Software as a Service (SAAS) is a unique business model that requires a particular set of metrics to understand better if the business is thriving. Many different places on the web can help a company calculate these metrics; what we plan to discuss is why those metrics matter and the key factors to consider when performing the calculation. 

Removing any Services Revenue and Costs

Before calculating any metrics, if the business has implementation services or any one-time revenue, that should be excluded from the metrics below. These services are not recurring and typically produce meager profits as they require people to deliver the revenue directly. While they can improve product stickiness and are valuable to the client, including them in the calculations will distort the long-term cash viability of the business.

Why is Margin So Key?

As mentioned above, most metrics aim to identify the long-term ability of the business to generate cash. In the SAAS space, any costs that directly support maintaining the customer every year should be included in the margin area. These include hosting costs and customer support unrelated to renewal sales or implementation. From a cash perspective, the revenue less margin is the profit earned on each customer after they are onboard and implemented. For the best-run SAAS companies, this margin is typically above 80%.

CAC Payback Period

Companies aim to keep the number of months to pay back sales under 12 after adjusting for margin, as those costs are already spent as described above. This metric includes all sales and marketing costs, including time and money spent that did not lead directly to the customer signing. If a SAAS company can break even on its first year of revenue from a new customer, which is what a margin-adjusted payback under 12 represents, then future years’ revenue can cover product development and other general costs.

LTV to CAC

This single metric, often targeted as needing to be above 3:1, combines multiple metrics into a single formula. To calculate LTV, the company must understand the Annual Contract Value per customer and churn, which drives most tenure calculations. The LTV to CAC metric highlights a company’s profitability after covering sales and marketing expenses. LTV is the expected revenue (adjusted for margin) over the customer’s anticipated lifetime. If a company has an LTV to CAC of 1:1, every dollar of income is spent on acquiring a new customer, with no profit left to cover the development or general/administrative teams. If a company has an LTV to CAC of 6:1, it can possibly invest more in sales and marketing to grow the business faster.

Churn

Churn calculations are fundamental to the business’s health but are often the most miscalculated item within SAAS. The critical item to consider when calculating churn is how much business was lost from the churned customer. While the number of clients leaving can be concerning, a better metric would be dollars lost in any period of time. Churn should also be calculated by cohort, either the product sold or the timeframe when the client started, to identify any trends. In addition to churn, downsell needs to be tracked appropriately and include any time the company does not collect the expected cash. If the company provides free service for a month due to product issues, that should be reflected in churn reporting as it impacts the expected ACV.

Timeframe and Channels

Every company should understand the CAC Payback and LTV to CAC at the holistic level, but as they grow, they will want to evaluate these metrics from different channels, different product types, and different timeframes. If the company is moving upmarket, historically low ACV customers will skew the profitability of new high ACV customers. If the company has put a new emphasis on reducing churn, that metric, which drives tenure, should be evaluated by cohort of when the clients started. If the company has multiple products, each should be evaluated independently to ensure that the value from acquiring the customer produces more than enough revenue to offset sales costs.

Different SAAS Business Models

Any company analyzing its metrics must understand if its business model matches the benchmark before determining success. Most sales metrics are based on large upfront sales and high renewals with some upsells over time. But if the business model has a small upfront sale, with significant expansion over time, calculations around ACV and churn likely need to be adjusted to reflect.

Conclusion

Delving into the intricacies of Software as a Service (SAAS) demands a nuanced understanding of vital metrics for gauging business success. By excluding one-time services revenue and costs, the focus sharpens on sustainable, recurring income. The pivotal role of a robust margin, encompassing hosting costs and customer support, becomes apparent in assessing long-term cash viability. The CAC Payback Period emerges as a crucial metric, seeking a prompt recovery of sales and marketing expenses. LTV to CAC, a comprehensive formula blending Annual Contract Value, churn, and profitability, underscores the delicate balance between customer acquisition and sustained revenue. Accurate churn calculations, evaluated across cohorts, enhance understanding by emphasizing not only the number of departing clients but also the dollars lost over specific periods. As companies expand, a nuanced approach to metric evaluation across channels, products, and timeframes is imperative. Finally, aligning SAAS business models with benchmark metrics is a prerequisite for accurately gauging success, recognizing the need for nuanced considerations that reflect the business’s health and growth potential.