4 Key SaaS Metrics Investors Actually Care About

It all boils down to unit economics.
Jeff Link
January 7, 2021
Updated: July 8, 2021
Jeff Link
January 7, 2021
Updated: July 8, 2021

As an executive or product owner, you can find dozens of metrics for measuring a SaaS company’s success. But here’s a dirty little secret: In the eyes of investors, most of them don’t matter much.

Villi Iltchev, who is a partner at the New York investment firm Two Sigma Ventures and former vice president at Salesforce, has written extensively about metrics, including a recent Medium takedown of annual recurring revenue (ARR), which he considers a vanity metric.

“When I worked at Salesforce,” he wrote, “Marc Benioff [the founder and CEO] understood that the only metric that mattered to describe growth was bookings. ARR was not a number that was ever discussed with employees. Most employees did not even know the ARR of the company. But everyone knew the bookings goal for the year.”

Iltchev told me that, when it comes to metrics, the mismatch between current expenses and the return on investment in the form of new revenue months or years later has resulted in widespread misapplication of SaaS metrics.

“There’s still this disconnect between why people think this is worth X, when the profit and loss (P&L) statement says it looks like garbage,” Iltchev said. “And it all boils down to unit economics.”

“Would you pay $1 to acquire 80 cents annuity for seven years? All day long.”

In a software-as-a-service context, unit economics assesses direct revenue and costs on a per-customer basis. The framework asks a simple question: Can you make more money from a customer than the cost it takes to acquire them — and how long will that take?

In many cases, the unit economics get better the longer you can hold onto your customers. Consider, for example, a company that spends $1 to sign customers up for an 80-cent annual contract. At first glance, that looks bad — you spent $1 to make 80 cents. But if the average customer sticks around for seven years, you just turned $1 into $5.60.

“So would you pay $1 to acquire 80 cents annuity for seven years? All day long,” Iltchev said.

But healthy growth can be a delicate tightrope to walk. A firm needs to evaluate sales and marketing spending, make accurate revenue forecasts, tabulate customer acquisition and churn rates. It also needs to have sufficient cash on hand to operate. But, if you zoom out, there are several telltale signs of a healthy SaaS company poised for growth.

Bruce Hogan, who is CEO of the software research firm SoftwarePundit and a long-time investment analyst, summed up these signals like this: “It’s growing quickly. ... It’s growing profitably, as the company acquires customers they’re profitable. Long-term the economics are good; they’re retaining customers.”

These factors can be assessed with four metrics many investors rely on to benchmark companies’ progress and estimate their values. Closely tracking these metrics can help guide product and spending decisions and, ultimately, steer a SaaS company toward sustained growth and profitability.

Top Saas Metrics

  • Net New Annual Recurring Revenue
  • Customer Acquisition Cost (CAC) Payback Period
  • Lifetime Value (LTV)/ CAC Ratio
  • Net Revenue Retention

 

ARR measures how quickly you are growing
Image: Shutterstok

Net New Annual Recurring Revenue

How Quickly Are You Growing?

Recurring revenue is the lifeblood of most SaaS companies. It’s a predictable cash flow generated from fixed subscription costs or service fees customers pay each month or year. Investors like it because it’s reliable and date-tied, and because it offers a snapshot of a business’ scale and how quickly that company is growing.

Let’s break down how it works.

Say your monthly subscription cost is $50 and you have 10 customers. You can reliably expect to earn $500 each month, or $6,000 for the year. Easy enough, until you consider newly acquired customers, new seats, upgrades, downgrades and customers who churn. The best formulas account for these variances by grouping users into cohorts who become customers during the same billing cycle and can be assessed at regular intervals.

