Part III: The Metrics You Need to Know to Profit in SaaS

Welcome back to the Smallcap Discoveries / Espace Microcaps joint 3-part series on Investing in the Software-as-a-Service (SaaS) space.

In Part I, we started high-level. We learned what SaaS was and the benefits of the model. We looked at why the market is paying big multiples for these companies.

In Part II of our series, we focused on SaaS in the smallcap space. We talked challenges of the SaaS model and what smallcaps need to do to survive.

And we finished by talking to Steve Levely, CEO of one of the biggest winners in the smallcap space so far in 2015, Ackroo Inc. (AKR.V, VEIFF:PINK).

So now in Part III, we are going to pull it all together. We are going to learn the metrics you must know for every SaaS company you invest in. And we’re going to tell exactly what you need to see to position yourself for profits.

Key Metrics

It all boils down to three key metrics that SaaS companies and investors use to gauge the health of their business: Customer Acquisition Cost (CAC), Churn, and Lifetime Customer Value (LTV).

Here’s what each of these metrics mean:

CAC: Marketing dollars spent to acquire a new customer

Churn: % of customers lost in a given period

LTV: Expected net recurring revenue over the life of an average customer

And here’s how you calculate them:

CAC = Sum of all sales & marketing expenses / # of new customers added

Churn = Number of lost customers over a period / total # of customers at beginning of period

LTV = Average Recurring Revenue per Customer per Year * Gross Margin * 1 / Annual Churn Rate¹

¹1 / Annual Churn Rate gives us the average lifetime of a customer. For example, if a company churns 5% of customers per year, we can expect the average customer to stay on board for 20 years.

A healthy annual churn rate for a SaaS company is 5-7%, according to Bessemer Venture Partners. In 2014, Pacific Crest did a survey of 306 private SaaS companies. The median churn rate was 8% for the 160 respondents with annual revenue of $2.5M or more.

The Most Important SaaS Metric of All

Taken alone, the CAC and the LTV don’t tell you much. But when combined, they become the most fundamental metric for any SaaS company: the LTV to CAC ratio (LTV divided by CAC).

This ratio calculates the return on each new customer added. A SaaS business should have a ratio of 3.0 or above in order to succeed. In other words, the cost of acquiring a new client should pay off three fold during the life of the client.

Another important metric is the CAC payback period. This is the number of months it takes to recoup customer acquisition costs and breakeven on a customer:

CAC payback period = CAC / (Average Recurring Revenue per Month per Customer * Gross Margin)

As a rule of thumb, the CAC payback period should be 12 months or less for a healthy SaaS business.

The challenge is companies don’t have to report CAC, churn, and LTV. They are non-IFRS and non-GAAP measures. And sometimes management won’t like to disclose them for competitive reasons.

If you don’t see the CAC/LTV numbers in a company’s filings, you should ask management directly. But if they are unwilling to give you them, here’s an alternative way you can get the payback period on CAC:

CAC ratio = Qn Sales & Marketing Expense / (Qn Gross Profit – Qn-1 Gross Profit) * 4

This ratio will give you the amount spent to acquire $1.00 of annualized incremental gross profit. By multiplying the answer by 12 months, it will give you the CAC payback period.

In other words, if this ratio is 1.00 it means it takes 12 months of gross profit to cover the CAC, translating to a one year CAC payback period, which is the maximum a company should allow for. In Pacific Crest’s 2014 survey, that ratio was 1.07 (not adjusted for gross margin), which means it takes 13 months to recoup CAC (12 months * 1.07).

A Little Case Study

In Part II of our series, we had a good chat with Steve Levely, CEO of Ackroo Inc. (AKR.V, VEIFF:PINK). Since we now have a better understanding of this company, why not use it to do a little case study on how to use key SaaS metrics!

(Note that we have excluded Ackroo’s latest acquisition, Dealer Rewards Canada, from calculations.)

