By way of introduction, I am a Chartered Accountant who joined an exciting, hyper growth, Software as a service (“SaaS) provider when the term “Cloud” was still in its infancy and was largely misunderstood by the non tech business community. As a solutions consultant, I recall when talking to prospects, a large portion of the meeting was spent educating and objection handling fears around the term “Cloud”.
Thankfully the cloud is widely accepted and understood as essentially a network of computer servers that allows users to access their data through the internet. My employer, SAP Concur uses cloud computing to store and process information so rather than our customers needing to install software on a single machine or hard drive, they can access it through their web browser or mobile application.
Whilst I believe the cloud is now largely understood by the broader business community, I suspect the understanding on how to value and benchmark SaaS Companies is relatively unknown.
This is quite typical in the tech start up sector where valuations or share prices may be grossly over or under inflated. It’s not uncommon to see volatility of listed company share prices as investors struggle to value these companies who commonly report year on year net losses whilst revenue and customer growth exceed expectations. This is often due to the fact these SaaS companies have a truck load of venture capital funds at their disposal and invest these funds for growth (people, product and marketing).
As a chartered accountant I thought I had a solid grasp on financial metrics and whilst the traditional metrics such as revenue, cash flow, profitability, liquidity still hold true, the introduction of the SaaS business model has introduced some new metrics that I had not heard of 10 years ago.
Below I will explain six metrics that should be considered when assessing the performance of a SaaS company:
Customer Acquisition Cost (CAC) – are the costs incurred to secure a new customer. These costs include upfront investment in sales and marketing.
Average Revenue Per Customer (ARPC) – this is calculated by dividing Monthly or Annual Recurring Revenue (A or MRR) by customer numbers at the end of period. To grow revenue, SAP Concur can either add more customers or increase Average revenue per Customer (ARPC). By adding new products and services, ARPC can be increased as more value is provided to our customers.
CAC Months – represent the number of months of ARPC required to recover the cost of acquiring each new customer.
Churn – Simply this is the % rate which customers cancel their recurring revenue subscriptions. Perhaps a better measurement of this metric is Monthly Recurring Revenue (“MRR”) Churn, this measures churn through revenue rather than the number of customers. MRR churn is the amount of MRR attached to customers that leave the company in the previous 12 months.
Lifetime value (LTV) – is a key measure of the value a customer represents to a SaaS company over the customers lifetime. LTV is calculated by dividing ARPC over the monthly churn rate to get the total revenue expected from a customer, then multiplied by the gross margin percentage to get total gross margin expected per customer.
There are multiple ways to improve LTV, such as enhancing products and services to existing subscribers to increase ARPC, improving efficiencies in costs, and investing in retaining customers. LTV of a customer can indicate potential future margins, whether the SaaS company is acquiring the right customers, and provides a strong signal to investors as to what they should expect as the company scales.
LTV/CAC – The LTV of the customer divided by the cost of acquisition per customer. The metric gives the gross margin of a customer’s lifetime as a multiple of the cost of acquisition. A LTV/CAC ratio of 1 would mean margins over the lifetime just cover the cost to acquire the customer.
Just like technology, the metrics and methods of valuing companies in the digital age are evolving, so keep these above indicators in mind when investing your hard-earn’t cash in that next SaaS Unicorn! Recurring Revenue is powerful just like compound interest.
This article was originally published on Linkedin.