Taking these into account, you have the formula below, as published in a guide by Eric Yu on ProfitWell:

Net New MRR = New MRR + Expansion MRR - Churned MRR

  • New MRR: Additional MRR from new customers 
  • Expansion MRR: Additional MRR from existing customers (also known as upgrades or upsells) 
  • Churned MRR: MRR lost from cancellations or downgrades

Citing data from the investment dashboard Public Comps, Hogan said the median year-over-year ARR growth rate for publicly traded SaaS companies is 43 percent. The best SaaS companies, those in the 90th percentile, report ARR growth of 83 percent. And some recent IPOs exceed even that.

“I think Zoom was at 118 percent when it filed for its IPO — but Zoom’s Zoom,” he said. Riding a wave of interest spurred by the pandemic, the company reported 376 percent YoY ARR growth in the last quarter.

Definitions are important here. Year-over-year ARR growth includes existing ARR, but also net new ARR, Hogan said. In other words, if a company had $100 of ARR in year one, then $165 or ARR in year two, year-over-year ARR growth would be 65 percent. Part, or all, of that $65 increase is net new ARR.

Bear in mind, ARR is “backwards facing,” as lltchev noted on Medium. “It actually provides little insight into performance, growth or execution. It is the wrong metric to focus the efforts of an organization around and it can provide a false sense of progress — a vanity metric,” he wrote.

Not all investors share his view. Still, it is true that a business can grow its ARR each year, and still be a poor investment prospect because its rate of growth is decreasing.

On the other hand, lltchev said, disambiguating a company’s historical ARR growth from its net new ARR growth — or bookings — can be deeply revealing. This is best done by measuring the contract value of new business from new and existing customers, he told me.

What matters most to investors like lltchev, in other words, is whether the rate of growth is increasing from one year to the next — and by how much. Is the curve a hockey stick? Or is it more like a cricket bat?

There’s no one-size-fits-all formula to forecast new ARR, Iltchev said, but it can often be inferred from other factors — such as how aggressively a company is hiring salespeople.

“Comcast is spending zero money on existing customers. All the sales and marketing they spend is to acquire new customers.”

Take a company with 10 salespeople whose bookings collectively account for ⅔ of new ARR. The additional ⅓ comes from bottom-up, organic adoption. Now, let’s assume these salespeople earned $6 million and organic adoption brought in $3 million. The total $9 million can be allocated various ways, but how it is spent is telling of a company’s market position.

Implicit in ltchev’s example is this: If the bulk of your marketing and advertising dollars are being spent to retain existing customers, you’re on shaky ground.

“If you’re Comcast, to bring it to the traditional world, Comcast is spending zero money on existing customers,” he said. “All the sales and marketing they spend is to acquire new customers.”

The $9 million figure can also help predict what the company will earn in the upcoming year, according to ltchev, based on the consistency of sales quotas.

“Salespeople do not magically produce a lot more than they did last year, or less, frankly,” Iltchev said. “If their quota is 600,000, 700,000 or 800,000 they are going to produce in that range. And so, I can now extrapolate that by hiring more salespeople, what is a reasonable expectation for the direct sales piece of new bookings to grow?”

If you add 10 new salespeople, the 20-person team will earn twice as much: $12 million. If organic adoption can increase to $5 million, Iltchev would forecast $17 million in new bookings, or 88 percent growth — an exciting number.

 

CAC measures whether you have cash to burn.
Image: Shutterstock

CAC Payback Period

Do You Have Cash to Burn?

Tomy Han, a principal at the Boston-based growth equity firm Volition Capital, told me another important metric, to most investors, is the customer acquisition cost (CAC) payback period. At the most basic level, the metric measures how long it takes for a company to be paid back for the sales and marketing dollars it spends to acquire a new customer.

Here’s the customer acquisition cost payback period formula Volition Capital uses, as Han outlines in a recent blog:

Sales and Marketing Spend / Number of Customers Acquired
÷
(Average Revenue Per Account x Gross Margin %) / 12

The first step to figuring out your CAC is to establish a time frame for evaluation — typically a month, quarter or year, aligned with your billing cycle. So if you’re spending $80 in sales and $40 in marketing each month, and you acquire 12 customers over that period, your CAC would be $10 per customer, per month.

