Venture Cheatsheet: SaaS Metrics 101
A field guide to SaaS metrics and benchmarks.
In one of my earlier posts about Integrated Payments, I mentioned a few metrics — such as ARPU, churn, net dollar retention — that are often used to describe and compare SaaS software companies. In my experience, these SaaS metrics are a truly powerful tool for the software investor.
The beauty of SaaS metrics is that they are a data-driven approach. They can cut through the vanity metrics, the hype, or any innate biases or misunderstanding about a software business to deliver unbiased insight into the quality of a SaaS company’s growth. Let me repeat that: quality of growth, is what really matters.
A company growing 100% per year could still be losing half of their customers every 12 months. Conversely, a company growing 50% per year could be growing much faster if it spent more on sales and marketing. How do you tell whether either of these profiles makes any sense?
SaaS metrics.
In this post, I’ll discuss these metrics in more detail and identify some of the industry benchmarks you can use to compare/rank a software company to its peers.
- Churn and Gross Dollar Retention.
- Net Dollar Retention.
- LTV and CAC.
- LTV/CAC Ratio.
- Sales Efficiency (i.e., Magic Number).
- Efficiency Score (i.e., the Rule of 40).
First, some base principles
The great thing about SaaS companies — and what differentiates them from most businesses, or even traditional software businesses — is that revenue is driven from customer subscriptions. For B2C SaaS companies, such as Spotify, the customer is a consumer who pays a monthly subscription for ad-free music. For B2B SaaS companies, such as Olo, the customer is a restaurant that signs up for a multi-year contract, paid annually in advance, to establish and scale their online ordering and delivery presence.
Perpetual License (old way) vs. SaaS (new way)
If we were to compare SaaS software subscriptions to the traditional on-premise software model, the revenue profiles are distinctly different. The traditional on-premise software model, typically referred to as the Perpetual License model, relied on a large upfront sale (for the software license) and then very small recurring maintenance payments thereafter. As an example, I’ve compared below Tableau’s old Perpetual License pricing model to its current SaaS Subscription model.
Perpetual Licenses definitely generate the more immediate upfront bump in revenue and historically locked-in customers with the magnitude of this sunk cost. However, from the comparison above, you can see that the SaaS Subscription model generates more cumulative revenue in just 2 years when compared to its legacy counterpart.
More importantly, SaaS pricing creates a steady, recurring stream of revenue. Unlike the Perpetual License, which generates a large, one-time contribution to revenue, the SaaS subscription contributes to revenue repeatedly, each month. As a result, we often characterize a company’s recurring revenue potential with one of two KPIs:
- MRR, or monthly recurring revenue: the total amount of recurring revenue in a particular month.
- ARR, or annual recurring revenue: the annualized total of a company’s MRR, i.e., the MRR multiplied by 12.
Revenue (old way) vs. ARR (new way)
Someone once asked me, “What’s the big deal with ARR? Isn’t it just a new-fashioned way to say ‘revenue’?”
TL;DR Incorrect — ARR is an important metric because it describes the forward-looking annualized revenue potential for a company at any given point in time. Unlike the traditional revenue figure, which is often backward-looking on an LTM (or last twelve months) basis, ARR captures how much revenue a SaaS company would generate in the next twelve months from the customers it already has. For high-growth software companies in particular, ARR can grow significantly from one year to the next, with a disproportionately smaller impact on traditional revenue.
For example, in the following illustration, these two hypothetical software companies have the exact same ARR as of December 2022, but their LTM revenues are significantly different — Company A generated 20% more revenue in the last twelve months, and yet, both companies will start 2023 with the same run-rate revenue of $120M of ARR.
If you looked only at the traditional revenue metric, you might overvalue Company A. Notably, in the example above, Company B tripled its ARR in one year, whereas Company A grew half as fast. Conclusion: ARR is the more relevant revenue metric to assess, whereas traditional revenue figures have the potential to be misleading.
SaaS Metrics
1. Churn and Gross Dollar Retention
If we think about our own, personal experiences with software subscriptions, e.g., Netflix, Tesla internet connectivity, Amazon Prime, Spotify, iCloud (it’s endless really)….so long as we continue to value the service we receive, we’ll continue to renew.
However, these are monthly contracts. So, if customers find a better solution, find a cheaper solution, or change their mind for any other number of reasons, then they will cancel. Churn represents these customers who cancel their subscriptions in a particular period — Churn is expressed as a percentage and is more relevant when expressed in revenue dollars, or ARR.
Gross retention is more typically reported by public companies. Mathematically, Gross Dollar Retention is the complementary percentage to the Churn, i.e., 100% minus churn.
Notably, some companies will quote their “logo churn,” or the number of customers lost, expressed as a percentage of total customers. This can be a good proxy, but the loss of one particularly large customer could be the revenue equivalent of ten smaller customers. So, logo churn can be misleading, whereas revenue churn is more accurate.
Benchmark: What is a good vs. bad level of churn? On a monthly basis, 1% average churn is a good benchmark to keep in mind. Or on an annual basis, 10% average churn, or equivalently, 90% gross dollar retention is a good benchmark.
2. Net Dollar Retention
If gross dollar retention measures how many revenue dollars were lost from existing customers, then Net Dollar Retention is the measure of how much revenue was gained, net of revenue dollars lost.
Many SaaS companies utilize a “land and expand” strategy, whereby customer success reps will try to up-sell their customers. This typically comes in one of two forms:
- A customer can buy more seats (i.e., users). For example, Hubspot prices its Professional Marketing Hub subscription at $800 per user per month. A customer may start with 10 Hubspot subscriptions, but could later add another 10 users — ARR from this customer would therefore expand from $96k to $192k.