From our conversation with management, here’s how the growth in merchant locations looks like:

2015 Q1 – 1,000 locations
2014 Q4 – 900 locations
2013 Q4 – 675 locations

Other key inputs (from Investor Presentation and discussions with management):

  • Expected lifetime of a customer = 5 years (even though 2014 Ackroo’s churn rate is only 9%, we prefer to use the industry’s benchmark given the short history of the company)
  • 2014 Monthly Recurring Revenue (MRR) per location = $71
  • 2014 Annual One-Time Revenue (OTR) per existing location = $222
  • Expected Annual One-Time Revenue (OTR) per existing location = $180 – non-recurring in theory, but high probability of occurrence over a broad portfolio of locations
  • Average Gross Margin = 70%

2014 financial year

LTV = Average Recurring Revenue per Customer per Year * Gross Margin * 1 / Annual Churn Rate = ($71 MRR * 12 months + $222 Annual OTR) * 70% gross margin * 5 years = $3,759

CAC = Sum of all sales & marketing expenses / # of new customers added = $596,385 / 225 new locations = $2,651

LTV to CAC ratio = $3,759 divided by $2,651 = 1.42x

CAC payback period = CAC / Average Recurring Revenue per Month per Customer * Gross Margin = $2,651 / (($71 MRR + $222 Annual OTR / 12 months) * 70%) = 42.3 months

On the surface, these SaaS metrics aren’t very appealing, but remember Ackroo was burning through a lot of cash before Steve Levely took over the CEO job in May 2014. He had some time to restructure the business and optimize sales and marketing activities so let’s take a look at how he did in the first quarter of 2015.

2015 first quarter

There is some seasonality in Ackroo’s revenues so we will use 2014 MRR per location to calculate 2015 first quarter key metrics.

LTV = Average Recurring Revenue per Customer per Year * Gross Margin * 1 / Annual Churn Rate = ($71 MRR * 12 months + $180 Expected Annual OTR) * 70% gross margin * 5 years = $3,612

CAC = Sum of all sales & marketing expenses / # of new customers added = ($6,643 + $30,000 adjustment* + $18,750 PhotoGIFTCARD**) / 100 new locations = $554

*2 full-time employees from operations doing S&M activities each at a salary of $60,000 per year
“**$150,000 / 24 months (expected period to convert PhotoGIFTCARD’s customers) * 3 months = $18,750”

LTV to CAC ratio = $3,612 divided by $554 = 6.52x

CAC payback period = CAC / Average Recurring Revenue per Month per Customer * Gross Margin = $554 / (($71 MRR + $180 Annual OTR / 12 months) * 70%) = 9.2 months

Now you can see the turnaround Ackroo’s strategy of focusing on referral partners, resellers and strategic acquisitions has had right in their key SaaS metrics.

Putting it All Together

So you’ve calculated your key SaaS metrics. You’ve looked at growth, valuation, and customer profitability metrics. Here’s everything you’ll want to see in your ideal SaaS investment:

1) Revenue growth of at least 25-30%, comparable to the industry
2) EV/Revenue multiple of 6x or less, unless the company can grow much quicker than 30%.
3) Recurring subscription revenue and professional services sales mix of 70/30. A minimum 70% of sales should be recurring.
4) Gross margin on recurring subscription revenue of 80+%
5) Annual churn of 7% or less.
6) LTV / CAC ratio of 3.0 or more.
7) CAC payback period of 12 months or less.
8) The business should be operating breakeven or profitably.

Now just because one or multiple criteria isn’t met, doesn’t mean it won’t be a homerun investment. But for each metric that isn’t met, we always work to understand why and if it’s fixable. Our experience is that investors who dig deep have the best chance of uncovering compelling SaaS investment opportunities.

Actually two of our recent SaaS investment both failed the first criteria on growth. These were Renoworks (RW.V – A Smallcap Discoveries’ pick) and Ackroo Inc. (AKR.V, VEIFF:PINK – Latest Espace MicroCaps’ pick). Both didn’t come close to hitting 25-30% growth and instead saw 0-5% growth over 2014.

Both missed for different reasons. Renoworks was transitioning from on-premise to a SaaS model while Ackroo has decided to cut 90% of its sales staff to pursue growth through resellers, referral partners, and strategic acquisitions. The modest growth in dollar revenue was masking the real increase in their customer base.

The point is these were (and are) one-time situations impacting revenues. Investors who did their homework figured out these companies were actually growing organically before other market participants. And they (and us) have made multiples on their investments.

There are many more of these companies out there waiting to be uncovered. It’s why the SaaS space is one of our favorite hunting grounds right now.

So if know your metrics, follow your checklist, and do your homework, you’ll be positioned for big profits in the SaaS space. You’ll be ready to join us on the hunt for those undervalued and underfollowed SaaS plays.

Want to learn more about the SaaS companies that are leading the industry and serving up big profits for investors?

Check out the Smallcap Discoveries newsletter and the Espace Microcaps blog. There’s always opportunity where others aren’t looking.

Happy (SaaS) investing!

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