Sizing Up a SaaS Company, Part I
There are numerous unit economic and financial measures investors apply to Software-as-a-Service (SaaS) businesses. This article has two purposes:
- Provide an informative and fairly comprehensive reference to the more common unit economic measures in this Part I of II, then link unit economic and financial measures in the next installment.
- Caution that companies exhibiting impressive unit metrics at a moment in time may not necessarily be strategically-sound companies building long term value and a great product with sustainable competitive advantage. In fact, a Sapphire Ventures analysis of post-IPO public SaaS companies showed only middling correlation between Sales Efficiency and Return on Equity, suggesting that companies with efficient operations shown by favorable unit economic measures won’t necessarily return more than the less efficient ones. I would infer that the market devalues those companies without an evident strategy to exceed their peers’ performance over time. 
If we consider representing your subscription-revenue company for a M&A transaction or raising Expansion Stage capital to grow, the information in this article will set a starting point for our discussions. M&A activity in this category is expected to increase this year as tech companies more aggressively pursue high quality SaaS assets to boost growth, partly enabled by a lower corporate tax rate and tax holiday on repatriating foreign assets at a lower tax rate than before.
“License Software is dead.”
SaaS is simply a subscriber model of software delivery, versus the increasingly-dated manner of selling software for ownership transfer, under a license that restricts its duplication for resale or use by more people than contracted by the buyer (“piracy”). Instead of the client company hosting the software on its own data center, implementing and maintaining it as in the past, the service provider hosts it and provides access to the client.
The software’s producer is responsible for ensuring that the latest anti-virus and other updates are deployed, not the purchaser. The purchaser merely pays an annual, quarterly or monthly bill, which includes the secure hosting of their proprietary business data. The producer will periodically issue improvements, preserving the customer’s data and customizations.
It is by now obvious that the Software-as-a-Service (SaaS) business model has overtaken the license model.
Quoting a recent Credit Suisse investment report, “License Software is DEAD. Long Live Subscription and Cloud! We believe that enterprises today are no longer debating whether they should move to the cloud (a stark contrast from prior years).” 
Stock Market Valuation of Subscriber Software Companies vs. Non-Subscriber
Credit Suisse tracks publicly-traded application software companies and assigns them to a Subscriber or Non-Subscriber universe for financial performance comparison. There are about twice as many in the Subscribers group. I have excerpted a few financial measures they’ve published to illustrate the profound difference in customer adoption and stock performance.2
|2017E Year over Year Revenue Growth, Median||Enterprise Value/2017E * Revenue Multiple, Median||Enterprise Value/2018E Revenue Multiple, Median||Enterprise Value/2017E Operating Cash Flow Multiple, Median||Enterprise Value/2018E Operating Cash Flow Multiple, Median|
|Subscriber Universe||26.8%||7.0 X||5.7 X||31.2 X||29.7 X|
|Non-Subscriber Universe||3.8%||4.8 X||4.5 X||15.2 X||14.4 X|
* 2017E refers to “estimate,” as their investor report was written at the beginning of January, before final 2017 numbers were available
Credit Suisse also expects to see at least 15-20% share price growth overall among publicly-traded Application Software companies in 2018, with Subscription Software averaging 22% year-over-year growth. Among closely-held companies, software is by far the largest recipient of venture capital, eclipsing all other investment categories, and while not broken out separately, it’s a safe bet that virtually all is SaaS.
What is the best way to Analyze and Compare SaaS Companies?
All subscriber businesses – from software, to phone contracts, to magazines, to insurance companies – depend fundamentally upon two performance measures, with a third, reflecting the combination of the first two. Anyone experienced in marketing subscriber businesses (as I am) is likely to have used these performance measures. Underneath these three fundamentals, there are numerous, detailed sub-measures, but understanding these three first puts those into perspective.
Three Fundamental Unit Economic Measures
- Acquisition – The company must acquire customers, then continue to acquire customers to replace the ones who stop buying from them. How do they do this, and how much does it cost per customer? Acquisition is a tremendous source of marketing expense. In the early 2000’s, while working with a client in the mobile phone industry, the average customer acquisition cost was somewhere around $370 per customer signed to a new mobile phone contract. Now, pretty much everyone has a mobile phone plan. At the time, many people still did not, and all the carriers were competing fiercely to sign up new customers before someone else did. Remember the free installation disks AOL sent again and again, for new customer acquisition? It was expensive, but sure did build their user base fast.
