The bread and butter of measuring success is inevitably crunching the numbers.
*cries in Excel spreadsheets*
When looking at the growth of your SaaS business, there are a number of metrics that are critical to understand.
A SaaS startup doesn’t follow traditional accounting methods, so a lack of understanding on these metrics leads to troubled waters for the future of your business.
Let’s break down the metrics in a way that’s simple, clear and gets you on the right path to measuring your success.
What is a SaaS business model?
A SaaS business is any business that hosts software in cloud infrastructure (basically computer systems On Demand) to clients or users. Essentially, as a customer, you don’t need to manage or directly house software on your computer or device in order to use it.
A great example of a SaaS is Netflix. You pay to get access to videos on demand. (Can you imagine trying to install Netflix on your computer like TurboTax?)
In terms of business clients, for example, a SaaS company benefits them by not requiring them to build and manage their own IT software systems. Businesses can purchase accounts (seats) for their team members and securely log in to access the software. A classic example of a B2B SaaS company is Salesforce.
Overall, the SaaS business model is complex, but typically is based around a regular renewal of a membership.
For many SaaS businesses, this typically looks like monthly or annual billing to the account owner. As SaaS companies move out of the startup phase, there are additional ways to upsell, down-sell and resell and build out additional revenue streams.
What are unit economics?
In order to effectively measure and do a “temperature check” on a startup’s activities and vitals, startups need to focus on specific metrics.
These specific metrics allow a startup to understand their success outside of vanity metrics that would otherwise lead you and your team to the innovation graveyard.
Optimism can kill a startup. Instead of this common launch assumption, founders and startup teams can make informed decisions on when to hit the gas, and when to slam the brakes.
Misunderstanding can also kill startups and the support from investors.
Case in point, the pattern of early cash flow.
In a startup’s first or early years, losses are exceptionally common. This can lead to a cash flow “trough”, especially when the cost to acquire new users is high and early growth is fast.
This can worry founders, teams and investors, but these losses have the ability to later “flip” and turn cash flow positive. This happens when the early customer base is established, growing, and able to offset costs by bringing in continual revenue.
Essentially, unit economics answer the following:
Is your startup profitable when comparing the direct revenues with the variable costs of development, infrastructure, team compensation, and the cost of acquiring customers?
Should your SaaS business focus more on acquiring more users, or on nurturing existing customers?
Unit economics analysis provide the sturdy foundation to craft sound projections for stakeholders, and determine financial success.
You can’t make effective decisions on market strategy, product-market fit, or do annual planning, without taking a glance at the numbers.
What are the key SaaS metrics?
The following are the key metrics that determine growth and success.
SaaS is different than most other businesses in that it requires accounting for the value of user over a long period of time. For example, over a period of months or annually, depending on the billing cycle.
As a result, you need to understand how you pull people on board, costs with acquiring and how to keep from jumping ship, and if they jump – what’s their lifetime value?
Let’s dive into it.
Monthly Recurring Revenue (MRR)
This is a cornerstone metric to tracking revenue for SaaS companies. It goes back to the concept of you going into business to make money while you sleep.
MRR helps to illustrate the pattern of cash flow month to month and show you how your efforts are sticking. Overall, you want your MRR going steady or on the upward trajectory.
If MRR is continually decreasing, you’re in a pricey pattern of having to continually get sales, and keep selling, and keep selling…
It’s a story that doesn’t have a good ending. MRR helps you track the trajectory.
Calculating MRR comes down to the following:
Take your average account amount (average of your pricing plans and add-ons) and multiply by the number of customers.
Beyond MRR, there’s also Net New MRR to observe what changes month to month.
Essentially, if MRR goes up or down – how is that accounted for? What happened?
This involves accounting for other types of MRR that better help you to calculate more specifically, such as for churned customers, downgrading customers, upgrading customers and then customers that reactivate.
Customer Acquisition Cost (CAC)
This metric equals the amount of cost it takes to make a sale and bring a new customer on board.
How do you calculate CAC?
CAC is calculate by taking the full amount you’ve spent in any one length of time on marketing and sales. Divide that amount by the number of customers. For example, for a $20 cost of acquisition for 15 customers over the course of the month, you’d have spent $300 total that month.
You want to know your CAC in order to know how that compares to your product price. Are you making a profit on your customers?
You could easily see your vanity metrics come into play here. You might have more monthly users and more sales, but what does your cash flow look like?
In marketing, this area is critical. In terms of sales rep efforts, sales strategies and advertising, you want to aim toward breaking even with the lifetime value of a user compared with the cost to acquire.
The ideal spot to be with CAC is that your LTV (discussed below) is in a 3:1 ratio. Meaning, the value of your customer is worth three times the amount spent to acquire them.
