower churn – they like the product and are in for the long haul. Normally all those new customers are increasing your churn rate, but without new customers the overall churn rate will drop, as those small number of high churning new customers will contribute a lot to overall churn.

    Agreed with David though that the simplest back-of-the-hand calculation will be to just think about your current revenues eroding, not to get into LTV. Most people calculate LTV from some key event (i.e. LTV of a Paid Trial, or LTV of a user who has made their first payment), if you want to use an LTV approach to decide remaining revenue in a run-off situation you look at the LTV for each cohort (from their first payment), and subtract the amount already paid. The DD guys are probably right that your current customers have likely paid somewhere roughly in the range of half of their LTV, assuming you’re calculating LTV from the first payment date.

  • http://www.forentrepreneurs.com David Skok

    Yasha, you are 100% right. Thanks for providing such valuable help.

  • Yasha Podeswa

    No problem, great post btw!

  • Racheli

    Thanks for the comprehensive and detailed overview. The only problem we encountered when selling to enterprises, was that they are not willing to purchase anything with a SaaS model… It’s always a big amount of money upfront + 15-20% yearly maintenance – till here all is well but they keep insisting on purchasing a perpetual license… How do we best convert SaaS to perpetual when we price them this way? Thx!

  • http://www.forentrepreneurs.com David Skok

    Pretty typical would be somewhere in the three to four years of SaaS revenue range.

  • Racheli

    Although SaaS customer churn is relative high?

  • http://www.forentrepreneurs.com David Skok

    Perhaps keep it at the three year level if that is the case. If that is too high for the customer, then you will need to look at the value the product is providing and make sure you are pricing in such a way that there is a good ROI for the customer.

  • Tanushree Jana

    Super useful ! Here are some SAAS churn and sales funnel conversion percentages. (No, I have nothing to do with Totango) http://www.totango.com/wp-content/uploads/2012/11/2012-SaaS-Conversions-Benchmark2.pdf

  • Anthony Parry

    Hi David,

    I am calculating the Product engagement score. #of users / # of users logging in each month. As a SaaS model software company for average user size of 15 users what would you say is a good PES Score?

  • http://www.forentrepreneurs.com David Skok

    Unfortunately there is no simple answer here as it depends on the specific nature of the product. For example one of my favorite products is Sanebox, and I never need to login. It does all its work in the background. Some other products are really only working if a user is in them several times a day. It just depends on the nature of the application.

  • Ross Ely

    David,

    Why do you suggest using gross margin for the LTV calculation as opposed to operating margin? Shouldn’t we be using the free cash flow to determine coverage of the CAC expenses? Using gross margin would seem to ignore overhead costs in SG&A.

    Thanks,
    Ross Ely

  • http://www.forentrepreneurs.com David Skok

    Ross, we are aiming to look at just the costs that are directly attached to the customer (i.e. variable costs). The guidelines I suggest where LTV needs to be 3x greater than CAC allows enough room for fixed costs such as R&D, G&A, etc.
    If we include those fixed costs in the calculation, you are no longer going to have clarity about what happens if you increase customer acquisition, as those fixed costs don’t need to scale.
    I hope that is clear. Best, David

  • Hassan Rostam

    Hi David,

    Thank you for an extremely valuable post.

    I was wondering if you’d kindly help me understand why there seems to be two definitions for the same metric “Net New MRR/ACV.” One definition appears in the main post (SaaS Metrics 2.0 – A Guide to Measuring and Improving what Matters) and the second one appears in a related post (SaaS Metrics 2.0 – Detailed Definitions).

    1) Definition of “Net New MRR/ACV” as it appears in the main post

    Net New MRR/ACV = New MRR/ACV (New Customers) + Expansion MRR/ACV (Existing Customers) – Churned Customers (Lost Customers)

    2) Definition of “Net New MRR/ACV” as it appears in the related post under the heading “The Metrics to help understand the Bookings” and subheading “Bookings”

    I read, Net New MRR/ACV is the sum of:
    - New MRR/ACV from new customer contracts
    - Renewals
    - Churned MRR/ACV

    - Expansion bookings

    It appears the difference between the two definitions is Renewals.

    Thank you again!

    Best,
    Hassan

  • http://www.forentrepreneurs.com David Skok

    Hi Hassan, sorry for the confusion. I am not sure how Renewals got into the equation, but it should not be there. If you remove it, you have the correct definition. Best, David

  • Hassan Rostam

    Thanks!

  • Hassan Rostam

    Hi again David! In calculating New New MRR, how would one deal with service-level downgrades?

  • http://www.forentrepreneurs.com David Skok

    I would suggest treating them as part of the Net New MRR, and subtract them from the number you get from the other three components. So now Net New MRR = New Customer Bookings + upgrades – downgrades – churned MRR.
    Best, David

  • Jörn Steinz

    Hey David, why do you describe saas as a winner takes it all game? There are no network effects, that would support this.

  • ChalupaBatman2

    Hi, David. If becoming Eskimo brothers with prospective clients resulted in lower customer acquisition costs thus a higher CAC ratio, do you think that more SaaS companies would use an Eskimo brother focused strategy to achieve a favorable churn?

  • http://www.forentrepreneurs.com David Skok

    Hi Jörn, the reasons I believe this to be true are:

    · Customer behavior: early majority to late majority customers like to buy based on references in their industry, and word of mouth. They also tend to like to buy from the clear market leader. So once someone starts to pull away, those customer segments add to the momentum of that leading company.
    · Press: in general, the press will write far more about the leading company than they will about the followers. That has a reinforcing effect.
    · Capital: the leader will have the ability to raise more capital, or if profitable, will be able to leverage their greater profitability to invest more in product differentiators, and greater sales and marketing.
    I hope that helps.

  • ChalupaBatman2

    Hi David, what do you think of a business that has low customer acquisition costs, but a high churn. For instance, Taco Corp’s MyFace.

  • http://www.forentrepreneurs.com David Skok

    That’s a great video!

    In case your question was serious: from an investor’s view point, high churn raises a very key question: is this a long term viable business? If the reason for the churn is that the business doesn’t provide the value that the customer is looking for, then there is a problem. If the reason for the churn is something like, you get the value, then don’t need the service any longer, then it is not a problem.