Key Metrics and Issues for

SaaS and Other Recurring

Revenue Businesses
Maxwell Locke & Ritter Financial Due Diligence

©2017 Maxwell Locke & Ritter

Introduction
Software-as-a-Service (“SaaS”) is a software licensing and delivery model in which
software is licensed on a subscription basis and centrally hosted.
The SaaS business model is fundamentally different than a traditional enterprise
software license model due to the recurring nature of the revenues and the upfront
nature of the costs.

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Key Metrics
The keys to evaluating SaaS and similar recurring revenue businesses lies in
understanding what constitutes recurring revenue, the relationship between the upfront
costs to acquire customers and the expected go-forward revenue streams, and how to
measure customer retention.
These relationships can be assessed by understanding the following key metrics:
► Monthly recurring revenue (“MRR”)
► Customer acquisition costs (“CAC”)
► Customer retention and churn rates
► Lifetime value of customers (“LTV”)

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Monthly Recurring Revenue (“MRR”)

MRR overview
► Monthly recurring revenue for each customer represents the monthly subscription price
charged by a SaaS business.
► The SaaS company’s aggregate MRR represents the contracted monthly recurring revenue for
all customers at a point in time.
► Most businesses require an annual contract with monthly billings.
► Annual recurring revenue (“ARR”) is measured as MRR x 12.
► SaaS businesses are often valued at multiples of ARR, so the higher the ARR, the higher the
Understanding what
valuation. revenue streams
― Understanding what service lines represent true recurring versus non-recurring or “re- represent true
occurring” revenue is extremely important when evaluating the business because it recurring revenue is
important to
affects the valuation.
establishing
― SaaS businesses focus on increasing the number of recurring revenue customers, enterprise value.
upselling to existing customers, and minimizing downsells and customer churn.

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Monthly Recurring Revenue (“MRR”)

MRR upsells
► Upselling(sales expansion) to existing customers generally requires less sales and marketing
spend compared to acquiring new customers.
► Accordingly, upselling provides a better return on sales and marketing resources.
► Sales expansion to existing customers can happen in several different ways:
― Increase in number of users or “seats,”
― Increase in usage or services, and
Minimizing downsells
― Add-on products. and customer churn is
just as important to
MRR downsells and churn retaining value as
► Downsells and churn represent lost recurring revenue due to reduction of services, acquiring new
cancellation of customer subscriptions, and non-renewals. customers via sales
and marketing
► Refer to Customer Retention and Churn Rates section of this presentation for further investment.
discussion of churn.

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Monthly Recurring Revenue (“MRR”)

Recurring revenue rollforward

2015-2017
2014 2015 2016 2017 average A recurring revenue
Beginning ARR - 1,627,149 3,571,223 6,133,558
Plus: New customer ARR 1,805,916 1,629,536 1,611,727 3,100,001
rollforward analysis
Plus: Existing customer upsells/expansion 779,229 2,007,039 5,005,375 8,460,014 demonstrates the
Less: Existing customer downsells/contraction (649,883) (1,254,362) (3,630,908) (6,024,234) effect of new
Less: Churned ARR from customer terminations (308,113) (438,139) (423,859) (1,063,280)
Ending ARR 1,627,149 3,571,223 6,133,558 10,606,059
customers, upsells,
downsells and
Churn rate % -26.9% -11.9% -17.3% -18.7% customer churn on a
Net expansion / (contraction) % 46.3% 38.5% 39.7% 41.5%
Net ARR expansion, (contraction) and (churn) % 19.3% 26.6% 22.4% 22.8%
company’s ARR base.

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Customer Acquisition Costs (“CAC”) and the CAC Ratio

Calculation of CAC
► CAC represents the sales and marketing spend required to acquire new customers and the
resulting incremental ARR.
► The CAC Ratio measures the payback time on the company’s sales and marketing investment.
A CAC ratio of 0.5 implies that half of your Understanding the
Current year ARR – Previous year S&M investment is paid back within a
ARR relationship between
CAC Ratio = year (two-year payback period).
customer acquisition
Sales and marketing costs A CAC ratio of 1.0 implies a one-year costs and increased
payback period.
► The CAC Ratio may be used to assess the company’s sales and marketing efficiency: ARR and/or
profitability helps
SaaS companies
assess current sales
CAC Ratio How to manage sales and marketing investment and marketing efforts
≥1.0 Invest more aggressively in S&M and/or optimize S&M spend and plan future
marketing strategies.
0.33-1.0 Maintain current S&M investment and focus on productivity
improvement
≤0.33 “Slam on the breaks” and focus on S&M productivity improvement
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Customer Acquisition Costs (“CAC”) and the CAC Ratio

Average customer acquisition costs

Based on a 2017
survey of
subscription-based
businesses with ARR
>$5 million,
companies spent a
median of $1.15 to
acquire each dollar of
new ARR from a new
customer.
KeyBanc Capital Markets, 2017 Private SaaS Company Survey Results, CAC Ratio: How Much Do You Spend
for $1 of New ARR from a New Customer?

