Evaluating SaaS companies

Evaluating SaaS companies

Albion Capital has been investing in software companies for almost 20 years. We usually invest in the Series
A round, focusing on recurring revenue cloud businesses, typically at the application layer.

This primer sets out the basic framework we use to evaluate SaaS businesses. It is an attempt to simplify
and explain a topic which has already generated a considerable amount of literature, leading to a sometimes
bewildering array of metrics (see sources listed on pages 18–20).

We use this framework to help answer five key questions:

1. Does the company provide a valuable service to its customers ?

2. Is the business model sustainable ?
3. Is there product/market fit in an attractive market ?
4. Can the company scale profitably ?
5. What is the company worth ?

In the Appendix on pages 14–15, we have also summarised our view of best practice approach to monitoring
these metrics on an ongoing basis, together with an indication as to what ‘good’ metrics look like based on
industry literature, surveys, public company information as well as analysis of our own portfolio companies.

Evaluating SaaS companies 3

 1. Does the company provide a valuable
service to its customers?

Analysis of customer renewals helps answer this question.

Renewals As customers rent a service, at each renewal date they make a decision on whether the value
they are getting from the service is worth what they are paying for it , also taking into account
the competitive environment and the costs of switching to a new service.

Churn Digging into the churn of a SaaS business gives insight into the value proposition and competitive
positioning – high churn could indicate any one of a range of concerns, such as poor user experience,
product breadth, competitive dynamics, account management, or overselling, amongst many others.
There are various measures of churn, all of which tell a different story.

Measures Gross churn shows if a business is able to retain its most valuable customers .
of Churn
Net churn shows the ability of the company to grow the ASP over time , as well as the annuity
value of the customer base.

Logo churn (the number of customers lost as a proportion of total customers) can give information
on the strength of the value proposition in different market segments , which informs the TAM,
and the efficiency of the marketing and sales functions.

Non-financial
Non-financial metrics also provide valuable insight, such as end user usage statistics and NPS scores.
metrics

Evaluating SaaS companies 4

 1. Does the company provide a valuable
service to its customers? continued

Useful metrics/analysis
Gross churn Measures the proportion of total revenue lost MRR lost in a given period/MRR at the beginning of a given period

Net churn Measures change in value across all existing customers (MRR lost – MRR from upsells) in a given period MRR at the
in a given period, i.e. lost customers offset by upsell to beginning of a given period
those remaining. Negative net churn means you are
increasing total revenue from all your existing accounts

Logo or Measures your ability to satisfy and retain Customers lost in a given period/Customers at the beginning
Account churn your customers of a given period

Renewal rate Measures what % of your customers renew their Customers that renewed their contract at the end of a given
contracts when their contract is up for renewal period/Customers that could have renewed their contract at the
end of a given period. Note: if you include customers that are
bound by a contract, it will make it look like you are doing
better than are

NPS Measures customer satisfaction, which is a good Index ranging from -100 to 100 that measures willingness of
predictor of future churn customers to recommend a company’s products or services

CX index Measures how well a brand’s customer experience Index ranging from 0-100 that measures how effectively customers
strengthens the loyalty of its customers felt needs were met and the ease and enjoyably of their experience

Cohort analysis Measures how churn and upsells trend out over time Used to compare groups of customers by the month joined and
follow how they behave over time

Engagement Measures cohort retention on metrics that matter e.g. DAU, MAU, photos shared, photos viewed etc.

Usage Specific to the company/application e.g. do 90% of your users log on every day?

Evaluating SaaS companies 5

 2. Is the business model sustainable?

Traditional GAAP accounting is not as useful for SaaS

businesses as for many other industries. The “Rule of 40”
In part this is because of the annuity nature of the revenues,
where sales costs are expensed up front but revenues The Rule of 40 is a high level
are recognised evenly over the lifetime of the customer. benchmark that adds growth rate
The effect is compounded further in high growth businesses and EBITDA margin together.