The CAC payback period is then calculated, on a unit basis, by considering the monthly revenue a customer is generating. If an average customer is bringing in $2,000 a year at a gross profit margin of 70 percent, they would be generating $1,400 per year, or $117 per month.

Thus, your CAC payback period is 11.7 months.

A CAC payback period less than 12 months is ideal, Han said, though for most SaaS companies in the $5 million to $30 million ARR range that his investment group targets, anything under 18 months is considered best in class.

Because it is tied to historical data, CAC tends to be reliable: “You know you’ve actually spent X amount of dollars in the last six months and landed Y amount of customers. That’s a fact, right? You know exactly how much they’re paying you.”

Still, there are several ways the metric can be misapplied. Sophia Bernazzani, writing for Hubspot, points out that total sales and marketing costs should include “all program and marketing spend, salaries, commissions, bonuses, and overhead associated with attracting new leads and converting them into customers.”

And as Brian Balfour, founder and CEO of Reforge, noted in a guest post published on investor Andrew Chen’s website, for CAC to be accurate, it should only include paying customers, not free registrations, activations and trials.

Balfour also points out that monthly marketing and sales spending should be assessed against a projected month in the future when that investment is likely to be recovered. Otherwise the figure can be distorted to look better or worse than it actually is.

“You can get better at Google Ads, if that’s your primary channel. You can add landing pages that work better with your ads.”

For a freemium product like Dropbox, that might be when a customer reaches their storage limit and has an opportunity to upgrade. For a SaaS company with an inside sales model, the delay might be the time between when a sales lead is developed and when a customer is acquired. The main point is the lag time needs to be included in spreadsheet modeling as Balfour’s model, seen here, takes into account.

CAC Payback Period Reflecting Predicted Spend-to-Recovery Gap

(Marketing Expenses (n-60) + ½ Sales (n-30) + ½ Sales (n)) / New Customers (n)  

In Balfour’s model, n reflects the current month. It is used to describe a cell’s position on a spreadsheet. Thirty and 60, one or two months, respectively, are placeholders denoting the predicted time lapse between spending and recovery. They vary from company to company. So if n = December, (n-30) and (n-60) refer to November and October, respectively.

Whatever accounting method you choose, the goal is to bring the CAC payback period down over time by reducing sales and marketing costs.

“As you get more efficient at acquiring customers, you get more referrals,” explained Tom Kuhr, vice president of marketing at Greenfly, citing organic adoption as one way to reduce CAC. “You can get better at Google Ads, if that’s your primary channel. You can add landing pages that work better with your ads.”

Lowering costs on the sales side is more difficult, but streamlining sales operations can shrink the average lead-to-close time and cut costs by increasing the capacity of your salesforce. For Greenfly, a Los Angeles-based company that works with clients like Major League Baseball and BET to distribute media assets to talent, this is an ongoing endeavor.

“How do we get our pitch down better,“ Kuhr said. “How do we have better follow-up materials? Usually, we have a buying team, not an individual buyer, so how do we find the rest of that buying team faster and get them convinced that this is a good idea? How do we get through legal and procurement faster? How efficient is our sales team at moving through each of the steps?”

More on Saas MetricsHow Do You Make Sure Your Company Isn’t Using Vanity Metrics?

 

LTV/CAC measures whether you are acquiring customers profitably?
Image: Shutterstock

LTV/CAC Ratio

Are You Acquiring New Customers Profitably?

If managing your cash flow efficiently is important, so is laying the foundation for future growth. Taking a longer view than the CAC payback period, the lifetime value to customer acquisition cost (LTV/CAC) ratio measures, on a unit basis, whether a business can generate more money from a new customer than they spend to acquire that customer, and by what factor.

