Salesforce led the way in changing how software is delivered and purchased. Rather than selling software as a one-time purchase, with a hefty upfront software license fee, Salesforce sold their customer relationship management (CRM) tools on a subscription basis, software-as-a-service (SaaS).
SaaS remains a desirable model for businesses and investors, over two decades since Salesforce's founding. It offers a stable and predictable source of income, enabling long-term growth planning. Apart from headcount costs, SaaS companies generally have low fixed and variable costs. Investors particularly favor companies that can create and deliver a product in a cost-efficient manner.
Some of the key metrics B2B SaaS finance leaders should care about are:
Annual Recurring Revenue (ARR). ARR is a key metric for measuring the growth and stability of the business. It shows how much revenue is generated from recurring subscriptions every year. For example, if a customer signs a 4-year, $20 million contract, the ARR = $5 million. ARR can be a valuable tool for forecasting future revenue and cash flow. When it comes down to it, SaaS company valuations are tied to the health of the business’s recurring revenue.
Average Revenue Per User (ARPU). ARPU shows how much revenue is generated from each user or account. This can be measured across different time periods depending on the SaaS company’s business model. ARPU is important to understand whether the company is targeting the right customers and generating enough revenue from each user. As a company grows, ARPU should increase consistently.
Customer retention is important to investors and buyers because when it comes down to it, happy customers rarely switch from software they’re happy with. Generally, ripping and replacing software, especially when it comes to enterprise B2B software, is difficult and and time-consuming. Thus, losing customers can be an indicator of low product or customer satisfaction, given the difficulties involved in switching software. High churn puts pressure on gross margins, increases CAC payback periods, and lowers customer lifetime value. When it comes to understanding churn, it’s important to look at Gross Revenue Retention and Net Revenue Retention.
- Gross Revenue Retention (GRR) = (Total Revenue – Churn) / Total Revenue. GRR focuses on the existing customer base. It’s measured by the annual gross dollar retention after churn, exclusive of upsells and expansion. It’s an indicator of the health and sustainability of the business. When GRR is high, it means that its customers are happy with the service they are receiving and are continuing to use it, which helps to ensure the business’s long-term success.
- Net Revenue Retention (NRR) = (ARR at Start of Period + Expansion ARR + Upsell ARR - Churn ARR - Downsell ARR) / ARR at Start of Period. NRR focuses on the existing customer base. It’s a good signal of the health of the customer base and the recurring revenue. It measures the revenue from existing customers after churn and inclusive of upsells and expansion. NRR can tell you about the growth potential of a business. Some of the top IPOs in the last few years (Twilio, Slack, Snowflake, PagerDuty) had well over 120% in NRR. A study by Gainsight showed that a 1% increase in NRR could translate to $700M in enterprise value.
Customer Acquisition Cost (CAC). CAC is the cost of acquiring new customers, calculated by looking at the months of subscription gross margin to recover the fully-loaded cost of acquiring a customer. To calculate CAC, you add up the costs associated with acquiring new customers (the amount spent on marketing and sales) and then divide that amount by the number of customers you acquired. It can be a useful metric for evaluating the efficiency and effectiveness of the company’s marketing and sales efforts.
Customer Lifetime Value (LTV). LTV is the total worth of a customer to the business over the whole period of their relationship. LTV is typically calculated as (Revenue Per Customer * Gross Margin) / Revenue Churn Rate. It’s an important metric as it costs less to keep existing customers than it does to acquire new ones, so increasing the value of your existing customers is a great way to drive growth. A good rule of thumb is that the ratio of lifetime value to customer acquisition cost should be at least 3:1. The higher the LTV and the lower the CAC, the faster the businesses will grow.
SaaS Magic Number. The SaaS Magic Number measures the efficiency of a company’s sales and marketing efforts. It’s calculated as ((Current Quarter’s Revenue – Previous Quarter’s Revenue) * 4) / Previous Quarter’s Sales and Marketing Expenses. It asks how much ARR is created for every dollar of sales and marketing spend. According to Scale Venture Partners, a Magic Number of 0.7x is a healthy efficiency baseline for most SaaS businesses. However, just because you have a Magic Number of 1 doesn’t mean your company is healthy — the Magic Number doesn’t consider gross margin.
SaaS Gross Margin. Traditionally Gross Margin is Revenue - the Cost of Goods Sold (COGS). However, with SaaS there is some nuance when it comes to COGS. The costs of developing and delivering a SaaS product are often heavily concentrated in the early stages, such as in research and development. Many SaaS companies operate with deep losses in their early years, hoping to overcome these losses in the future via continued expansion and sales of the product. The digital nature of the product also means that it is important to separate fixed costs from the costs of actually selling the product. So, depending on the business, COGS for SaaS may include:
- Customer success, support, and account management costs
- Costs for employees directly involved in production and delivery (infrastructure, DevOps, internal engineering)
- Costs of third-party software or data that is included in your delivered product
- Data communication expenses
- Hosting expenses
- Professional services and training personnel costs
- Website development and support costs.
This is a measure that many investors look at when making funding decisions. The SaaS Gross Margin can help illustrate the organization’s sustainability potential. If the SaaS Gross Margin is low or even negative, the business will continue to face financial challenges, even in the best-case scenario. According to Openview Partners, a good SaaS business model should have a gross margin of about 80-90%.
Rule of 40. The Rule of 40 is a simple metric often used by investors to measure the growth and profitability of a public or mature SaaS business (generally $50 million or more in revenue; no earlier than $1 million in revenue and with repeatable go-to-market). It states that the combined percentage of the company’s revenue growth rate and profit margin should be at least 40% to be considered a healthy SaaS business well-positioned for the future. This is key because SaaS often has margins of 70-90%. For example, if a company has a growth rate (year-over-year changes in ARR) of 20% and a profit margin of 20%, the Rule of 40 would be satisfied because 20 + 20 = 40.
These metrics are essential to SaaS businesses because they provide critical insights into company performance and help finance leaders make informed decisions about the direction of the business. By monitoring these metrics, SaaS finance leaders can identify areas of opportunity to improve and grow the business.