Friday, July 06, 2007

How to fish a salmon

When there is a will, there is a way!

SaaS business metrics: why are they different?

NetSuite One System. No Limits.I was surprised today when I went through the NetSuite IPO filling (S1) to see that it looked very much like any Enterprise software document - not a single mention of churn or % of recurring revenues.
However, SaaS companies are trading today at an average of 5-6x trailing revenues (salesforce leading the pack with 8.7x), while traditional software companies are in the 2-3x range. The reason for this difference, from an investor perspective, is that the SaaS model provides far clearer visibility into future revenues. In addition, they grow organically from service usage expansion from their existing accounts and are better positioned to upsell since they interact with their customers regularly. This is fairly different from the traditional perpetual license model, where companies can experience huge variability between quarters depending on when large contracts are closed.

Different models require different performance metrics. David Cowan, the Bessemer Managing Partner who pioneered early stage investments in automated subscription services (Verisign, Postini, Netli...), developed a white paper on performance metrics for Technology service Vendors (TSV) and this post present the key elements of his reflexion adapted for SaaS companies.

Why the traditional "bookings" number does not work for SaaS companies:
  • Firstly, bookings foretell revenues in a perpetual license model, but for a SaaS company, it is not the case, since the contract is subject to churn on one hand and seats expansion on the other hand
  • secondly, the bookings number often include renewals and upsells. While upgrading a customer in a perpetual license model is comparable to a new sales, a renewal for a saas company is significantly easier to get than a new account sale. so the bookings would need to be split into "renewal/upsells" and "new sales". But even if we do this, the renewal number would mask the churn
  • Finally, the booking number does not make the difference between the "recurring" revenue of high value and the non-recurring revenue (implementation services, training...) of lower value
The right metric: MRR/CMRR

As recurring revenue (RR) is the primary source of value for a SaaS company, the primary metric must derive from it. New accounts, higher pricing, lower churn and upsells all contribute to RR, so they should become components of the primary metric.
To make it practical, the best is to look at Monthly Recurring Revenues or MRR, since this number changes a lot each month for a fast growing company. It also facilitates cash management since expenses varies by month.
The MRR equation from one month to the other is straightforward:
MRR (month+1) = MRR (month 1) + MRR from new accounts + MRR from upsells - MRR from churn

This simple metric becomes the key indicator to drive sales reps. Their objective becomes to increase the MRR for their territory by the target amount. It is up to them to drive this growth from new accounts or upsells. Minor adjustments can be made based on faster cash payments and one time revenues, but the key focus should be MRR.

The MRR is a great metrics, but it can be perfected. For example, there can be a few months delay to set-up the service, and SaaS company cannot recognize the revenues before the service is up and running. Conversely, if an account already mentioned its willingness to churn at a specific date, it would be misleading to represent that customer as a recurring revenue account.

So a more meaningful metric is the Committed Monthly Recurring Revenue or CMRR.

CMRR = MRR + purchase orders for future recurring revenues - revenues that is likely to churn within the year

This graph presenting the different components of the CMRR communicates all the highlights of the business: new accounts (green), organic growth (purple), renewals (blue) and churn (red arrows). Comparing the CMRR to the monthly expenses is a also a key indicator of the health of the business.

In addition to the CMRR, there are a few other key metrics that SaaS companies need to monitor on a monthly basis:
  • Number of customers
  • Average CMRR per customer
  • Average number of "product" or "module" per customer
  • Average CMRR per "product" or "module" per customer
I wish I had seen these numbers in the NetSuite S1!

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