In recent years, Software as a Service (SaaS) startups have been fed on a steady diet of cheap money and notions like ‘Growth at all costs’ and ‘Winner takes all’.
In turn, this was reflected in the way SaaS performance is measured, the way companies undertook capital raisings, how they spend their cash and how they are perceived by stakeholders including investors.
But when the tap for cheap money was suddenly turned off, along came the belated realisation by the broader market that like all businesses, even SaaS startups need to become profitable one day.
So how should founders measure and manage the performance of their SaaS startup in this ‘new’ climate?
At William Buck, the three main groups of metrics that we look at are:
- Cash flow
- Growth, and
To get a true picture of how a SaaS startup is performing, each of these metrics need to be analysed separately and then considered as a whole.
A cliched but true saying is ‘cash is king’. This is especially the case for SaaS startups and scaleups that are looking to quickly ramp up customer acquisition before their cash runs out. The key challenge for founders is the lag between the initial investment to acquire customers and the subsequent cash flow generated.
Founders will need to know how aggressively they can expand operations without over doing it. Here, cash flow forecasts are required. The key metrics are:
- Cash flow runway: How long does the business have until it runs out of cash? This figure represents a deadline to improve the ratio of cash inflows to cash outflows, and to get the startup to the ‘next stage’ in terms of product development, customers and team capability.
- Gross cash burn rate: What are the business’s monthly expenses as a portion of the total cash reserves? This should be calculated each month and used to analyse the trend in cash flow outgoings.
- Net cash burn rate: What are the business’s net outgoings after including revenue cash inflows? Comparing the result from each month can show the volatility in the business’s cash flow and whether the cash flow trend is improving or deteriorating.
These metrics, when considered together, tell a story of the cash flow position.
SaaS startups are in a race against time to achieve a level of growth to make them attractive to investors and to fund the expansion needed without suffering excessive dilution. The key metrics to analyse growth are:
- Customers acquired: Simply the number of new customers who have started using the business’s products in a month.
- Customer churn rate: How many customers did the business lose in the month as a percentage of the users at the start of the month? A high churn rate indicates that customers are not satisfied with the offering once they used it. Founders will need to determine why.
- Annual recurring revenue (ARR): What is the recurring revenue being generated by its customer base? Once the king of all metrics for measuring SaaS companies, it still holds an importance place in any conversation about a startup.
- Expansion / Contraction of ARR: What level of ARR was generated in the month from existing customers changing their use of your products? As an extension of ARR, this metric can help founders determine the pricing of subscription tiers and understand the value proposition from customer perspectives.
Ultimately SaaS startups want to see low customer churn and meaningful increases in ARR in each month, subject to…
Ultimately, the purpose of analysing cash flow and growth is to help the business get to a stage where it is profitable. While the stereotypical idea of a tech startup is a company that prioritises growth over profitability, the current economic climate now places further emphasis on startups being able to demonstrate a credible path to profitability.
To understand the drivers impacting profitability, the key metrics to analyse are:
- Customer acquisition cost (CAC): How much does the business spend on average in acquiring each customer? Validates the effectiveness of the sales strategy and the return on investment the business generates from the sales staff and marketing budget.
- Lifetime customer value (LTV): What is the amount of revenue that is generated from the average customer before they churn? There are two ways a business can change this in itsfavour – by reducing the churn rate or by increasing the revenue per customer through new offerings or increasing prices. Clearly, founders need to be aware of the direct correlation between pricing and churn rate.
- LTV to CAC ratio: What is the expected total lifetime revenue generated from each customer compared to the cost of acquiring that customer? A higher ratio indicates higher profitability from each customer. A ratio of less than 3:1 shows a weak level of profit being generated from each customer.
- CAC payback period: As an alternative, the startup can look at how long it takes the average customer to generate the revenue needed to cover the cost of acquiring that customer. This is a function of revenue per customer and CAC and is the more effective metric to track for low churn, high CAC startups with high LTV to CAC ratios, but long payback periods.
Looking at these metrics holistically, if a SaaS startup can get the profitability per customer into a strong position and grow its customer numbers at a fast enough rate, then the business will be sustainable in its quest to scale.
The challenge with data
None of the above metrics can be calculated from a generic set of management accounts generated from bookkeeping software. From the outset, SaaS startups need to keep separate records that allow these metrics to be produced. Each business is different and there is no one size fits all approach. Each startup will need to consider the relevance of data and inputs that feed into the metrics.
Ultimately these metrics should be tailored to the specific product and customer mix of the business. It is important from the beginning that the inputs to these KPIs are clearly defined and agreed upon.
It is sometimes said that ‘You can’t manage what you can’t measure’ – and we think this is especially true for tough times like these where founders need to peddle a lot harder to raise capital. As long as they apply the time and effort needed to capture the right data, interpret the meaning using these metrics and adjust their business accordingly, Australian startups will have their best chance of sailing through these stormy seas and achieve their potential to the fullest.
If you would like more information on raising capital for your start-up and how we can help you manage your finances, please contact your William Buck advisor.