- Retention – This measure is simply holding on to customers. Every year your company doesn’t have to pay to acquire a customer is more profitable, once the initial acquisition cost is amortized. It is generally expressed as a %, and often referred to in the negative as “churn.” Now that the mobile phone market has matured, I suspect that the marketing budgets of the mobile carriers has shifted from Acquisition priority to Retention priority to prevent account churn.
- Lifetime Value (LTV) – LTV measures the lifetime expenditure of a customer on the subscriber product, minus the cost to acquire and serve them. It is a function of the acquisition cost, any marketing expense required to retain them, the amount they spend over the course of the relationship, and for how long. LTV is built by upgrading customers to a more expensive product, and/or cross-selling them additional products and services, and by delivering a great product at a fair value and keeping people satisfied to minimize churn. LTV is more easily applied to life insurance companies and mobile carriers than SaaS companies, because the true lifetime of a customer relationship is more predictable. In SaaS companies, a proxy for average customer lifetime is 1 divided by the annual or monthly churn rate, so for instance 3% monthly churn results in a customer lifetime of 33 months. In reality, that churn rate without new customer acquisition would wipe out the business in short order.
Multiple Unit Economics Sub-Measures
A seasoned, early stage SaaS-experienced investor in private companies, Mamoon Hamid, cited in a Full Ratchet Podcast interview the following set of metrics essential for a SaaS company, whether early-stage or mature. 
The relationship to the above Acquisition, Retention and Lifetime Value measures should be apparent.
|Measure||Comment||What He Looks For|
|MRR: Monthly Recurring Revenue aggregating all sources||This is a gross, top-line number inclusive of finer measures listed below.
Following GAAP accounting rules for recognizing subscription revenue is critical for even start-up’s to ensure that investors consider them credible.
|$1 Million ARR or greater within 12 months of launch
New MRR is increasing quarter-over-quarter
Seed Stage company should be adding 5-10k of MRR per month
Series A should be adding 10-20k per month
|Net New MRR: There are four sub-components used to calculate Net New MRR:
1. New MRR: Revenue from newly acquired customers
2. + Expansion MRR: More $ generated from existing businesses, i.e. from trading them up to more expensive packages
3. (-) Canceled MRR: Revenue lost as a result of business cancellations
4. 4. (-) Contraction MRR: Revenue lost as a result of businesses reducing the value of their account, i.e. trading down to less expensive services or cancelling a portion of service
|This measure is very diagnostically valuable, as it demonstrates the ability of the company to build acquisition, retain customers and trade them up, or conversely, it reveals quickly where trouble lies.
Mamoon says that Net New MRR should always be increasing If not month-to-month, then definitely on a quarter-to-quarter basis.
|Doesn’t want to see Net New MRR is flat or down quarter-over-quarter, and ideally, not month-to-month either.
It’s the “engine of SaaS,” revealing the company’s ability to close new deals, upsell accounts and minimize churn.
|ARR: Annual Recurring Revenue.||MRR is aggregated to calculate annual recurring revenue.||If a funded startup company takes 18 months or more to get to $1M ARR, it could indicate that Quarterly Net New MRR is flat or down and/or the Quick Ratio is 2 or less.|
|Gross MRR Churn %: Total $ of churn in the current period, divided by the MRR from the previous period, expressed as a %.||A constant monthly churn rate creates exponential loss in the customer base.
Therefore, new customer acquisition Revenue and Expansion Revenue must “refill the leaky bucket.”
This measure is heavily influenced by Average Contract Value. The larger the contracts and customers, the less churn likely to occur.
|Prefers Gross MRR Churn less than 3%|
|Net MRR Churn: Calculate this by dividing the Net New MRR by the previous period’s MRR (whether monthly or annually). Or, (Churned MRR-Expansion MRR) / Previous Month’s MRR||When Expansion Revenue from existing customers exceeds the lost revenue from churn, the number will turn to a negative (desirable).||Wants to see a negative number.|
|Average Contract Size: $ Revenue made per customer per month, averaged over all contracts||Obviously, the larger the better.|
|Average Contract Length: # of months the average customer is retained, i.e. assuming a mix of contract lengths, average duration||This is not a measure of churn, it’s based on contractual terms.||For example, a user base comprising 80% one year contracts and 20% six month contracts is far preferable to the reverse.|
|Average Contract Value (ACV): Average revenue per customer, per month x the contract length|
|Price per Seat: $ Revenue per user per month|
|Sales Efficiency: It’s best to look at this two ways: ARR from New Business & ARR from Existing Business.