“I think it has a lot of merit. It really covers everything, from retention to the gross margin profile of the business, to the efficiency of the sales and marketing spend,” Han said. “So, I think it’s a very encompassing all-in-one type metric.”

In a blog post for Volition Capital, Han writes that “generally, we like to see companies with a ratio of 5x plus. This means for every dollar of S&M spend, you can expect to make five dollars over the course of your average customer’s engagement with your company.”

Volition calculates LTV/CAC through the following equation:

LTV/CAC

Average Revenue per Account (ARPA) * Gross Margin % * Expected Lifetime ÷ (S&M spend / # of Customers Acquired)

We’ve covered the CAC side of the ratio earlier. So let’s look at the two components of the LTV side.

Expected Lifetime = 1 / % of gross churn. If you lose 20 percent of your customers per year, the figure becomes one over 20 percent, a five-year lifetime.

Value = ARPA multiplied by the gross margin percentage. If you earn $100 per year, per account, at an 80 percent gross margin, each customer generates $80 per year in value.

Putting the figures in this hypothetical together, the LTV is $400. If the CAC is $100, you have a 4:1 ratio.

“It really covers everything, from retention to the gross margin profile of the business, to the efficiency of the sales and marketing spend.”

The LTV/CAC ratio is generally not linear across time, Han told me. Some businesses have accelerating churn curves, with high retention over the first few months followed by a steep cliff. These tend to be one-time diagnostic or infrastructure tools: they fix a problem and then they are no longer needed.

Others have decelerating curves with a steep churn rate early in the product lifecycle that tapers off over time: the proverbial “long tail.” These tend to be companies with self-serve, high-velocity freemium models, such as Dropbox.

Though the LTV/CAC ratio is a good predictor of success, it has some inherent flaws, particularly for large enterprise companies with high retention rates.

“Just doing the math, if you say you churn 5 percent of your customers per year, you get a lifetime of 20 years,” Han said. “We all know there is no such thing as a 20-year lifetime for any customer of any company.”

Because structural churn is an unavoidable reality — business representatives relocate, companies go bankrupt, people turn to competing products — Volition caps lifetime value by industry: a cybersecurity company, for example, might be capped at eight years.

On the flip side, a high-growth company investing heavily in sales and marketing may be performing better than the ratio indicates because of a lag in payback time on advertising spending, and the onboarding time it takes new sales associates to ramp up to full productivity.

Thus, for the clearest assessment of a company’s financial health and growth prospects, it’s best to consider the LTV/CAC ratio alongside the CAC payback period.

“There’s a curve that exists between the number of customers you can get, and the amount you’re willing to pay for those customers,” said Ryan Pitylak, CMO at the Austin-based business resource platform ZenBusiness. “And, as a marketer, it’s your job to figure out, what is that inflection point: My allowable CAC?”

“Your revenue is what it is, and your churn is what it is,” he continued. “But if any of that improves over time, [the LTV/CAC ratio] gives you more flexibility on the marketing side to acquire even more customers. Whereas, if you look at these metrics in isolation, what you’re trying to do is improve each metric individually. And that can sometimes be a path to a dying business.”

 

CAC measures whether you have cash to burn.
Image: Shutterstock

Net Revenue Retention

Do You Keeping Paying Customers Around?

To an investor or growth analyst, Pitylak told me, recurring revenue is a much better barometer of success than transactional revenue. It creates an annuity in the future that a SaaS business can generally rely upon. But even recurring revenue needs to be hedged against customer attrition.

Enter net revenue retention: a metric that assesses a company’s ability to effectively offset churn by adding new customers and upgrading service options.

Here’s the formula Pitylak uses to calculate it:

Net revenue retention

((Recurring Revenue at the Beginning of the Period) + (Expansion Recurring Revenue During the Period) - (Downgraded Recurring Revenue During the Period) - (Canceled Recurring Revenue During the Period)) ÷ (Recurring Revenue at the Beginning of the Period)

Like the LTV/CAC ratio, net revenue retention rate is a global metric. For any given dollar that a cohort spends at the beginning of an evaluative cycle, it assesses how much they will spend at the end of that cycle.