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Customer Acquisition Costs (“CAC”) and the CAC Ratio

CAC payback period

Although there was a

wide distribution of
responses, a 2017
survey of
subscription-based
companies revealed a
median CAC payback
period of 18 months.
KeyBanc Capital Markets, 2017 Private SaaS Company Survey Results, CAC Payback Period

©2017 Maxwell Locke & Ritter 9

Customer Retention and Churn Rates

Churn overview
► The “stickiness,” or rate of renewal after annual subscription contracts expire is measured by
retention or churn.
― The CAC ratio is directly impacted by customer retention rates. Improved customer retention
(reduced churn) drives ARR retention and consequently increases the CAC ratio.
►A small change in the monthly churn rate makes a significant difference in long term ARR
retention. The 1-, 3- and 5-year customer retention rates based on monthly churn rates is shown
below:
Monthly churn 1.0% 2.0% 3.0% 4.0% Even with 2% monthly churn, half of all
Monthly retention 99.0% 98.0% 97.0% 96.0% customers will be gone in three years.

1-year retention 88.6% 78.5% 69.4% 61.3%

3-year retention 69.6% 48.3% 33.4% 23.0%

At 4% churn, more than 75% of customers Customer churn
will be lost rates directly impact
5-year retention 54.7% 29.8% 16.1% 8.6%
a Company’s ability
Griffin, Carter and Hartz, Neil, Cloud Computing: A Closer Look at Churn, Updata Partners, June 2012.
to scale.

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Customer Retention and Churn Rates (cont.)

Types of churn
► Customer (account) churn measures the rate that customer accounts are lost
► Dollar churn measures the actual recurring revenue value lost over time
― Dollar churn is often a more valuable measure, as it takes into account the relative value of Based on a 2017
survey of over 200
large and small customers, as well as intra-period customer “upsells” and “downsells”
subscription-based
► “Acceptable” churn rates are typically dependent on the particular industry, customer acquisition businesses, the
costs, the total addressable market, and the potential to increase retention post-transaction. median annual gross
dollar churn rate was
► Refer to chart below for the results of a 2017 survey of average churn rates: 8%.
A company’s measure
of “tolerable” churn is
dependent on a wide
variety of company-
and industry-specific
factors.
KeyBanc Capital Markets, 2017 Private
SaaS Company Survey Results, CAC
Ratio: How Much Do You Spend for $1
of New ARR from a New Customer?

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Customer Retention and Churn Rates (cont.)

Negative churn
► Negative churn occurs when upsells/expansion outpaces contraction and churned
recurring revenue
► Negative churn is ideal, and can be a big growth multiplier. It typically results from a
strong inside sales group focused on renewals and upselling the existing customer base

Recurring revenue rollforward

2015 2016 TTM 2017
Beginning ARR 6,449,312 8,192,899 10,109,311
Plus: New customer ARR 1,695,242 2,109,399 2,114,514
Plus: Existing customer upsells/expansion 215,248 473,294 457,657
Less: Existing customer downsells/contraction (25,232) (43,285) (38,950)
Less: Churned ARR from customer terminations (141,671) (212,441) (240,297)
Ending ARR 8,192,899 10,519,866 12,402,235
In this example, the company
demonstrated “negative churn”.
Net new ARR added 1,743,587 2,326,967 2,292,924
Net ARR growth 27.0% 28.4% 22.7%
Net expansion / (contraction) % 2.9% 5.2% 4.1%
Net ARR expansion, (contraction) and (churn) % 0.7% 2.7% 1.8%

©2017 Maxwell Locke & Ritter 12

Customer Retention and Churn Rates (cont.)

Analyzing churn
Example cohort analysis
► Since customer retention is critical to the growth (and valuation) of a SaaS-based $14,000,000

business, management teams typically monitor churn closely. $12,000,000 $1,321,760

► Performing a cohort analysis is one technique used to gain insight into churn $10,000,000
$1,391,280
$2,073,156

$1,658,456
trends. $8,000,000
$1,122,004
$1,641,506
$1,437,419
$1,363,750
$6,000,000 $1,350,164
$1,016,860 $1,232,727
— A cohort analysis groups customers into buckets, or cohorts, and analyzes trends $4,000,000
$1,130,856
$1,186,692
$1,196,969
$1,222,814 $1,319,839
$864,373 $1,112,249 $1,139,649
within those buckets over time. $2,000,000
$1,031,933
$2,064,336 $2,251,830 $2,552,827 $2,582,424
$1,696,942
$363,895 $631,195 $711,161 $740,292 $815,532
► In high-growth environments, small changes to the inside sales team, problems $0

with implementation, or any other factors may contribute to significant changes in Pre 2007 2007-2011 2012 2013 2014 2015 2016 2017

customer retention.
Cohort analyses help
— Cohort analyses enable management teams to track customer behavior and their demonstrate a SaaS
reactions to variables over time. business’ customer and
dollar churn rate trends over
— Frequent cohort analyses allow management teams to continuously assess the
time.
effect of those variables on customer churn.

