In our previous post, we looked at nine fundamental financial metrics for technology startups. These metrics are critical to helping us evaluate the health and performance of any tech firm. Building upon that, in this post we will look at some of the important metrics specifically for software-as-a-service (SaaS) firms.
It’s important to realize that underlying these metrics is the importance of having a good accounting operation in which you can rely on the numbers being reported. Without a reliable system of qualified staff, policies and procedures, the quality of the financial data cannot be trusted, which makes successfully managing a company that much more difficult.
GAAP vs. SaaS Metrics
Financial statements are typically prepared according to what’s known as generally accepted accounting principles (GAAP). This allows for a level of comparability and consistency between competing companies. However, while GAAP financial statements do provide good insights into a company’s financial health, deeper insights can be gained by more industry-specific SaaS metrics.
In fact, these metrics are so important that Rob Reid, CEO of Sage Intacct, has indicated that he pays attention to GAAP financial statements only once per quarter, but that he focuses on SaaS metrics on a daily basis.
One issue with SaaS metrics is that because they lack an authoritative standard like GAAP, there can be dozens of different ways to measure the same thing, e.g., retention and renewal rates. The problem with this practice is that if every SaaS company comes up with its own way to measure its rate of customer retention, then there’s no way to directly compare one company’s performance to another. This ultimately leads to the metrics being worthless – and even deceptive.
To see just how widespread this is, check out one recent study comparing how 69 different public SaaS companies use dozens of different ways to calculate their retention and renewal rates. Such a lack of standards hardly increases one’s ability to compare the performance of competing companies; in fact, it hinders that ability. This is not useful.
Why do companies do this? Well, if it allows them to promote what they consider their preferred way to report performance, why wouldn’t they? And yet, there is a downside: These metrics are what the Securities and Exchange Commission (SEC) calls either Non-GAAP measures or ‘Other metrics’ (Key Performance Indicators). And the SEC has the power to regulate these measures to prevent improper use and to keep them from being inconsistent with GAAP numbers by requiring reconciliations between GAAP figures and Non-GAAP financial measures.
To address some of these issues, one of the accounting industry’s think tanks, The Center for Audit Quality, recently came out with a publication addressing Non-GAAP measures for audit committees (Non-GAAP Measures: A Roadmap for Audit Committees). This report highlights some of the challenges related to non-GAAP measures such as consistency, comparability and transparency.
A related concern is that executives and managers sometimes can get too caught up in analyzing their company’s numbers, a habit that long ago gave rise to the term ‘paralysis by analysis.’ However, the overriding lesson here is that it’s critical to look at the right numbers.
For executives at small but growing SaaS firms, it’s important to carefully decide which metrics are important to your company, and hopefully that list will overlap with the metrics that make the most sense to your investors and board of directors. Not only will this cause you to focus on the most important performance measures, you’ll also get your management team to focus on those metrics that are truly important to you in running the business.
The Five Essential Accounting Metrics for SaaS Companies
With all that in mind, we believe that the following five metrics are the most useful and universally used financial metrics for SaaS companies:
- Monthly Recurring Revenue (MRR): The most important metric to any subscription-based business is monthly recurring revenue. In fact, most SaaS firms are valued by the strength of their MRR. This measure includes only recurring revenue items (such as price paid for monthly seat licenses) and excludes occasional or one-time items such as consulting revenue. The trend over time is critical here. One sidenote: An even more telling metric is Committed Monthly Recurring Revenue (CMRR), which is found by taking MRR, subtracting the known cancellations, and adding to that the known new recurring revenue. This one is a little more complex to calculate, as it requires knowledge of upcoming subscription and cancellations, but make certain that your SaaS firm at least has a good handle on its MRR.
- ARPU (Average Revenue Per User or Unit): The ARPU is a SaaS company’s total subscription revenue divided by its number of active customers. This shows a measure of a customer’s average contribution to revenue. The goal for companies is to increase their ARPU through up-sells or cross-sells. As everyone knows, one of the best ways to increase revenue is through keeping happy customers happy – and ARPU is a good measure of that.
- Customer Acquisition Cost (CAC): This is a company’s total costs associated with customer acquisition divided by the firm’s total number of new customers within a specified time period. In this way, the CAC demonstrates how much it costs a company to attract each new customer, and it’s a good way to monitor the efficiency of the company’s marketing processes and sales team. This is important to gauge how much investment it is taking to grow the business.
- Gross Customer Churn Rate (or rate of attrition): This metric, commonly referred to as Gross Churn, is found by taking the number of customers that the company has lost over the previous quarter or year, and dividing that figure by the number of the company’s customers at the beginning of the period. This shows how well (or poorly) the company is able to hold onto its customers. The absolute value is important, but perhaps even more important is the trend, which should decline as the company matures. If Gross Churn suddenly spikes or plateaus at a high level, it’s critical to figure out why. Gross Churn can also be calculated on a dollar value basis. Along with MRR, the churn rate is one of the most telling metrics to any SaaS business. It is calculated from dividing total lost revenue (from lost customers and downgrades/contractions from continuing customers) by MRR at the beginning of the period. For many companies, tracking churn rates can be very telling and sometimes painful to see on paper. We all know it is always easier to retain customers than acquire a new one.
- Customer Lifetime Value (CLV): Keeping a customer for a long time is a clear way to increase value to a tech firm. Customer Lifetime Value is an estimate of the economic value of a customer over its lifetime. There are several ways to calculate this. Some of the more complex ways include the cost of servicing the customer, which will give you an indication on how profitable the customer is in the long run. However, the simple way is to divide the annual recurring revenue per customer (ARR) by the Gross churn rate. CLV is also a major consideration in a SaaS company valuation, as the longer a customer stays and pays, the more valuable the business will be.
Accurately tracking these SaaS metrics can go a long way to properly getting a handle on your company’s financial performance – and they will help you and others perform apples-to-apples financial comparisons.
Once your company get larger, you can dig deeper and segment your metrics by geography, sales channel, customer type, etc. Along the way, don’t forget the potential revenue stream that can be found in professional services. This can be an advantageous way to simultaneously generate cash and deepen relationships with your customers by helping them solve problems for their business.
Ultimately, SaaS is a subscription revenue business just like traditional newspaper or magazine subscriptions. Focus on continuing to deliver a valuable service and you’ll have customers for life.
Written by Gerry Preville and Prasanna Janaswamy