“It’s a holistic view of the existing business,” Hogan said. “How well is that existing business expanding?”

In September, when the cloud-based data warehousing company Snowflake priced its IPO at $120 a share, its NRR was 158 percent, a remarkably high rate. “But Snowflake and Zoom are probably the two standout stories. From a software standpoint, in the past year, so it’s not surprising that their metrics are pretty phenomenal,” Hogan said.

More conceivably, Han said, an enterprise software company that shows “90-percent-plus growth retention is very strong,” and “for higher velocity, SMB-focused businesses, 80 percent plus is a very strong number.”

Churn is a key component of the equation, and should be assessed by cohort; that is, the group of customers you acquire during a particular billing cycle. For an enterprise company, “more than 5 percent churn” is troublesome, Kuhr told me. A high-transaction SMB or consumer software company, by comparison, can remain healthy with a churn rate of 10 to 15 percent.

But a company can sustain churn, particularly in lower-performing customer segments, if they can find new income streams. A common way for companies to fortify their NRR is through freemium and professional-grade pricing models that introduce higher fees as subscription services expand, new seats are added or usage demands increase.

“Email software is a really good example,” Hogan said. “It’s always priced on the volume of emails you send, right, so an email vendor will say, ‘Well, if you’re going to send 300 million emails this year, that’s going to be roughly 40 cents per 1,000 emails. But if you want to send an extra 100 million, obviously, it’s going to cost you more.”

Customer support software is another vertical where tiered pricing can be effective. “So Zendesk, you know, we’re going to help with your customer ticket,” Hogan told me. “As your business grows, you’re going to need more reps, so you’re going to pay us more money.”

Then there’s the story of Asana: “Of our 100 largest customers today,” states its August S-1 filing to the SEC, “virtually all came to Asana using a free trial of our paid levels or through an upgrade from our Basic level.”

Yes, Asana’s keeping customers. But it’s also finding ways to earn more from them, and thus propping up the expansion side of the equation. That’s, in large part, why the rapidly growing work management platform has seen 90 percent year-over-year revenue growth.

“What if one customer represents 90 percent of your revenue, and you keep that one customer while churning the rest?”

Again, definitions matter. Han said it’s important to draw a distinction between net revenue retention and gross revenue retention. The latter does not include revenue from upsells or price increases.

Logo retention, the percentage of customers you retain in a given period, is another way to assess churn. While net revenue retention tends to be the most illuminating of these metrics, all can be useful in guiding operational decisions, especially when viewed in comparison.

“What if one customer represents 90 percent of your revenue, and you keep that one customer while churning the rest? Then you would have a very low logo retention, but a very high gross retention,” he said.

Alternatively, you may be churning low-dollar customers at a high rate. “Does that mean we’re focusing our sales and marketing efforts in the wrong part of the market? Does it make sense to spend more resources on bigger customers, if that dynamic holds?” Han asked.

These are theoretical questions. What’s important is the way in which various components of net revenue retention can suggest where it’s best to allocate capital.

“If it’s high velocity, but slightly higher churn — but there’s a lot of good upsell —  that tells us that, as long as long as the market is big enough, we should continue acquiring customers, and spend a lot of energy in upselling these customers and keeping them,” Han said.

Then again, if it’s lower velocity, perhaps an enterprise firm with a higher price point, “maybe we need to build out a sales organization that’s really more accustomed to enterprise deals, higher price points and slightly longer sales cycle.”

Let unit economics be your guide.

“It really changes the DNA of what type of spending will take place post investment,” Han said.

More on Saas MetricsWhat Is Product Market Fit? How Do You Best Measure It?

Great Companies Need Great People. That's Where We Come In.

Recruit With Us