In my previous post, I introduced Bessemer’s first Law and now I am moving on to introduce the second law that focuses on the financial side of a SaaS vendor. The ISVs that have software products running it with a more traditional licensing model will have to adjust their operations to the new financial realities of the SaaS world and learn to monitor the right metrics in respect to SaaS business model.
The Bessemer’s second Law #2 will address the most common SaaS metrics that are used based on the experiences that they have had with hundreds of SaaS companies and also having invested in SaaS companies. The second law calls these SaaS metrics for 6C’s, but I want to emphasize that there are a bunch of others that can also be added to drive the overall financial condition of the company.
Law #2: Get Instrument Rated, and trust the 6C’s of Cloud Finance
Bessemer’s Cloud Laws focus on six financial metrics and they are as follows:
- CMRR – Committed Monthly Recurring Revenue
- Cash Flow
- CPipe – CMRR pipeline
- CAC Ratio – Customer Acquisition Cost Ratio
- CLTV – Customer LifeTime Value
Let’s look at this metrics in more detail, starting with CMRR that is the driver of the business revenue.
CMRR – Committed Monthly Recurring Revenue
The way Bessemer defines the difference between MRR (Monthly Recurring Revenue) and CMRR (Committed Monthly Recurring Revenue) is that in the latter, you would also include signed contracts but not yet moved to productions on top of the ones that are already in production. If you think about it, that really makes more sense and gives a fuller picture of the financial situation for the company.
The way the recurring revenue is calculated is by using the Rule of 78’s which is very well known concept from the Telecom world as described well in the BusinessToolsBlog.com blog entry. It is simple math and the formula is as follows:
Full Year Revenue = (Current Run rate) + (Average Monthly Net Installs) * 78
The rule itself is simple, but I have to admit that it is not that obvious with the first look. What it means and the way you have to think about this is as follows assuming that you get a new client each month that pays you $1 in recurring revenue:
- When you get $1 of recurring revenue on January 1st, you will receive $1 revenue for every month of this contract
- When you get $1 of recurring revenue on February 1st, you will receive revenue for 11 months of that year
I am sure you get my point here. When you calculate the payments months together, you will have following type of scenario:
It is easy for you to see that the more you get net revenue to flow in (new contracts) earlier the year, the better you will be off. This is not the case with traditional software license deals. You aim to get a good chunk of cash any time of the year, and things even out itself with time. I still remember vividly the end-of-quarter discussions we had with prospects and the explanations I had to do with my board of directors if something slipped to the next quarter.
From a sales incentive perspective, it did not make a huge difference to me one way or the other, but in the recurring revenue model, the difference of getting a deal in January or June is huge, it is the months of recurring revenue that you will be missing. You can play with the numbers using a spreadsheet, but I am sure you get the point very quickly.
Cash is king as they say and cash is crucial for any SaaS vendor as clients will pay month-by-month (or other agreed terms) and this will not be enough to support the ISV at least in the beginning stages. Some SaaS executives can increase the incoming cash flow by giving discounts for pre-payments and other things that is available for them. This again, can be simulated by a spreadsheet and we use Invest for Excel to do this job.
CPipe – CMRR pipeline
CMRR and Cash Flow are critical to any SaaS company, but so is the pipeline visibility that a company has of upcoming prospective deals. We believe that traditional software sales model has changed for good and organizations need to be watching the cost of sales as the profit margin can be eaten up very quickly by inside sales teams that do not generate enough leads/prospects to the pipeline. In the past, we could always convince ourselves to keep sales people onboard even if they did not immediately generate results, but in a SaaS setting , this scenario is not that easy. Every month without enough in the pipeline will quickly impact your overall profitability as you will know that every month you are losing money due to the recurring revenue impact. A monthly payment in June is not the same thing as starting to get payments in January! What you have to expect from the pipeline review is full transparency and the CPipe should be a good leading indicator for upcoming CMRR, Cash flow can CAC.
Churn can kill a SaaS company if not the executives are paying attention to this metric. I have always said that a good sales person can sell anything, but if the product does not meet the standards and requirements of the clients/customer market segment, it does not matter how good the sales man is. Churn also has an immediate impact on the SaaS vendor as a lost client is a client gone forever. With the traditional software license model, clients might still keep the maintenance running even if they do not use the software as the rule of thumb in the enterprise has been that if you drop annual maintenance, you will have to re-purchase the software package. Based on research and data on good SaaS companies, renewal rate of more than 90% is something that a SaaS company should be able to live with and you really can’t avoid situations such as bankruptcies and acquisitions that create a situation where the client discontinues the use of the solution.
CAC – Customer Acquisition Cost Ratio
Sales will cost and having sales people that do not perform, costs a lot. Having sales people with wrong incentives can be fatal. The question that a SaaS company will have is how much to invest in sales and marketing and how quickly the company should be able to recoup the investment. The “non-official” standard in the market is that the CAC cost should be recouped within a year whereby the following year is to cover the cost of administration, product development etc. If you lose the client in churn during the first year, you will have a negative lifetime value for the client (unless the pricing doesn’t cover multiple years, which is typically hardly the case).