Every company has some degree of churn in their business.
This means that customers are dropping off from using your product or service. They are clicking the “Cancel Subscription” button or downgrading their service level tier.
The earlier in the game your company, the higher the monthly customer churn is going to be. This makes it harder to most accurately understand the value of your customer (their lifetime value).
How do you calculate churn early in the game?
An excellent question.
In the beginning, you will have fewer customers and a limited runway. Your churn is going to be more educated guesswork than hard and fast calculations, and you understand that this value will morph in time.
How do you calculate churn?
There are several ways to calculate churn, but the most straightforward approach is by taking the number of customers lost in a period of time, and divide by your total customers at the start of that period.
You have 200 customers at the start of February and 25 users cancel their subscriptions.
Churn = 25/200 x 100 = 12.5%
The other piece to consider with churn is negative churn. This means that the upgrades and upsell items purchased from existing customers outweighs the total value of downgrades and cancellations.
Understanding your churn is to understand the reasons that early customers are not “sticking”. This comes through surveys and interviews with your early users to gauge their real use. (Not just assumptions of customer use.)
For example, you include an exit survey that asks users what they disliked about the service, what didn’t live up to expectations, and their thoughts around pricing.
How can you decrease churn?
Focus on your more profitable customer segment and refine the customer experience. You want to focus on users that have more traction and profit attached. Don’t cast a wider net to other segments until you have gained more profit to be able to focus appropriately to other segments and expansion.
Look at your pricing model. Are you offering a premium pricing that is more than your user base can commit to? Do they see the value in your problem solving?
Or, is your pricing too low? Are you effectively communicating your value? Otherwise, is your pricing unable to offset customer churn and acquisition?
Customer Lifetime Value (CLTV)
CLV equals the total value that a customer brings throughout their whole relationship with your company and product. This is also called lifetime value or LTV?
How do you calculate CLTV?
There are several methods to go about calculating CLTV.
The simplest way is to multiply the average account value by the customer lifetime and frequency.
For example, a customer stays on for 6 months paying $100 per month.
The Lifetime Customer Value would look like the following:
$100 x 6 = $600
For CLTV, the most precise value will be based on the more advanced calculation below.
- Calculate your average revenue per account by taking your MRR calculation and divide by the total number of accounts.
- Determine your gross margin. Subtract your cost of goods (operations and infrastructure cost) from your net sales (total revenue minus returns, discounts and allowances).
- Take your ARPA value from step 1, multiply by the percentage of gross margin from step 2, and divide by your churn rate.
Note: Make sure calculations reflect the same time frame. For example, if ARPA is calculated based on a monthly period, churn rate should also be calculated on a monthly time frame as well.
Take the average revenue per each user account and divide by the cost to provide the service your platform provides. Then you divide by the churn rate (equation above).
Being able to account for CLTV involves does a deeper dive into major aspects of your business.
In some cases, the average account (user) value will be straightforward if you have a fixed monthly subscription. In other cases, you might have upsells.
An example in Active Campaign: You pay for monthly use of the email service provider based on the number of contacts and emails sent out. However, they have an upsell add-on feature called Conversations. Here, you can introduce a chat feature on your website for $9 per seat that you purchase in the app portal.
In still other cases, you might have 10 different add-ons or multiple tiers to account for in leading up the the average account value.
Regarding operational and service costs: Even though SaaS companies are far removed from brick-and-mortar stores, they still have technical overhead.
There are many factors involved in delving into these costs. These are a few examples:
Say you have an app hosted on Amazon Web Services (AWS).
- How much does hosting on Amazon cost you per month?
- If you send text messages to users, what SMS messaging rates apply?
- If you have an API connection, how many requests are you allotted for your gateway and how much do you pay per number of requests beyond that?
You’ll also have continual development and updates that are required. The general rule is to allot 20% of your initial product build to updates.
Example: It takes $175,000 to build the MVP. Count on spending $35,000 per year on updates and maintenance.
What is the most important SaaS metric(s)?
If I were to name the most important metric – it would be CLV.
This is often tough to put a finger on and calculate with certainty, especially in earlier company stages.
Given what you’ve learned from CLV above, it intersects with many parts and pieces of your business, like churn and knowing average value per customer.
For early-stage founders, you’re not going to have a certain value out of the gate.
However, understanding this on a deeper level allows you to tap into bettering user experience and marketing. You better understand your user’s journey with your brand, and give more focus on how to retain software users.
If you know CLV, you know whether customers see value for the price point. You know whether your time in making a sale and paying the necessary marketing expenses to acquire a customer, actually lead to long-term value.