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Customer Retention and Churn Rates (cont.)

Methods to limit churn

► Companies can increase retention in a number of ways, including:
― Improving customer service;
― Increasing the number of users/adopters at each client;
― Improving the onboarding/adoption process;
― Improving integration with customer’s systems and processes; and
― Improving the contract renewal process.

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Lifetime Value of Customers (“LTV”)

Lifetime value
► Customer LTV is an estimate of the average gross revenue that a customer will generate before
they churn. LTV is typically calculated as follows:
Average margin per account (AMPU) in MRR
LTV =
Monthly churn rate

► Knowing the average customer LTV helps a SaaS business to –

(1) Apply guardrails around customer acquisition costs – if a SaaS business is spending more
on customer acquisition than it anticipates earnings from a customer in revenue, it needs Understanding LTV
to reassess its S&M strategy. trends for different
customer types or
(2) Evaluate marking channels – measuring LTV for each marketing channel can help segments can help
prioritize S&M spend. focus a SaaS
business’ sales and
(3) Focus on retaining most valuable customers – focusing on customers belonging to the marketing strategy.
segment with the highest LTV could help a SaaS business maintain or accelerate MRR
growth.

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LTV:CAC ratio

LTV:CAC
► LTV:CAC measures the lifetime value of a customer compared to the cost to acquire the
customer. The metric is essential for evaluating the return on investment for each customer. It
provides an answer to the simple question, is the customer worth more than what it costs to sell
to them?

LTV:CA Lifetime value of customers

=
C Customer acquisition costs

► Calculating the LTV:CAC ratio is a great way to assess a company’s position for sustainable The LTV:CAC ratio is
growth. a metric used to
►A ratio of 1:1 means you lose money the more you sell. For growing SaaS companies, the measure the
efficiency of the sales
industry standard LTV:CAC ratio is 3x or higher.
and marketing
► However, higher is not always better. If the ratio is too high, the company is likely restraining its function.
growth by underspending on sales and marketing.

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Key Diligence Issues
When evaluating SaaS and similar recurring revenue businesses for our clients, we often
encounter issues affecting MRR, deferred revenue and post-acquisition accounting.
These issues include the following:
► Importance of gross margins
► Cancelled invoices
► Customers not using the software (or never going live)
► Deferred revenue “haircut”

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Importance of gross margins

Gross margins
► SaaS gross margins are high relative to other industries, typically in the 70%-90% range. Part
of what makes a SaaS business attractive to investors is its ability to service current customers
at nominal cost.
Because gross
Cost of goods sold margins are important
in evaluating a
► Expenses typically included in cost of goods include the following: business’ ability to
— Application hosting and monitoring costs, scale, SaaS
management teams
— Implementation-related costs, must be careful to
assess what costs are
— Employee costs related to keeping the production environment running,
required to deliver the
— Customer support and account management costs, services and ensure
those costs are
— Third-party software license or data fees used in the delivered product, and reflected in cost of
— Any other direct costs to deliver the ongoing service goods sold.

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Importance of gross margins

Gross margins on SaaS revenues

Based on a 2017
survey of over 200
subscription-based
businesses, the
median annual gross
margin was 78%.
KeyBanc Capital Markets, 2017 Private SaaS Company Survey Results, Subscription Gross Margin

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Importance of gross margins

Typical SaaS cost structure

KeyBanc Capital Markets, 2017 Private SaaS Company Survey Results, Median Cost Structure by Size

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Deferred revenue “haircut”

Deferred revenue “haircut”

► Under FASB Accounting Standards Codification (“ASC”) 805, an acquirer must recognize any
assets acquired and liabilities assumed, measured at fair value as of that date. This includes
the deferred revenue balance at transaction close.
► The process of determining the fair value of deferred revenue can result in a significant
downward adjustment, or “haircut,” to the target company’s deferred revenue book value.
► Under the guidance, the deferred revenue liability may be estimated as the costs associated with
delivering the services plus a “reasonable” profit margin.
► In the current market, the majority of lenders allow companies to remove the deferred revenue
haircut from consideration in the calculations of loan covenants. However, GAAP revenue will be
affected post-close.

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Contact

Lathrop Smith Rob Repass Lesley Brandon Lamb Chris Ramsay Frank Xia
Partner Partner Hargraves Director Associate Associate
512-275-2715 512-370-3209 Partner 512-275-2711 512-370-3255 512-370-3243
[email protected] [email protected] 512-275-2717 [email protected] [email protected] [email protected]
[email protected]

©2017 Maxwell Locke & Ritter 22

Thank You

About Maxwell Locke & Ritter

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©2017 Maxwell Locke & Ritter