Last updated on February 13, 2023
As a SaaS business investor, I wanted to understand how these businesses differ from traditional ones. So I could better understand what to look at when earnings come out (and why).
What these metrics mean in real life. And how they are related. So I could understand how well (or poorly) the companies are doing.
In this post I will:
1. Summarize the essence of a SaaS business compared to a traditional one.
2. Cover the most important metrics and see how they are correlated.
Obviously, the major difference is that SaaS companies come in a subscription form. This means customers will pay on a per-month basis for their product or service (software in this case).
What this means for the companies is that they have better visibility into their revenues as most of these subscriptions are offered through annual (or even multi-year) contracts.
This makes it easier to track, upsell, and hence grow next year’s revenue as the company has already a base to start off. Last year’s customers are not going anywhere so the company only needs to grow from there.
So, any growth in new customers will drive revenues up significantly on a YoY basis as existing clients, most of the time, spend more through add-ons offered by the company thus driving their original cost to acquire further down as time goes by.
But you probably already knew this. So, let’s dig a bit deeper.
What you'll learn:
⓵ What’s the difference between a SaaS business and a traditional company?
Recurring revenue, as explained above, makes SaaS completely different from what we were used to so far. Both as clients and as investors. Here’s how it makes it different for the business owners and the management team.
The revenue of the business comes over an extended period of time (customer lifetime). It is not a one-off thing. “So what?”, you may ask. Well, this turns everything upside down. Because the point now is not to just sell.
It’s to onboard as many happy customers as possible (emphasis on happy, more on that in a bit). Words like profitability are not of main concern (at least not during the early innings of the company).
Because every customer you acquire today will be printing money for life — provided he/she is happy.
Happy clients will stick around (less churn), buy more products/services from you (more growth), and also recommend your product/service to others within their organization as well as outside (network effect).
This makes acquiring SaaS customers not as expensive as it might initially appear. The average payback time for the Customer Acquisition Cost (COC) is around 18–24 months. Less than that is considered excellent, and more than that is worrisome.
When you consider that most customers will stick around for years then it makes absolutely no sense to cut costs, but now is the time to increase Sales & Marketing (S&M) to try to capture as many of those clients as possible.
Because in about 2 years (or less) you will make it all back and then the customer starts to really contribute to your profitability. This is what is known as a Land & Expand strategy.
⓶ What’s Land & Expand in a SaaS business?
“Land and expand” is not simply increasing the seats or licenses sold to existing clients. Your sales team will probably help land a client.
But then it is up to the customer success team to cultivate a healthy ongoing relationship with your clients. In order to find out how they can better serve them. And make your offering mission-critical and churn-proof no matter any changes in management and decision makers within the client’s company.
In order to do so successfully, you’ll need to track new user signups, deepen relationships with decision-makers, monitor user adoption, and then leverage the relationship built with decision makers to drive adoption through entire organizations.
If executed right, you’ll see an increase in Average Revenue per User (ARPU), wider adoption across departments within the client’s organization, higher Dollar Based Net Retention Rate (DBNRR), and higher lifetime value of your clients since you’ll have managed to prove your solution’s importance and criticality within your customer’s organization.
So, our SaaS companies need to:
- Acquire customers
- Retain customers
- And then finally monetize customers
Most investors would not understand the basic economics behind a SaaS company and thus worry when they see a squeeze in profitability (cash flow positive) even with perfect execution. And the reason behind this is simple, as explained above the first goal is to acquire (fast) as many happy customers as possible.
This means that every client onboarded takes money out of your pocket (COC). SaaS companies should accelerate their S&M spending (not the opposite) to boost the customer acquisition pace.
And when, finally, there is a solid base of customers, the contribution will be meaningful to the profitability of the company. However, just because you see customers flowing in you shouldn’t stop investing in your growth just to be profitable.
There is plenty of growth potential unless you have penetrated your TAM significantly (which is almost never the case). At that time, it makes perfect sense to accelerate your S&M spending to help scale your growth even further even if it deepens your losses temporarily.