However, in the end it all comes down to profitability and Intuitively the rule follows that it is
cash generation , and so we assess the long term viability of a acceptable to be loss-making if you
business by reviewing the ‘underlying profit’ and unit economics. are growing fast, and you must make
money and increasing amounts of
We typically focus on:
it as your growth slows.
1. Gross profit margin (%)
At scale, growth rate + EBITDA
2. EBITDA pre sales & marketing costs (EBITDASM)
margin should be > 40%.
3. The Rule of 40 (%)

Evaluating SaaS companies 6

 2. Is the business model sustainable? continued

Useful metrics/analysis
Gross Profit % This is a traditional GAAP measure. Low GP % can Revenue/Gross profit
indicate a heavy services layer, which will typically
be less scalable

EBITDASM Measures underlying profitability i.e. if you stopped Operating profit (including all R&D spend) with depreciation
(but incl. account investing in growth, is the business profitable? & amortisation and sales & marketing costs added back.
management) But account management and customer success costs still included

Rule of 40% A rule of thumb measure for a ‘healthy’ SaaS Growth rate + EBITDA margin > 40%. Growth rate is defined as
company at scale yoy growth rate of monthly MRR

Evaluating SaaS companies 7

 3. Is there product/market fit
in an attractive market?

To help answer this question we review the three key metrics below. Reviewing bookings,
recurring revenue and ASP gives insight into the growth potential and the TAM.

Growth Trends in ASP Market sizing

over time estimates
Product market fit is a ASP also informs the What defines an attractive
nebulous concept, but a Go To Market options: market is equally complex…
company that isn’t growing
A low ASP will not support … but the Total Addressable
fast hasn’t demonstrated it
long and expensive field Market must be large
We review: sales cycles

Bookings growth A high ASP might suggest

MRR/ARR growth that inbound marketing

alone won’t be enough
New logos

Evaluating SaaS companies 8

 3. Is there product/market fit
in an attractive market? continued

Useful metrics/analysis
Bookings Leading indicator of growth rate Monthly or quarterly ACV
growth (especially for early stage companies)

MRR growth Measures how quickly recurring revenue is growing

Increasing ASP/ Measures if you are acquiring higher value customers.

deal size A high ASP makes high-touch sales strategies viable

New MRR v Measures whether growth is coming from new

Expansion MRR or existing customers

Quick ratio Measures if you are growing at a healthy rate (New MRR + Expansion MRR)/ Churned MRR + Contraction MRR)
and have low enough churn

TAM Total addressable market or market size Everyone worldwide who could buy your product

SAM Total serviceable addressable market size The market you can acquire with your product
(e.g. geography, vertical etc.)

SOM Total serviceable obtainable market size Portion of the market you can get to use your product
(e.g. SME vs Enterprise)

Evaluating SaaS companies 9

 4. Can the company scale?

Understanding the business model: Sales efficiency metrics, together with gross margin analysis
and an understanding of the deployment model, give insight into the scalability, viability and efficiency
of a SaaS business.

Understanding the Go To Market strategy: Every great business has to effective Go To Market
strategy, but the impact on SaaS businesses is pronounced given the simplicity and profitability
of delivering a standardised service over the web.

Key metric –cost versus value: As with consumer marketing businesses, SaaS companies review
he sales and marketing costs to acquire a new customer against the lifetime value of the customer
once it is won.

There is a huge amount of literature available on this topic (referenced in the Appendix).

Evaluating SaaS companies 10

 4. Can the company scale? continued

Useful metrics/analysis
Blended CAC: Measures how much you need to spend on sales S&M costs/# of new customers. Note: it is important to factor
and marketing to acquire a single customer in the length of the sales cycle to the calculation

Paid CAC: Measures how much you need to spend on paid Paid S&M costs/# of new customers. Note: it is important to
campaigns to acquire a single customer factor in the length of the sales cycle to the calculation

Customer Measures the customer lifetime in months or years 1/customer churn rate % e.g. a monthly churn rate of 3%
lifetime: indicates a customer lifetime value of 33 months

LTV: Measures how much each customer is contributing to ARPA * gross margin * customer lifetime
your revenue and for how long, and guides you how
much you should be spending to acquire them

CAC payback Measures how long before a new customer pays for CAC/(ARPA * gross margin)
(months): the costs of signing them up

