Julianne Brands - April 2016
In the last ten years, we’ve been lucky enough to see successful exits of our portfolio companies. Of these exits, we’ve noticed a particular theme - 10 of them have been SaaS companies.
In order to better understand the dynamics of investing and building SaaS companies, we convened a panel of experts to explore the question of, How should we approach building and investing in SaaS companies, and what are the appropriate business metrics and key indicators of success at the early and later stages of growth?
We’ve compiled our takeaways below. Since SaaS companies vary greatly depending on their stage, we’ve broken down our discussion points to reflect what guidelines are important as a company is finding product/market fit, repeatable sales processes, and then looking to scale.
Len Jordan, Managing Director, Madrona Ventures
Ben Bayat, General Partner, Illuminate Ventures
Kevin Bobowski, CMO, Act-On Software
Matt Compton, COO, Simple Finance
Julianne Brands, organizer and discussion leader
How should we approach building and investing in SaaS companies?
How do market idiosyncrasies and company stage dictate what’s important for operators and investors to measure?
What are the appropriate business metrics and key indicators of success at the early and later stages of growth?
Key takeaways by company stage:
Product/market fit stage:
Indicators of success are more important than metrics at this stage. As entrepreneurs develop their product market/fit, metrics are less applicable and can be misleading. Instead, look at indicators that can point to early signs of success.
Customer utilization is an early indicator of customer value. Evaluating an appropriate sample of early customers (i.e., not family and friends!) is key to understanding how customers use a product. How many of the first 30 customers are not just family and friends? Is the use case the same for a significant number of customers? i.e., are customers using the product in the same way or to solve the same problem? This is an important early indicator of product/market fit!
Does my average contract value line up with my sales plan? Spending too much money early on a sales team can be deadly for startups, so understanding how a sales process line up with annual contract values is critical to making sure companies are getting paid back appropriately. Ask, is the sales process in line with the annual contract value (ACV)? For example, if its an enterprise saas product, $3,000- $5,000 is the minimum average value of an annual contract to justify an inside sales team. The economics do not work out otherwise, assuming the company is paying salespeople a minimum of $100K per year.
The repeatable sales process stage:
After two years, companies should start to have consistent, uniform metrics that can help drive decision making. One panelist noted that metrics will not start to look uniform until after two years when companies have nailed their product/market fit and are building repeatable sales processes. Tracking metrics like customer acquisition cost (CAC), lifetime customer value (LTV), and churn (revenue and unit) can help operators understand the appropriate levers to turn in order to scale.
Is the Lifetime Value of the customer 3x higher than the cost to acquire the customer?: Generally, after two years, companies can better understand how much it’s costing them to acquire customers vs. what they pay you over time. A strong ratio is 3:1. Anything below 2 might be an indication that either pricing, sales and marketing costs, or churn should be controlled.
Net Promoter Scores can be a measure of customer happiness and a leading indicator of churn. At this stage, many companies are using leading indicators like Net Promoter Scores to understand how happy customers are, with the idea being, happier customers are less likely to churn and more likely to pay you more. One participant also noted it’s helpful to ask customers, why did you almost not buy the product?
But, make sure comparing apples to apples when you start to consider metrics! In order for operators, and investors, to drive meaningful insights from this data, it’s key to look at metrics within a specific timeline or of a specific cohort of customers to make appropriate decisions based on actionable data.
The scaling phase:
Metrics become most important for measuring internal sales efficiency, and can help companies optimize for scalable growth. Sales efficiency is important throughout a company’s lifecycle, but as a company scales, measuring sales efficiency can be a key lever of growth. For example, once a sales person is fully ramped (after 3 quarters, per one panelist) the annual contract value of each salesperson generates should be 4 times their all in compensation. In order to justify field sales vs. inside sales, then, average annual contracts need to be over $5,000K. Understanding these dynamics can help drive decision around pricing, hiring, and overall performance over time.
As a business scales, so too must the understanding of the unit economics. For example, one panelist noted they shifted from SMB customers to enterprise customers due to their understanding of Lifetime Customer Value. Enterprise customers had a much higher LTV, their revenue churn was negative, and even though it cost them more to acquire the customer at the front end, they were able to charge their customers more over time.
Markets matter (see chart below)! At this stage, the market a team is selling into will help to dictate what metrics matter for a business. Selling into the enterprise often includes longer sales cycle, with higher price tags, lower customer churn, with fewer customers. For companies selling into the enterprise, often, lifetime customer value matters more, as does revenue churn. The SMB market often includes short sales cycle, lower price tags, higher customer churn, and more customers! For these companies, customer acquisition cost and customer unit churn can become more important indicators of success, as lifetime customer value and annual contract value are often fairly uniform. Similar dynamics can be found depending on your end customer - IT often has a longer sales cycle, whereas HR and marketing can often have shorter sales cycles.
But, as investors, comparing metrics across companies needs to be done with caution! One panelist noted that when companies are under $10M in revenue, they need to be at least doubling or tripling in growth. After $50M, it becomes significantly harder to triple in growth, but the best companies will still be growing 80% year over year. However, different characteristics, like the ones detailed above, make it critical to understand the systematic differences between saas companies (like time frame, stage, market, end customer, etc.) in order to make appropriate comparisons as investors.
We’ve found these to be important guidelines when investing, but of course, aren’t hard and fast rules. Happy investing!
SaaS Cheat Sheet…
ARPU: Average Revenue Per Unit. Total revenue divided by number of subscribers.
ARPA: Average Revenue Per Account. One enterprise account may have multiple subscribers.
CPL: Cost Per Lead. Marketing costs divided by number of qualified leads.
Conversion Rate: % of leads that become subscribers.
ACV: Annual Contract Value
CAC: Customer Acquisition Cost. Sum of all sales and marketing expenses divided by the number of new customers added in a period.
LTV: Lifetime Customer Value. (ARPA) * (% Gross Margin) / (% MRR Churn Rate)
MRR: Monthly Recurring Revenue
Churn: Customer or revenue turnover within a period. % of subscribers that discontinue their subscription within a given time period.
Payback Period: Time it takes for one customers acquisition cost to be made back from recurring revenue from that customer.