New Business Acquisition Costs/New Business Attained During the Period. Do the same for existing business and compare the two as a management tool.
|Calculation results in a cents on the dollar presentation. For every $X.XX in sales and marketing spend, you will generate $1.00 of new ARR. it is a very straight-forward and intuitive way to look at your sales and marketing spend and whether you should invest more in sales and marketing or wait until you have better traction.|
|LTV: Lifetime Value attempts to measure the total value of a customer over their total duration as a customer
The LTV calculation can be quite complex when done thoroughly and thoughtfully (that’s not always the case). The detail is beyond the scope of this article, but here is an excellent source. 
|See “3.Lifetime Value” discussion above the chart.
This measure is best applied to more mature companies which have generated enough data to be reliable. If at all, use cautiously for Early Stage companies, until real data is available in the Expansion Stage.
|Doesn’t like this metric since it requires a forecast built on assumptions not based on available data, such as future contract length, churn, expansion revenue and its timing, etc.|
|CAC: Customer acquisition cost. The amount it costs to convert a new customer. Sum of all sales and marketing expenses (including personnel) divided by number of new customers added||See “1. Acquisition” discussion above the chart.||Mamoon treats this measure cautiously since it assumes unknowns.|
|Quick Ratio: Added MRR / Lost MRR
Concept adopts the same name as a financial liquidity ratio: Cash + Marketable securities + Accounts Receivable/ Current Liabilities.
|New MRR and any expansion MRR (more $ per customer) divided by Canceled MRR (lost customers) and Contraction MRR (reduced $ per customer). Naturally, this will be more relevant in year two+ and beyond when expansion and contraction revenue can be calculated.||Quick Ratio of 4x or greater
Doesn’t want to see Quick Ratio less than 2 (which indicates that new sales aren’t converting fast enough and churn is too high).
This critical metric quickly reveals if the company is having a significant churn issue.
There are many additional measures used by SaaS companies and their investors, but this covers most. The calculation specifics are detailed and sometimes may be complex to apply. A more advanced discussion of that is beyond the scope of this article.
To manage length, this article will be in two parts, posted sequentially. The next installment will discuss:
- The Growth Rate vs. Profitability Trade Off for both private and public companies
- Shortcuts sophisticated SaaS investors use to quickly sort through private companies and decide which ones are worthy of deeper inspection
- Shifting preferences among investors in publicly traded SaaS companies (which should be interpreted as relevant to private ones, too)
McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, LLC, an investment bank headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC. He can be contacted at (415) 294-0002 or mdb @ mid-marketsecurities.com.
Disclaimer: This article provides general information, and is not intended to constitute, and should not be construed as, legal, tax, accounting or business advice, nor does it constitute an offer to sell or to purchase securities. Rather, it is summary compilation of timely issues confronting your industry and as such does not purport to be a full recitation of the matters presented. Prior to acting upon any information set forth in this article or related to this article, you should consult independent counsel and/or more detail contained in the Source Information. The article reflects the opinion of the writer, and does not necessarily reflect the opinions of Mid-Market Securities, LLC, or its affiliates. IRS Circular 230 Disclosure: In order to comply with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax discussion contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
 “Great Saas Metrics Aren’t Enough’” Max Wessel, Sapphire Venture Partners, CB Insights Guest Post, 12/1/2015
 Credit Suisse 2018 Application Software Outlook, January 8, 2017
 The Full Ratchet interview with investor Mamoon Hamid of The Social+Capital Partnership, http://fullratchet.net/ep36-saas-startup-investing-mamoon-hamid/ and http://fullratchet.net/saas-metrics-to-measure-manage/
 A great discussion of calculations is here. http://www.forentrepreneurs.com/saas-metrics-2-definitions-2/