LTV: CAC ratio: Measures how much it costs to sign a customer up LTV/CAC
versus how much that customer is worth to the business

Magic number: Measures for every £ in S&M spent, how many £ of

ARR is created, essentially the profitability of the for the earlier of the two quarters
business model

Evaluating SaaS companies 11

 4. Can the company scale? continued

Useful metrics/analysis
S&M costs Measures rate of investment in growth S&M costs/total revenue
as a % of total
revenue:

Professional Measures (1) the recurring nature of revenue, and (2) PS revenue/total revenue
services as a % the total cost of service
of total revenue:

Attachment Measures professional services revenue as a % of PS revenue/ACV in year 1

rate: first year ACV, essentially understanding the role
professional services play in deployment, which has
an effect on your Go To Market strategy

Gross capital Measures how much capital has been consumed Gross cumulative capital consumed/ARR achieved. Note: Gross
consumption to grow your ARR cumulative capital is defined as total cumulative equity raised plus
ratio: debt drawn. If there is significant cash on the balance sheet then
consider net cumulative capital (i.e. less surplus cash on the
balance sheet)

Evaluating SaaS companies 12

 5. What is the company worth?

The $$$ question.

To the extent we are using science rather than art, we typically ARR
focus on the metrics in the table opposite.
ARR growth rate
The last point (cash generation) is important – a fast growing
GP %
company whose customers pay annually up front is going to be
significantly cheaper to finance than one paid monthly in arrears, EBITDASM
and so less capital will be required to build the same value.
Gross churn
Revenue retention rate/net churn
ASP growth
TAM
CAC payback and LTV ratio
Cash generation

Evaluating SaaS companies 13

Appendix
 What should SaaS businesses measure
on an ongoing basis?
A. Detailed Analysis: The Customer Lifecycle as a Dashboard Process designed by Keith Wallington

Leads Demo views # new customers Activations C2S

Content downloads New MRR Successful 1st use Feature Use
Live chat users MRR or CMRR* Customer Satisfaction
APRA (or CXi)
CAC NPS
CAC Ratio Get set Use
Discover Evaluate Buy up

Promotes a customer centric approach

Aligns with customer development and lean methods
Keeps the team aligned (use to set lead & lag goals and OKR’s)
understand your business and explain how it works
Get
Look for insights not just in each stage but across the lifecycle Renew support
Identifies and promotes focus on the bottle necks that need addressing now
Keeps you connected to your customers
Drives scale!
LTV Buy Support
LTC: CAC ratio Customer
Churn
more Satisfaction (Cxi)
# of support
Upsells cases
Every business is unique and the mix of metrics should
New upsell MRR
be adjusted accordingly. The philosophy of thinking about ARPA by cohort
your business in this holistic way is what is important.
*CMRR = MRR + committed signed contracts = churn (including predicted churn) Evaluating SaaS companies 15
 What should SaaS businesses measure
on an ongoing basis? continued
B. High-level Analysis: The Top Metrics to Track

ARR

Net churn

ACV

# of customers

CAC payback

Gross margin

Evaluating SaaS companies 16

 What does ‘good’ look like?

These benchmarks are from the perspective of a venture investor

Gross churn <12% per annum

Net churn Negative is good (upsell is greater than gross churn)

Logo churn <7% per annum

Renewal rate >90%

ARR growth 50%+ (>£5m revenue), 100%+ (<£5m revenue)

Quick ratio >4 means growing at healthy rate and low churn rate

CAC payback <12 months (for earlier stage)

LTV: CAC ratio >3x

Magic number >0.5x

S&M costs as % of total revenue c.40% at Series A stage

PS as a % of total revenue Lower the better

Gross margin >80%

EBITDASM c.45–55%

NPS >50 is impressive

Evaluating SaaS companies 17

 Glossary

Key terms and definitions

ACV Annual contract value KB Knowledge base

APRA Average revenue per account LTV Lifetime value

(MRR divided by no. of active accounts)

ARR Annual recurring revenue MAU Monthly active users

ASP Average selling price MRR Monthly recurring revenue

CAC Customer acquisition cost NPS Net promoter score

C2S Click to scan OKR Objectives and key results

CMRR Committed monthly recurring revenue (existing MRR PS Professional services

plus new bookings less downgrades & churn)

