SaaS 101
An overview of the core metrics used to analyze and monitor SaaS companies and investments
SaaS has become an ever larger component of the global software industry. As it has grown, the SaaS business model has introduced new frameworks and ratios to measure SaaS business performance and value, many of which were borrowed or repurposed from other subscription-based industries such as newspapers, magazine, telephone, and cable television. From an investor standpoint, SaaS metrics complement standard GAAP reporting of revenue, gross margin, and cash flow, and provide additional insight into current and future business performance. From an operational standpoint, the metrics can help set financial budgets, make resource allocation decisions, and determine executive and sales compensation. This white paper provides background on several of the core definitions and metrics used to analyze and monitor SaaS companies and investments.
Software as a service (SaaS; pronounced /sæs/) is a software licensing and delivery model in which software is licensed on a subscription basis and is centrally hosted. It is sometimes referred to as “on-demand software”. SaaS is typically accessed by users using a thin client via a web browser.” –Wikipedia
Overview of the SaaS Business Model
In the SaaS business model a customer typically commits to a term limited contract, most often either one or three years, which provides the right to use a software product during that time period[1]. In a SaaS model, the customer typically accesses the software via a web browser and the vendor hosts and manages the systems on which its software is installed according to service level agreements. The vendor may offer the software through its own data center, a leased facility, or through public cloud services such as Amazon Web Services, Google Cloud or Microsoft Azure. Maintenance and improvements to the software are included as part of the SaaS contract. At the end of the contract period, the customer has the option to renew or discontinue use. From an investor standpoint, the SaaS model provides predictability through ratable revenue recognition as well as the opportunity for a compounding return through recurring, growing cash flows. From a business planning standpoint, the SaaS model generates predictability through the contract’s terms and specific renewal dates. The SaaS business model is considered a recurring revenue model due to the accounting treatment of contracts and customers’ behavioral propensity to renew, although there is no contractual obligation to continue with the same solution. The SaaS business model is also described as a subscription model as the customer signs up and often pays upfront and prior to service delivery — sub (before) scription (signing).
Booking, Billings, Revenue and Deferred Revenue
Starting at the top, a company’s reported Bookings and Billings provide the best picture of sales performance for a SaaS business. Bookings is defined as all business booked — the dollar amount of signed contracts — in the period. Billings is defined as all business billed — the dollar amount of contracts invoiced — during the period. Bookings and Billings, therefore, will differ based on payment terms and timing. To use a simple example, if a customer signed a $1,500,000 two year contract billed annually, Bookings in the period would be $1,500,000 and Billings would be $750,000 in year one and $750,000 in year two.
Under GAAP accounting, SaaS contracts are recognized ratably as revenue over the contract duration[2]. Revenue is the amount of the booked and billed contract value that falls in an accounting period. The divergence between business results (inbound cash flows and expense payments) and accounting results (ratable revenue recognition) is the primary cause of misunderstanding of SaaS financial performance.
Using the same example above, the $1.5 million contract should generate Revenue of $62,500 ($1.5 million / 24 months) in each month of its duration, assuming billing takes place immediately upon contract signing. (Note that a SaaS contract with “multiple elements” — the addition of services or hardware — will complicate this example.) To simplify the relationships, if the business is able to bill customers upfront, which is the case with many annual contracts, then billings and bookings will be the same; if the business bills customers on a monthly basis, which is more often the case with SaaS solutions sold to SMB market, monthly billings will match ratable Revenue.
Under GAAP accounting, monies that have been collected from a customer for services that have not yet been performed become Deferred Revenue. The upfront billing and collection of SaaS contracts, typically annual contracts, and the ratable recognition of those contracts, creates Deferred Revenue. Deferred Revenue is considered a liability as it is an obligation to deliver services that have already been paid for. The Deferred Revenue balance is drawn down over the ratable term of the contract from the Deferred Revenue account on the balance sheet into Revenue on the income statement. Deferred Revenue with a duration of over one year (beyond the period of annual financial statements), falls into its own accounting category of Long Term Deferred Revenue. Bookings that are not billed may be disclosed as Contractual Backlog; although many companies will not separately report this figure.
