By 2020, more than 80 percent of software companies will change their business model from traditional license and maintenance to subscription. Yet, many are unprepared for the unique challenges and opportunities that come with managing the financial operations of a SaaS business and how the choices they make early on can impact their ability to successfully grow the business.
SaaS Financial Operations: A Different Approach
While the benefits of moving to a recurring revenue model are easy to see, there is a vast difference in managing the financial operations of a traditional business vs. a SaaS business.
Most finance systems that address SaaS business requirements are expensive and out of reach. Not to mention, they aren’t designed to meet the unique needs of B2B SaaS. To avoid this expense in the early stages of their business, many entrepreneurs cobble together spreadsheets and traditional accounting software to create homegrown SaaS financial operations. While the effect of taking this approach might not be seen in the first six months, growth will reveal that spreadsheets are poorly suited for managing a recurring revenue business. As the customer base grows, it becomes clear that spreadsheets become too complex trying to account for the upgrades, downgrades, renewals, re-negotiations of renewals, upgrade-extensions, cancellations and early terminations that are inevitable in a SaaS business.
If you take this approach, it isn’t long before you’ll be unable to capture real-time metrics and thus, lack confidence in the accuracy of your data. This makes it difficult to make informed decisions about the business and is problematic in a lot of ways, but especially in your efforts to raise capital.
Proving Your Business is a Good Investment
While VCs and private equity professionals don’t expect the CEO of an early stage company to be a CFO, they will expect financial data for insight into your company’s past performance, present standing and future plans. Taking a step toward sound financial operations early on will ensure that you can easily and confidently show VCs and private equity professionals why your business is a valuable investment. While these metrics might not be as important in early stages, they will be important as your business grows from early stage to emerging to growth stage (seed, series A, series B+). By collecting these metrics at an early stage, you’ll benefit from having historical data to see your progress and as you grow, use these metrics to drive decisions and help scale the business. And eventually, you’ll also be able to deliver metrics that matter the most to investors. We asked Chad Hooker, senior associate with Fulcrum Equity Partners, for his take on the key performance indicators important for scaling a SaaS business and proving your business is a good investment.
MRR or ARR
At a Glance: Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR) is the value of the contracted recurring revenue components of your term subscriptions normalized to a one-month or annual period.
Hooker shared that MRR or ARR are the best leading indicators of overall business performance. “Quarter-over-quarter bookings growth gives us valuable insight into the momentum and velocity of your business and its potential for growth.”
Average Contract Value
At a Glance: Average Contract Value (ACV) is a measure of the average revenue generated per customer and is usually calculated on an annual basis. A growing or contracting ACV is a good indicator of the value you’re providing to customers. It’s also critical for your sales and marketing because it provides visibility into how many leads and opportunities are needed to achieve your goals.
According to Hooker, tracking ACV over time is valuable for understand evolving customer behaviors. “It helps drive decision making for your product roadmap and sales, marketing, customer success and retention strategies. It’s also useful in measuring the success of land-and-expand growth strategies, upsell initiatives and your ability to deliver more and more value to customers.”
Customer Acquisition Costs and Customer Lifetime Value
At a Glance: Customer acquisition costs (CAC), customer lifetime value (CLV) and CAC payback impact how you allocate sales and marketing spend and are valuable in understanding how much your company is making from each new customer and how long it takes to surpass the money you spent to acquire that customer.
“CAC, CLV and CAC payback indicate sales and marketing performance and helps us understand efficiency of a company’s growth model,” Hooker shared. “We spend a significant amount of time analyzing the scalability of a sales and marketing organization and these metrics are great validations that additional investment in sales and marketing activities will drive value creation.”
Churn and Retention
At a Glance: Churn can happen for a multitude of reasons, but as one of the most important indicators of the health of your business, you need
to understand why. As your company expands and the size of your subscription base grows, the revenue lost to churn can also grow, requiring more bookings from new customers to replace what was lost.
“We pay very close attention to churn because customer retention is at least 95 percent of SaaS business revenue,” said Hooker. “In a SaaS business, everything is amortized over two- to three-year contracts, so high retention and strong renewal rates are key value drivers and crucial to increasing CLV.”
At a Glance: Generating revenue from existing customers is a good indicator of whether they’re receiving value from your product and expanding their use. Expansion revenue includes customers who upgrade to a more robust plan or those who pay for additional users or features.
“It takes significantly more time and resources to acquire and onboard a new customer than it does to retain and upsell existing ones,” said Hooker. “We look closely at expansion and upsell revenue metrics and ascribe high value to businesses that can grow organically by expanding existing customer relationships.”
At a Glance: Grouping customers by product, vertical, sales channel, deal size, etc., also known as cohort analysis helps uncover trends in specific customer groups. For example, if a large number of customers are churning in the first or second month, you may need to address your onboarding process. Emerging SaaS companies typically have customers that vary in size, so cohort analysis by deal size can highlight which “group” has the lowest churn rates.
“Customers have different needs and understanding these needs across cohorts can help improve customer relationships, go-to- market messaging, predict upsell/expansion opportunities and combat churn,” Hooker shared. “Customer behavior across various cohorts gives us valuable insight into how different customer segments are interacting with your product, sales and marketing teams.”
Whether you’re motivated by growth, raising capital or just want to make more informed decisions about your business, taking control of your financial operations and putting in place the processes and solutions today that will scale as your SaaS business grows is a worthy investment.
About the Author: Tim McCormick is the Chief Executive Officer of SaaSOptics, an affordable and flexible subscription management platform for emerging and growing SaaS and subscription-based businesses. Founded in 2009 by entrepreneurs who lived the challenges of running their own SaaS business, SaaSOptics is the only solution that can scale with a growing business, providing the day-to-day financial management capabilities needed and the auditing, reporting and analytics that are critical for future growth.