Metrics in a SaaS Environment
SaaS Is a Unique Animal
Software-as-a-Service (“SaaS”) businesses are incredibly simple in most of their elements. There’s no inventory, no supply chain, no bills of materials, no labor and overhead allocation, and comparatively low capital budgets. However, SaaS businesses are unique and complex in two critical areas:
- The Sales/Marketing funnel or process that generates that revenue
Successful, high growth SaaS companies manage both of these elements very well. A handful of metrics and their understanding is the key to this successful management.
Unwinding SaaS Metrics
There is no GAAP for SaaS metrics, so I’ve spent more than my fair share of effort learning best practices for how to calculate them. There are now many Internet resources that explain how to calculate the metrics and what they mean. I leaned heavily on articles and postings by @David Skok to learn and understand the calculation mechanics (thank you, David). Over time, the ‘why’ of the metrics, and their interrelationship, crystallized for me. In this post and follow on posts, I want to share what I’ve learned through work with numerous and varied SaaS companies, investors, board members, and professional colleagues about the ‘why’ of SaaS metrics.
The ‘Why’ of SaaS Revenue Metrics
Before delving into the specifics of SaaS metrics, it is essential to understand why there are a unique set of metrics for SaaS companies and why they are meaningful. It is because the behavior of SaaS revenue is different from traditional companies. I specifically referenced SaaS revenue behavior because there is not much ‘behavior’ in a conventional revenue transaction. In a traditional revenue transaction, the vendor and customer agree on a price, and the customer buys and pays. Hopefully, all seller costs are covered, a profit earned, and the transaction is closed – the end.
In a SaaS transaction, the booking (sale) is just the beginning. While the booking may close, the revenue transaction lives on and doesn’t finally ‘close’ until the customer/subscriber cancels or decides not to renew their subscription. When everything works well, the subscriber remains a customer through multiple renewal cycles before the transaction finally ‘closes.’ Meanwhile, many revenue behaviors are occurring that affect the value of each SaaS transaction over its lifetime:
- Original contract value – the beginning
- Organic growth in revenue due to added users or consumption of more of a service
- Upsell to additional products/features and organic growth in those upsells
- Multiple cycles of contract renewal
- Value of each renewal in comparison with the prior contract
- Professional services overlays, and the difference in those margins from subscription margins
An effectively run SaaS company can influence and manage each of those behaviors and optimize each customer’s value over its revenue lifetime.
Common Metrics and Why They Aren’t Enough
Monthly recurring revenue (“MRR”), annual recurring revenue (” ARR”), and GAAP revenue are common measures used in analyzing SaaS revenue. While the metrics are important, limiting your revenue analysis to those measures can cause you to miss underlying weaknesses in your go-to-market strategy and in the execution of your operations. You can also miss seeing where you are performing exceptionally and should be focusing additional energy and resources.
Consider a simple example – a company is delivering 40% year-over-year ARR growth, with 85% of the growth coming from expansion and upsell in its installed base of customers, and only 15% of the growth coming from new customers. In the near term, results will look good, and unless the company addresses the lack of new customer ARR growth, the growth curve will fall off, and the company’s momentum will stall. Without a more in-depth analysis of the revenue growth, a logical operational conclusion is to invest heavily in infrastructure in anticipation of continued robust growth when, in fact, the company needs to focus on their go-to-market strategy to land new customers. The result when the growth curve flattens is excess capacity and a potential cash crunch. Analyzing the ARR growth by new, expansion, and upsell shines a spotlight on the lack of new ARR growth and enables better operational and investment decisions.
In my upcoming posts, I will have more examples of the interrelationship of these revenue metrics, add more metrics to the mix, and talk about how to think about them in the light of a healthy SaaS business. I will also begin to share my views on measuring and managing the SaaS go-to-market effort’s efficiency and why it is important.
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