There are two ratios that are important to test within these relationships. First, the health of a SaaS business is often measured by their Bookings to Billings ratio: the ratio of bookings to billings in a period. For example, if the business had bookings of $110,000 and billed $100,000 to customers for products or services delivered in a quarter, the Book to Bill ratio is 1.1. A Book to Bill ratio above 1 implies a growing demand; however, a figure much higher than 1 can also be a sign that a company has challenges with customer acceptance or, worse, is doing the equivalent of “stuffing the channel” by signing up customers with very favorable release terms.
The second ratio is the Change in Deferred Revenue, calculated as the difference in the balance sheet Deferred Revenue balance from one period to another, and which should be changing at approximately the same rate as revenue. If the Change in Deferred Revenue growth rate is lower, it could be a sign that the business is having difficulty selling new contracts. If the rate is higher, it could be a sign that the company’s actual growth rate is improving: it is booking and billing more business at a faster rate than reflected in its GAAP financials.[3]
TCV, ACV, MRR, & ARR
Most SaaS businesses will report Bookings as TCV (Total Contract Value) or ACV (Annual Contract Value) and use these figures as their primary sales metrics. TCV reflects all of the contract value over the full contract duration and may cover multiple years with multiple payment dates and multiple elements. ACV measures the value of the contract over a twelve month period. Using the earlier example, a $1,500,000 two year contract billed annually, would generate TCV of $1.5 million and ACV of $750,000.
For most companies, ACV is preferable to TCV as ACV is closer to recognized revenue and better reflects near term activity. As described above, ACV will differ from Revenue depending on the timing of the booking and the timing of the billing. A $1.2 million one year contract signed and billed in the last month of the fiscal year would only report a fraction (1/12) of ACV or $100,000 as revenue. Note that TCV and ACV will include all of the contract value, which may include services, hardware, training or other elements, and, therefore, could overstate the level of recurring revenue activity and mask recurring revenue growth or decline[4].
To address this concern and isolate recurring revenue, many investors focus on Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR),[5] which represent the combined value of all of the recognized recurring subscription revenue on a monthly or annual basis and do not include services or other elements. For example, a $1.5 million one year contract with $300,000 of services would generate ACV of $1.5 million and ARR of $1.2 million.
To illustrate the interactions of these metrics, consider two contracts: Contract A is a twelve month contract with a $10,000 monthly subscription value and $10,000 of professional services. In this contract, TCV = $130,000, ACV = $130,000, and ARR = $120,000. Contract B is a three year contract with a $5,000 monthly subscription and $80,000 of services. In this contract, TCV = $260,000, ACV = $140,000, and ARR = $60,000. At first glance, Contract B looks like the better opportunity at twice the size, but despite lower TCV and ACV, Contract A will gross $370,000 of cash flow over three years due to its higher ARR component, whereas Contract B will gross only $260,000. Contract A will also likely carry a higher gross margin and generate more profit since it requires less lower margin services.
From an operational perspective, sales compensation plans based off of TCV, ACV and ARR will drive different behaviors, e.g., a focus on TCV may come at the expense of near term recognize-able revenue. Likewise, companies should consider whether to separate compensation for new business sales (new customers, expansions or both) from recurring business sales (renewals of existing contracts).
Types of Recurring Revenue
In general, companies refer to a “recurring revenue” line, but not all recurring revenue streams are equivalent. To understand the differences requires understanding the underlying customer contracts and payment and renewal terms. The key factors to review are certainty and timing of cash flows. Three primary examples are:
1. Fixed length, paid up front contract. This is the most valuable recurring revenue stream as it generates high predictability of revenue over the contract term (100%, unless there are contractual outs) and high, front-loaded cash flow. An example would be an annual contract recognized as revenue over 12 months and billed in full up front. At the end of the contract term, the customer is sold a renewal which presents a follow-on sales and contract expansion opportunity.
2. Auto-renewing subscription contract. An auto-renewing subscription, e.g., monthly or quarterly automatic renewal, with billing tied to the renewal is also very valuable, but it will not generate as high upfront cash flow or the same predictability. Each renewal point introduces the potential for attrition. A contract that requires the initial purchase of hardware or services (implementation, integration, training) may add stickiness and switching costs, e.g., the Bloomberg Terminal is a proprietary platform required to subscribe to Bloomberg’s financial information.
3. Re-occuring purchases. This refers to customers that make an initial one time purchase and who then return to purchase the same (or more) product or service value, e.g., a monthly SaaS contract that expires and is then renewed each month. This type of recurring revenue has a high risk of attrition and likely also requires higher sales & marketing spending to fully capture renewals.