CXi Customer experience index S&M Sales and marketing

DAU Daily active users TAM Total addressable market

GTM Go To Market

Evaluating SaaS companies 18

 Sources

Key terms and links to source materials online

Churn https://www.slideshare.net/botteri/bessemer-5-cs-of-saa-s-finance-presentation
https://labs.openviewpartners.com/mapping-key-metrics-to-saas-growth-stages/#.Wd0JQWhSyUl
http://tomtunguz.com/maximum-viable-churn/http://www.forentrepreneurs.com/customer-success/
https://kellblog.com/2016/12/27/a-fresh-look-at-how-to-measure-saas-churn-rates

Renewal rate https://www.sethlevine.com/archives/2017/08/how-to-value-your-saas-company.html

http://www.startupcfo.ca/2011/09/saas-math-activation-retention-and-churn/

NPS http://tomtunguz.com/nps-benchmarks/
https://www.saastock.com/blog/view/genius-or-luck-what-it-takes-to-build-a-successful-smb-saas-business

Cohort analysis http://christophjanz.blogspot.com/2014/03/cohort-analysis-practical-q-guest-post.html

https://blog.intercom.com/retention-cohorts-and-visualisations/

Engagement/Usage https://a16z.com/2015/08/21/16-metrics/
http://tomtunguz.com/your-startups-10-most-important-metrics/

Bookings growth https://a16z.com/2015/08/21/16-metrics/

http://tomtunguz.com/your-startups-10-most-important-metrics/

MRR growth http://tomtunguz.com/mrr-growth/

Evaluating SaaS companies 19

 Sources continued

Key terms and links to source materials online

Quick ratio https://www.cobloom.com/blog/saas-metrics?
utm_campaign=Quora+Answers&utm_medium=social&utm_source=quora#
https://www.saastr.com/mamoon-hamid-socialcapital-why-sht-really-gets-funded/

TAM https://a16z.com/2015/09/23/16-more-metrics/

Paid CAC https://www.slideshare.net/PointNineCap/9-worst-practices-insaas-metrics

https://a16z.com/2015/08/21/16-metrics/

Blended CAC http://www.forentrepreneurs.com/saas-metrics-2/

https://techvibes.com/2011/07/25/simple-saas-the-3-most-important-metrics-for-investors-2011-07-25

LTV https://labs.openviewpartners.com/what-are-key-performance-indicators-6-saas-metrics-that-really-
matter/#.Wd0F7WhSyUl

CAC payback (months) http://www.forentrepreneurs.com/saas-metrics-2/

http://labs.openviewpartners.com/saas-sales-and-marketing-metrics/#.WaaVlciGOUk

LTV: CAC ratio http://cracking-the-code.blogspot.co.uk/2014/01/refining-your-customer-acquisition-cost.htmlhttp://www.

forentrepreneurs.com/saas-metrics-2/https://kellblog.com/2014/07/30/the-ultimate-saas-metric-ltv-cac/

Evaluating SaaS companies 20

 Sources continued

Key terms and links to source materials online

Magic number https://www.scalevp.com/blog/magic-number-math
http://www.thesaascfo.com/calculate-saas-magic-number/

S&M costs as a % of total revenue https://labs.openviewpartners.com/saas-sales-budget/#.Wd0LHmhSyUk

Attachment rate http://www.forentrepreneurs.com/2017-saas-survey-part-1/

Gross margin https://davidcummings.org/2014/09/01/gross-margin-and-saas/

https://davidcummings.org/2016/10/16/gross-margin-as-part-of-lifetime-customer-value/

Rule of 40% http://avc.com/2015/02/the-40-rule/

https://feld.com/archives/2015/02/rule-40-healthy-saas-company.html
https://www.sethlevine.com/archives/2017/08/how-to-value-your-saas-company.html

Capital consumption ratio http://www.forentrepreneurs.com/2017-saas-survey-part-1/

http://tomtunguz.com/box-ipo/
https://www.sethlevine.com/archives/2017/08/how-to-value-your-saas-company.html

Evaluating SaaS companies 21