Why would we want to accelerate the spend if everything seems to work out perfectly? Simply because there are usually other players competing for the same market share and offering similar products/services.
For this, our companies need to get all the growth while they can. Speed matters here. If you are too slow, others will get ahead of you. And since this is a sticky business, you won’t be able to convert them to your service easily (if at all).
This is why valuation is usually higher for higher-growing SaaS companies. And this is why Saul’s method has revenue growth as the no1 thing to look at when trying to identify the best business. Companies growing rapidly means they take market share and are becoming the leader in their space.
⓷ What are the key metrics in a SaaS business?
Even though some companies select and define the key metrics differently, here are the most common ones:
❖ Annual Recurring Revenue (ARR)
This shows how much a customer is expected to spend within 12 months. So, if for example, a customer buys a $20 subscription for 2 years you automatically have a $240 ARR. If you have 10 clients buying that then your ARR is $2400.
This tells you in advance how much your clients are expected to spend within 12 months.
There are three things to consider when it comes to ARR. First, how much new ARR comes from new clients? Secondly, how much churn there was from existing clients. And finally, how much expansion you had from existing clients expanding their subscriptions?
❖ Bookings/Revenue/Deferred Revenue/RPO
Bookings refer to when a contract is signed. For example, a customer just signed a 3-year contract for $3m. Your bookings are $3m and your ARR is $1m. Revenues will only start to appear once the customer starts paying (billings recognized) leaving deferred revenue to be realized down the line.
For example, once the first year goes by you will still have $1m more in deferred revenue per year and $2m in total Remaining Performance Obligation (RPO).
❖ Customer Lifetime Value (CLV)
This shows how much revenue you will get from a customer minus the cost to acquire (COC). This is important because if your customers are spending less than it costs to acquire over their lifetime then it makes no sense to acquire them in the first place.
If that is the case, then the COC needs to come down and then to reconsider.
❖ Net Revenue Retention (NRR) or NDR or DBNRR
This metric shows how much revenue you keep or grow including churn. By including churn and upsells it gives you a better understanding of whether your product is a good fit for the market. For example, you have 10 clients bringing in $100 for year 1.
Then the same cohort of clients brings in $120 even though there are now 9 clients because of churn. Even with fewer clients, you managed to bring in more dollars. So, there’s a 120% NRR. Anything above 130% is excellent, and less than 110% is worrisome.
Even though the scope of a SaaS business is to acquire customers first, in reality, what they really do need to do is to focus on customer retention. Because if you keep adding unhappy customers you will lose them too eventually.
This is why churn is super critical for a SaaS company. Even a slight twitch in your churn can work wonders.
❖ Net Promoter Score
The NPS shows how many of your clients would recommend your product/service. There are promoters (those who give you a 9–10/10), detractors (those who give you a 0–6/10), and neutrals (those who give you a 7–8/10).
This score is an indication to the churn. A high NPS makes your business much stickier and thus easier to grow. A low NPS would make it harder to maintain because of the higher possibility of churn, thus reducing your NRR.
If I could write the essence of a SaaS business in 2 sentences this would be it: “To acquire high lifetime value (LTV) customers and keep them happy for as long as possible while offering a never-ending pool of new products/services that meet their needs.”
Personally, I think that subscription models are best for everyone. Better for clients, as they have more control over how much they spend. Better for companies, as they have better visibility into their revenues and overall performance.
And better for investors too, as they have better predictability on what to expect from their investments.
⓸ A business owner or an investor?
It makes sense to be able to understand the companies we invest in so that we can assess their progress and the stage they are at, to make informed decisions. To do so successfully we should think as business owners first and then as investors.
However, one thing to note is that even though we ought to think as business owners there’s an understated difference between the two and there’s a big advantage we have over actual business owners.
A business owner will not be able to jump ship when something is wrong with the organization, they’ll most probably stick around to figure things out.
We (as SaaS business investors though) have no obligation to stay invested until and if the management figures things out.
Our advantage is that we can simply exit our position and reenter when things improve while reallocating our funds elsewhere in the meantime to avoid extended losses and — most importantly — the opportunity cost.
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