How to measure the profitability of your SaaS business

SaaS businesses are more complex to optimize and grow than others. This is because their business model requires important upfront investments, to develop the platform and acquire customers, while the recurring revenue stream materialises later and over a long period of time. This renders profitability harder to measure, and creates cash flow challenges during growth periods. As a result, SaaS businesses are faced with the increased pressure to find new indicators that can help track the real issues and give decision makers the control they need.

What most SaaS businesses need to think about as they reflect on the viability and profitability of their model, is threefold:

• What does it take to acquire new customers and how do they measure this cost;
• What does it take to keep a customer satisfied and engaged over time, and how to progressively deepen their use of the SaaS service, to the point of creating stickiness and long term loyalty;
• What is the right monetisation model to capture this value created for the customer and the user, and how to do so in manner that is both economically viable for the SaaS business and sustainable for the customer.

We will look at a number of metrics that attempt to answer these questions, starting with the cost of customer acquisition (CAC), the long-term customer value (LTV), the recurring revenue and customer retention.

The cost of customer acquisition (CAC)

The cost of customer acquisition, CAC, measures the cost of acquiring a new customer. It is defined as the sum of all sales & marketing expenses, divided by the number of new customers added in the same period. In the early days of a business this cost can rate high, so it is useful to combine this with a long-term view of its evolution, as the number of acquired customers grows steadily.

A directly related and important cash flow indicator is the time to recover the CAC (in months). It measures time to capital recovery and gives a useful indication of what cash flow needs will be. It is calculated by dividing the monthly CAC by the monthly recurring profit of these new customers (revenue times gross margin).

In general, a relatively high CAC, will mean that the customer acquisition process is complex, long, and the sales model relies too heavily on human touch, which is very expensive from a SaaS perspective.

These are some common root causes to explore, but they are not exhaustive:

• The level of complexity of the solution means customers need longer time to understand and evaluate it. They also require the assistance of a sales team;
• Internal adoption requires significant change to the way people work;
• Implementing the solution requires the purchase of additional elements, or integration and development work to create a complete solution;
• Not enough use is made of digital marketing to drive lead flow, and not enough low touch, or touchless conversion processes are in place;
• Too much involvement of the direct field sales force, instead of low cost inside sales.

The long-term value of the customer (LTV), and assessment of the unit economics

The second key metric, the long-term value of the customer or LTV, can be broken down in two measure- the lifetime of a customer and the value extracted during this time.

The lifetime is the time a customer is kept engaged and paying for the SaaS solution. It reflects how satisfied he or she is with the solution, and whether they believe they are paying the right price for it. When businesses lose customers in any given period, this is measured by the % churn, hence the mathematical formula for the lifetime becomes the inverse of the % churn rate. The unit of the lifetime is the same as the churn, so if churn is expressed in % lost customers per month or years, the lifetime will be respectively in number of months or years.

To calculate the LTV, we simply multiply the monthly or yearly recurring revenue per customer, by the gross margin (%), and by the customer lifetime as calculated above. Other methods use discounted cash flows when the recurring revenue changes significantly during the lifetime of the customer. They are more accurate in that case.

Finally, the LTV to CAC ratio gives us here a very important indicator which is by what multiple will the profit generated by each customer compare to the cost of its acquisition. This unit economic measure will determine at any time if the SaaS business is viable and whether its fundamentals are sound.

The following benchmarks are frequently used in the industry: They require that LTV: CAC should be higher than 3, and the time to recover CAC should be less than 12 months. You can read more about this topic in the great blog by David Skok- SaaS metrics 2.0.

 Measuring the recurrent revenue and its key drivers

The next important point of which SaaS managers need to have a good understanding of is the net new recurrent revenue and its drivers. What we are looking for here is a strong indicator that the SaaS business has found a repeatable and scalable growth process.

In any SaaS business, recurrent revenue will either be monthly or yearly. There is an essential positive impact on cash flow to have the recurrent revenue paid yearly and in advance, so many successful businesses focus their efforts on achieving this. They deploy a number of tactical offers to make this option more attractive to customers, such as small cash discounts or other promotional benefits. These are essential to alleviate the cash flow burden which is a real challenge in periods of high growth.

Net new recurrent revenue will have three drivers: the revenue addition from new customers, the revenue addition from growth of existing customers, and the loss of revenue from churned customers. These three drivers should be measured separately and their result summarised in a Net new recurrent revenue metric. By breaking out each component the management team is able to measure each driver and how it affects the business.

 The importance of measuring customer retention and churn

As a business grows, customer retention and churn take an increasing importance because of their impact on growth. It is also useful to differentiate between customer churn and revenue churn; this gives an indication of whether the larger revenue contributors are churning or not.

Some of the reasons for high churn can include:

• The product may not be creating enough value to the customer because of missing essential features or because it is not addressing a big enough pain;
• The product may not be ready technically with too many bugs and technical errors;
• It could be very difficult to achieve adoption by the largest group of users, due to the necessity to change behaviour or invest in additional products to create a total solution.
• The product does not have enough sticky features, allowing users to dip in and out. Such features could be for example the need to store proprietary data on the platform, or offer free stand-alone features that make the users loyal and accessing the platform daily.
• Pricing is high or buyers are unable to find the right plan for them;

These main churn metrics could be summarised in a retention dashboard and give an overall view of the situation and for any given financial period:

• Number of new customers;
• Number of churned customers;
• % customer churn;
• Net new customers – this is defined as Number of new customers – Number of churned customers;
• % recurrent revenue churn- this is defined as the lost revenue due to lost customers as a percentage of the total recurring revenue;
• % recurrent revenue expansion- this is defined as the expansion revenue from existing customers as a percentage of total recurring revenue;
• % net revenue churn- this is defined as % recurrent revenue churn- % recurrent revenue expansion.

You can also add to that a number of useful more general metrics that give an indication of the customer engagement with the solution:

• Average contract value and trend;
• Average contract length and trend;
• % of customers paying yearly and upfront their SaaS fee;
• Net promoter score.

In conclusion, since fast growth and market share acquisition are so essential in the SaaS competitive landscape, these key metrics help decision makers decide when the business is in the right shape to be grown. These metrics also help assess the viability and efficiency of various leads source, and various segments being targeted. It is therefore essential to calculate these metrics by lead source and by segment to be able to make that comparison. Only then will the management team be able to steer resources to the most profitable lead sources and customer segments.