So, how do you calculate the CAC Ratio? It can be calculated by looking at quarterly GAAP P&L and by dividing NEW Annualized Net Gross Margin added during the quarter (gross new CMRR x your average Gross Margin % x 4 quarters) by the sales and marketing costs of the previous quarter excluding any account management costs attributed to the “farming” of the accounts. I will get to this topic of farming vs. new accounts in later blog entries as this has to do with the sales commissions and how sales people are compensated. There is a big difference how sales people behave based on what they are compensated for and what not.
CLTV – Customer LifeTime Value
Based on the Bessemer law, the CLTV is the Net Present Value of the recurring profit streams of a given customer less the acquisition cost. Based on this, a positive CLTV also means that it is profitable business for the SaaS vendor. The Bessemer write-up gives a good example of how this works:
- Let’s assume the customer generates $1 of annual recurring revenue with a CAC ratio of 1.0 (sales and marketing costs are recouped in one year)
- Let’s assume that the company has a 70% Gross Margin and 10% in R&D and 10% in G&A costs (General and Administration).
The result of this calculation is as follows:
- The $1 of revenue will generate $0.7 of gross margin and $0.5 of profit each year ($0.7 less $0.1 in R&D and $0.1 in G&A costs).
- Over 5 years, the customer will generate $2.5 of profit (5 years x $0.5/year)
- A CAC ratio of 1.0 means a $0.7 upfront acquisition costs, making the CLTV equal $1.8 ($2.5-$0.7)
- The $1.8 is equivalent to $0.36 of annualized profit ($1.8/5) or 35% profit margin.
- The calculation can be redefined to include some allocation of sales and marketing costs (as part of maintaining current clients) for example with 15% and that would then reduce the CLTV to $1.23 or 25% annualized profit margin
The calculation above gives an overall view how to deal with lifetime values in respect to clients and it is obvious that young companies might not have as good estimation of this in respect to churn as well as estimation of real lifetime customer values. Based on Bessemer, it will take 3-4 years for SMB customer to achieve these types of calculations and 5-7 years for enterprise customers.
Summary and relating this to Business Model Canvas
The SaaS business model is different and the way one needs to think about it different. Many mature ISVs might do the mistake of running its business “as is”, trying to run a SaaS business the way they have run in the past with enterprise software. The result of this is eventually failure as you just can’t think the same way in SaaS business as you do in enterprise sales.
Some mature ISVs might never achieve full understanding what it takes to make a transition, even if it was a slow one. It will take a specific DNA to be implanted to the company, a DNA that will treat the business in a different way, with different attitude and with different approach. I think it is specifically hard for sales people that have been accustomed to large pay-checks and now they have to deal with uncertainty of future years and how the client will or will not renew the contract. I will discuss about this in a future blog entry.
Try on a spreadsheet and you will see how it works. Also, once you look at the model you will see that the earlier you sign a client, the better you will be off in respect to the Rule of 78. It is hard to comprehend it without really playing around with the numbers and I did it with Invest for Excel that also gives me an ideal model to simulate cash-flows, different payment terms and the impact of them in working capital and many other similar things. Churn is a key metric as well and the good SaaS companies will have above 90% annual renewals of existing clients.
Where does this fit in the Business Model Canvas and how does the financial consideration impact the overall business for a SaaS vendor?
It is the Revenue Streams (RS) and Cost Structure (CS) elements from a financial perspective, but it has a direct impact on Customer Segment (CS), Customer Relationship (CR), Channels (C) as well as Value Proposition (VP). Let me explain why the financial models might have an impact on all of the Business Model Canvas building blocks.
Let’s start with the Value Proposition (VP). The first year when the SaaS company gets the client hooked in the solution, there is not much the customer can do during the year. It is at the renewal time when the SaaS vendor will know whether the solution has met the requirements and satisfied the needs. If not, the customer will turn into the “churn” category. The Value Proposition (VP) is also directly linked to the Customer Segment (CS), whereby it is assumed that the SaaS vendor understands what market they are serving and what the requirements are in that market. If not, it is easy to see the customer walk away from the solution. Being a software solution vendor servicing “everybody” is not going to work in today’s world without a large sum of money. Trying to be everything to everybody is hardly ever a good strategy. That is regardless whether you are a SaaS vendor or traditional enterprise software vendor.
The Cost Structure (CS) is going to be mostly impacted of the investment that the company is doing in both sales and marketing, but also in other things such as R&D and G&A. We stated some economic ratios that the SaaS vendor should monitor, and these numbers are based on experience and best practices from tens if not hundreds of other SaaS companies. The Revenue Streams (RS) is tied to the Value Proposition (VP) and to the market overall, even if there are some that claim that one should not copy competitors pricing or models. That might be the scenario in the perfect world, but having been in the frontline for 20+ years, it might be difficult to execute in practice.
We have not touched financial numbers from a channel perspective, but one of the Bessemer’s laws is to ignore the traditional channel. I will discuss about the channel, the importance of providing a solution that others can build on in later blog entries.
Needless to say, the financial numbers, the Bessemer 6C’s are all tied into each and every Business Model Canvas building block, so the SaaS vendor has to identify a good and balanced business model that it can live with, both as a start-up as also an established vendor.