Retention, Renewals & Churn
Retention rates — also referred to as “renewal rates” or by their inverse “churn rates” — are critical metrics for SaaS businesses and any recurring revenue business. Put simply, it is very expensive and time consuming to grow a subscription revenue business with high levels of customer churn — the bottom of the bucket keeps leaking the new water that fills in at the top. Retention rates can be tracked with several key sub-metrics:
- Net Revenue Retention. Net Revenue Retention (also referred to as Net Retention or Net Renewals) is the metric that most companies track and public SaaS companies report. It measures the total change in recurring revenue from a pool of customers over time and is calculated by dividing a company’s monthly recurring revenue in a period (year, quarter or month) a year prior by the current ARR from that same group of customers in the current period. Net Retention captures the negative impact of lost customers, but also the positive impact of cross-sells, up-sells, price changes and growth in usage or seats within the installed base of customers. Net Retention is the most comprehensive retention metric because it tells the complete revenue story of the installed base of customers. It answers the question of what the company’s top-line revenue would do if it did not gain one more customer. A good Net Retention figure would be at or above 100% and a very good figure would be above 110%.[6] Lower net retention figures (and gross revenue retention) may be acceptable if the acquisition costs are low, as discussed below.
- Gross Revenue Retention. Gross Revenue Retention (Gross Retention) eliminates the impact of cross-selling and up-selling, and volume expansion within the installed customer base. The calculation is the same as net revenue retention; however, the ARR for each individual customer in the current year cannot exceed the ARR for that customer from one year prior. Gross Retention is the best indicator of how a company is doing in retaining revenue from existing customers, since a large upsell or expansion from one customer cannot offset a decline in revenue from another. Gross Retention is always equal to, or lower than, Net Retention and cannot be greater than 100%. A good Gross Retention figure is above 90% and a very good figure is above 95%.
- Customer Retention or Logo Churn. Customer Retention (or its inverse Logo Churn) is used in conjunction with Net Retention to get better visibility into the underlying customer population dynamics. Customer Retention is calculated by taking a count of active customers one period prior and comparing it to the number of active customers from that same group one period later. For example, if a business had a group of 100 active customers at the end of 2015 and 90 of those same customers were active in 2016, its Customer Retention for the period would be 90% and its Logo Churn would be 10%. The deficiency of this metric is that it does not distinguish between contract values — small contract sizes may be less attractive to keep — or differentiate between customer sizes and types. SMBs churn more frequently than enterprises, and more mature customers churn less frequently. Logo Churn will vary based on market with good Logo Churn rates for enterprise customers below 10% and very good rates below 5%; SMB rates will be a notch wider given the higher risk of business failure.
While some churn may be related to macro-economic factors, in general it is highly dependent on customer satisfaction. Customer satisfaction measures, such as Net Promoter scores or other customer surveys, can be valuable supplementary data to the metrics above.
Cohorts and Cohort Analysis
Cohort analysis is the measurement of the behavior of a specific group or “cohort”. Most often, the cohort is measured over time and defined by the date or time period the customer was acquired; for example, a “November 2016” cohort or a “2014” cohort. Cohort analysis can provide insight into customer behavior over time: do customers continue to renew year after year? Do they buy more over time? Are churn rates high in the first year and then stable thereafter? Cohorts can also be refined based on customer size, geography, vertical, product or sales channel to add further clarity to the business. Do European customers renew at higher rates than U.S.? Do customers of product A churn at higher rates than product B? Is direct sales yielding higher revenue customers than channel sales? How does customer behavior vary by product? Note that more refined cohort-based analysis requires detailed customer-level data or may require granular tracking of SKUs and cost centers, which may not be available, in particular in evaluating a public company.
“Magic Number”
The SaaS Magic Number is a quick-to-calculate formula to gauge SaaS sales efficiency. It answers the operational and investor question, “for every dollar in S&M spend, how many dollars of recurring revenue are created?” It compares a revenue output — annualized recurring revenue growth — to a sales and marketing input — spending on sales and marketing. The Magic Number will be low if (i) S&M spend is not efficient (poor marketing, sales turnover, low sales productivity and execution) or (ii) customer retention is low. A low Magic Number ratio may also be a sign that the underlying market or product / solution has challenges.
