This is the final installment of a series on Investing in SaaS Ventures. Which was born from a question and suggestion from a dear reader, Taliba M.
Taliba is a new angel investor who’s ready to make her second investment. She wants to place a bet on a SaaS startup but feels that she can’t make an informed decision due to her lack of experience with SaaS ventures. She wants to know what we think and we gave her our thoughts in Effective Ways to Invest in the Unknown.
Below is the rest of the series:
* This series isn’t investment advice and it’s by no means a comprehensive guide to SaaS. Read Effective Ways to Invest in the Unknown for the purpose of this series, which is purely informational.
Here, we’ll go through the metrics for SaaS companies, courtesy of Bessemer Venture Partners.
If you have time, read Bessemer’s “Top 10 Laws for Being SaaS-y” (PDF). The document is “the result of conversations with dozens of SaaS executives from within [Bessemer’s] past and current portfolio companies, as well as hundreds of executives from other leading public and private SaaS companies.” It offers great insights for investors and entrepreneurs.
Key monthly business metrics for SaaS companies are CMRR, Churn, and Cash flow:
Committed Monthly Recurring Revenue (CMRR) “is the single most important metric for a SaaS business to monitor.”
Unlike MRR (Monthly Recurring Revenue), CMRR “includes both ‘in production’ recurring revenues of customer and also those with signed contracts going into production.”
Also, since CMRR is reduced by “churn” — the MRR expected to be lost from customers who decide to discontinue the service – Bessemer believes that this metric “provides the clearest visibility into the health of any SaaS business.”
Churn, also known as attrition rate, refers to the proportion of customers or subscribers who discontinue the service during a given time period.
A high churn may indicate “customer dissatisfaction, cheaper and/or better offers from the competition, more successful sales and/or marketing by the competition, or [other] reasons having to do with the customer life cycle.”
Bessemer points out that “[i]t’s very difficult and expensive to grow subscription businesses if [churn is moderate], and prohibitive if churn is high.”
If the company “churns or loses 5% of customers every month, then during the course of the year the company will have to replace a significant number of customers just to maintain status quo,” writes Ed Sims of Dawntreader Ventures. This could increase customer acquisition costs.
So, while adding new customers is important, the company should also find out why customers are leaving and “make sure customer satisfaction is up to snuff,” Sim explains.
Cash is king and it’s especially true for SaaS companies because, as mentioned in Investing in SaaS Ventures (Part 1): The Basics, costs are often front-loaded with payments delayed. Bessemer notes that most SaaS businesses consume more short-term cash if they start growing faster. So they need “a comfortable cash cushion” and they need to “weigh forward investments carefully.”
Sim shares that offering discounts to customers who pay upfront “is a great way for SAAS companies to keep the cash coming in earlier so they can use it to fuel growth.”
The best indicators of long term value creation are CAC and CLTV:
Customer Acquisition Cost (CAC) is mainly marketing related, which includes free trials, referral fees, awareness campaigns, and introductory prices. The CAC ratio determines the payback time on the company’s sales and marketing investment. It’s calculated by dividing the annualized net gross margin by the sales and marketing costs of the previous quarter.
A CAC ratio of 0.5 means that half of its investment is paid back per year, so the payback period is 2 years.
A CAC ratio of a third (0.33) or less is bad, as it suggests a payback period of at least 3 years. It indicates that the company is spending too much to acquire customers. The company needs to hold back on sales and marketing until it can improve its sales efficiency. “Ramping up too quickly will burn precious cash reserve and could sink the business.”
A CAC ratio of 1 or higher means the payback period is less than 1 year, which is great. It also indicates that the company should invest more on sales and marketing.
Customer LifeTime Value (CLTV) tells whether the company is building a profitable business. The CLTV is the net present value of the recurring profit streams of a given customer less the acquisition cost:
CLTV = NPV (Recurring Profit Streams of a Given Customer) – CAC
A profitable business will have a positive CLTV.
Bessemer adds that “it may be more of an art than a science to estimate the lifetime period of the customer [for young companies], as [their] churn data is still limited.” Therefore, the firm “very conservatively [takes] 3-4 years for SMB customers, and 5-7 years for enterprise customers.”
“Together, CMRR, Churn, Cash flow, CAC, and CLTV make up the ‘5 Cs of SaaS Finance,’” Bessemer states.
This concludes our series on the basics of SaaS companies. While this series won’t turn you into a SaaS expert, you’re now at least in a better position to decide whether or not to invest in one.
Again, it’s not recommended that you go it alone given your lack of experience in this area. Co-invest with seasoned investors who are familiar with SaaS companies — if they let you tag along. Your new gained knowledge has made it easier for others to mentor you.
Good luck to you, Taliba, and those who want to back SaaS startups!
* For series, references are published in the last installment of the series.
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