- A customer could upgrade its plan. For example, Hubspot also offers an Enterprise Marketing Hub subscription priced at $3,600 per user per month. A customer may start with 10 Professional subscriptions, but could later upgrade to Enterprise subscriptions — ARR from this customer would therefore expand from $96k to $432k.
Net dollar retention takes into account these sources of revenue expansion, while still deducting for churn. In other words, if a company had 10 customers at the start of the year that generated $100M of ARR, but then ended the year with only 9 of those customers, net dollar retention measures how much ARR is generated from these remaining 9 customers, as a percentage of the original $100M of ARR. If these remaining 9 customers now generate $120M of ARR, then the company achieved 120% net dollar retention.
Benchmark: The median for private SaaS companies is a net dollar retention of roughly 110%, and the top quartile surpasses 125%.
3. Lifetime Value (LTV) and Customer Acquisition Cost (CAC)
Lifetime Customer Value is an estimate of the future value generated from each new customer, where:
- Value is estimated from the annual gross profit contributed from each customer (not revenue contribution).
- Future value is based on an estimate of the average customer lifetime, which can be determined from the annual churn metric.
Notably, LTV on its own is not all that relevant or insightful. LTV has to be viewed relative to the cost to acquire each customer, or CAC, which can be estimated by dividing the total sales & marketing spend in a given period by the number of customers acquired in that same period.
4. LTV/CAC Ratio
The ratio of LTV/CAC is effectively a return on investment calculation, of how much value a company will receive (over time) in return for each $1 dollar it spends to acquire a new customer.
In my experience, the LTV/CAC ratio is a simple, yet comprehensive, assessment of a company’s sales efficacy. So many of the individual metrics incorporated into the LTV/CAC ratio — gross margin, pricing, churn, CAC— if viewed in isolation, could be misleading. But together, the LTV/CAC ratio reveals whether or not a company can grow efficiently and sustainably.
Notably, not everyone calculates LTV the same way, so be careful! And be consistent. The most common variation is when companies will use revenue contribution, not gross profit contribution, in their calculation of LTV. However, this inflates LTV relative to LTV/CAC benchmarks.
Benchmark: As co-founder of Blossom Street Ventures, Sammy Abdullah, wrote in an analysis he posted in 2019:
LTV/CAC is the critical metric to watch for most B2C companies. Generally it’s thought that this figure needs to be north of 3x, meaning the customer is worth three times what he/she costs to acquire.
Generally challenging to find publicly published stats on LTV/CAC ratios, but here is an excerpt from an equity research note from Credit Suisse (albeit from 2017) that cites an average LTV/CAC ratio of 2.0x among publicly traded SaaS companies. In my experience, the top quartile is able to achieve an LTV/CAC ratio of 3.5x or better.
In a future post, I will discuss how to construct a more detailed LTV/CAC analysis — one that relies on cohort-specific data. However, the challenge with the LTV/CAC ratio is that companies don’t always provide all of the data or information you need to even calculate it, let alone on a historical basis for trend analysis.
The remaining two SaaS metrics are more readily available with publicly available information.
5. Sales Efficiency Ratio (i.e., Magic Number)
In the absence of detailed financial information, or perhaps as an initial screening tool, the Sales Efficiency Ratio can provide a rough assessment of a company’s quality of growth. The Sales Efficiency Ratio is defined as net new ARR in a given period, divided by the sales and marketing spend from that period. If you work out the math, it is a fairly close proxy to the LTV/CAC ratio, except that it focuses on revenue, not gross profit; and it measures a specific period’s contribution, not lifetime contribution.
Benchmark: Blossom Street Ventures’ Sammy Abdullah posted an analysis in 2021, highlighting the Sales Efficiency of SaaS IPOs from 2017–2019, where the dataset exhibited a median of 0.63x and the top quartile surpassed 0.92x.
6. Efficiency Score (i.e., the Rule of 40)
Particularly in the current market environment, where the pendulum has swung from “growth at all costs” to “growth with a path to profitability,” the Efficiency Score has become increasingly important. The Efficiency Score is simply the sum of a company’s growth rate and its profitability. Notably, profitability can take many forms, but I tend to rely on EBITDA margin as it’s a fairly close proxy for free cash flow, without being too cumbersome to calculate.
The resulting sum is a percentage. Historically, a SaaS company with an Efficiency Score greater than 40% is doing well, and a SaaS company with an Efficiency Score less than 40% is not doing so well….which is why most people call this the “Rule of 40.”
Benchmark: I prefer the term “Efficiency Score” because it allows for a more thoughtful conversation about degrees of efficiency, as opposed to a hard fast rule.
As Mary D’Onofrio and Andrew Schmitt from Bessemer detailed in a recent post on their Parting the Clouds substack, the public markets reward higher valuation multiples to those companies with higher Efficiency Scores. In Q2'22, companies with scores above 60% traded at an average of 21x ARR, companies with scores between 40% and 60% traded at an average of 10.1x ARR, and companies with scores less than 40% traded at an average of 6.4x ARR.
A relatively long post, especially if you’re new to SaaS, but I hope you found this informative— these really are the metrics and benchmarks that I use on a daily basis when thinking about SaaS companies. There are a lot of interesting variations to these metrics and I’ll try to dissect them in future posts, but it’s helpful to first familiarize yourself with these SaaS metrics as a starting point.
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Disclaimer: The views expressed here do not necessarily reflect those of my employer.