The beauty of the Magic Number is its simplicity:
(Current Quarter’s Recurring Revenue — Previous Quarter’s Recurring Revenue) x 4 / Previous Quarter’s Sales & Marketing Expense
For example, if a business spent $1.0 million on S&M in Q1 17 and its ARR increased by $250,000 in Q2 17 (which annualizes to $1.0 million), the Magic Number would be 1.0.
There are three key assumptions in the Magic Number. First, the metric treats all recurring revenue the same and does not distinguish between new customers and existing customer renewals and upsells. It includes recurring revenue growth from all areas — new sales, expansions, upsells, cross sells and price increases. (The Magic Number should not include license software revenue, professional services, or other non-recurring revenue contracts.) Second, the Magic Number assumes that all Sales & Marketing expense is going to generate near term sales. Third, the Magic Number is based on revenue and not gross margin. It measures the efficiency of sales in growing topline and not the efficiency of the company in onboarding and serving the customer contract. (Note that the metric can also be used to measure overall sales efficiency by simply taking the change in overall revenue vs. the specific change in recurring revenue.)
A Magic Number of less than 0.5 reflects an inefficient sales model, and a figure above 1.0 reflects a highly scalable model. Figures in the middle will require more analysis to determine the attractiveness of scaling the sales model.
Payback Period
The Payback Period uses ARR, Gross Margin and Sales & Marketing expense to calculate the amount of time it takes to breakeven on new SaaS sales. With this ratio, as with the Magic Number, the simplest approach is to use the total Sales & Marketing expense from the prior quarter. This approach limits the amount of adjustment and interpretation from quarter to quarter and allows a simple comparison between companies[7].
The Payback Period is calculated by taking sales and marketing costs of the previous time period (typically a quarter prior) and dividing by the change in the recurring gross profit (recognized recurring revenue multiplied by gross margin) from the prior to the current period:
Previous Quarter’s Sales & Marketing Expense / (Recurring Revenue in Current Quarter — Recurring Revenue in Prior Quarter) x Gross Margin)
For example, if a company’s Q1 sales and marketing costs were $900,000 and it added $200,000 of recurring revenue in Q2 at a 70% gross margin or $140,000 in recurring gross profit for the quarter and, therefore, $46,666 per month, then the business would need 19.3 months ($900,000/$46,666) to breakeven on its its S&M spend. The Payback Period would be 19.3 months.
Payback Periods vary by market segment and stage of growth. SMB customers provide shorter monetization opportunities due to higher churn; therefore, a shorter payback period is needed, in the range of 6–18 months. More stable enterprise customers with high retention rates and longer retention periods may be more comfortable with payback periods of 18–24 months. A Payback Period of under 12 months may mean that the business should spend more in sales and marketing to capture more customers, and a Payback Period of more than two years requires real conviction in the durability of a customer relationship and market opportunity.
LTV to CAC Ratio
The Lifetime Value (LTV) to CAC Ratio integrates sales & marketing spending, retention rates, and revenue and margins to provide a metric that measures the total ROI of customer acquisition. This metric is at the heart of the SaaS business model — and all recurring revenue companies — and indicates whether a particular business is financially viable. The metric is important to understand as many SaaS businesses will show losses as they seek to build a customer base, with the view that once the upfront costs to acquire a customer are incurred, the subsequent cash flows from that customer will be highly attractive for some time.
The first component in the ratio is the Customer Lifespan — the duration of an average customer’s use of a product. Without an extensive history of customer buying patterns, it may be more of an art than a science to estimate that time period, particularly given very rapid changes in technology. One common way of calculating lifespan is to divide 1 by the Net Revenue Churn (1-Net Revenue Retention) in a period. For example, if the annual Net Revenue Churn rate is 4% the average customer lifespan would be 1 / 4% or 25 years. While this figure is mathematically accurate, it would be very optimistic to assume a 25 year life for any technology product given the rapid rate of innovation and market change. A more conservative and realistic view would be to assume a 3–4 year life for an SMB customer and a 5–7 year life for an enterprise customer.
The next component is the Average Revenue per Customer or User (ARPU) which can be calculated by dividing a period’s ARR by the average number of customers over that period. For example, a company with ARR of $60mm and an average of 1,000 customers over the year would have an ARPU of $60,000. Lifetime Value (LTV) takes ARPU and multiplies by gross margin and the customer life span, e.g., a business with ARPU of $60,000, gross margin of 80% and a Customer Lifespan of five years would have an LTV = 80% * $60,000 * 5 = $240,000.
The final component of the metric is Customer Acquisition Cost (CAC), which is calculated by taking total Sales & Marketing expense over the period and dividing by the number of new customers added: a company with annual S&M expense of $18mm and the addition of 200 new customers would have a CAC of $90,000. Note that the new customer figure is the gross new customer additions figure and not the net of churn figure.
The LTV to CAC Ratio is simply the LTV divided by the CAC. In the example above, the LTV to CAC ratio would be $240,000 / $90,000 or 2.7x. This ratio could also be calculated on a quarterly basis to show trends over the year.
The general rule of thumb in the software industry is that the LTV to CAC ratio should be above 3.0x (the value of a customer should be three times more than the cost of acquiring them) and below 5.0x. A ratio below 1.0x means the business never pays back its sales and marketing expense (the infamous slogan, “don’t worry we are losing money today but will make it up in volume tomorrow”). If the ratio is 5x or higher, the business likely should be spending more money to capture more customers given the attractive future cash flows.
While the LTV to CAC Ratio is a widely used metric, it can be refined in three important ways. First, by segmenting sales & marketing expense between new and existing customers, as most businesses will need to dedicate sales and marketing resources to renew existing customers and the cost structures and sales productivity of each segment are likely different. Second, by layering in additional expenses that is truly variable; for example, if a portion of R&D expense is needed to keep current customers happy, then some of R&D spending could be considered a cost of goods sold. Third, the metric can discount future cash flows in determining the lifetime value. However, these adjustments may make comparisons across companies more difficult.
The “Rule of 40”
Stepping back from more granular metrics, the Rule of 40 is a simple and broad ratio to rank growth stage SaaS and other software investments. It assumes a business should balance growth and profitability — faster growing businesses should be investing in growth and operate at lower profits, and slower growers should be more profitable. Under the Rule of 40, growth rate + profit margin should be at or above 40%, e.g., a business operating at a 20% growth rate should generate profit of 20%, and a 40% growth rate can operate with 0% profit. Revenue growth is measured as year-to-year growth and profit is typically EBITDA margin. This metric is used as a rule of thumb and taken in context of a company’s maturity and its peer group.
Conclusion
Many of the metrics above are straightforward and critical to analyzing SaaS businesses. Prior to investment, they can help determine the initial attractiveness of an investment, highlight diligence concerns, and provide benchmarks to compare comparable businesses. Post investment, the metrics can help guide the value-add plan and levers to drive returns, set financial budgets, make resource allocation decisions, and determine executive and sales compensation.
[1] SaaS solutions sold to the SMB and consumer market may also be month-month contracts.
[2] For accounting purposes, SaaS subscription revenues are considered “non-refundable up-front fees.” This means that revenue should not be recognized until: “Persuasive evidence of an arrangement exists.” “The seller’s price to the buyer is fixed or determinable.” “Collectibility is reasonably assured.” “Delivery has occurred or services have been rendered.” The terms of most SaaS companies satisfy the first three conditions, but since delivery of the service takes place over time it leads to recognizing revenue on a straight-line basis. ASC 605 and ASC 985 are the relevant accounting standards documents.
[3] Deferred Revenue will also change if the company changes its invoicing, e.g., annual to quarterly.
[4] A disproportionate amount of services revenue in TCV or ACV may be a sign that significant implementation work is required for a solution, which adds time and risk. Services work also introduces friction to growth: a business can scale only in proportion to the growth of its services and the hiring and training of services personnel. A caveat to the above is that professional services can also make a solution more “sticky” as the services investment by a customer may make that customer reluctant to switch vendors in the future.
[5] Many popular SaaS metrics are expressed in monthly terms, e.g., MRR. However, the cadence of most enterprise businesses is quarterly or annual.
[6] The variables within retention are important. A company churning a lot of customer logos, but offsetting those customer losses with revenue expansion in its retained base through cross-selling or price increases, faces very different challenges and opportunities than a business that is retaining 95% of its accounts but not selling them any additional value.
[7] An alternative approach to calculate CAC is to include any one-time onboarding costs, such as implementation services, training and data migration that may not be included in Sales & Marketing expense, and to exclude any costs within the Sales & Marketing expense line dedicated to renewals vs. new sales. This more granular approach will depend on the availability of data and may make comparisons between companies difficult if a comparable data set is not available for all businesses.
