{"id":382,"date":"2015-08-20T16:00:34","date_gmt":"2015-08-20T23:00:34","guid":{"rendered":"http:\/\/smallcapdiscoveries.com\/?p=382"},"modified":"2022-01-11T12:46:53","modified_gmt":"2022-01-11T20:46:53","slug":"part-iii-the-metrics-you-need-to-know-to-profit-in-saas","status":"publish","type":"post","link":"https:\/\/smallcapdiscoveries.com\/reports\/part-iii-the-metrics-you-need-to-know-to-profit-in-saas\/","title":{"rendered":"Part III: The Metrics You Need to Know to Profit in SaaS"},"content":{"rendered":"

Part III: The Metrics You Need to Know to Profit in SaaS<\/h2>

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

In Part I,<\/a> 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.<\/p>\n

In Part II<\/a> 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.<\/p>\n

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).<\/p>\n

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\u2019re going to tell exactly what you need to see to position yourself for profits.<\/p>\n

Key Metrics<\/strong><\/p>\n

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).<\/strong><\/p>\n

Here\u2019s what each of these metrics mean:<\/p>\n

CAC:<\/strong> Marketing dollars spent to acquire a new customer<\/p>\n

Churn:<\/strong> % of customers lost in a given period<\/p>\n

LTV:<\/strong> Expected net recurring revenue over the life of an average customer<\/p>\n

And here\u2019s how you calculate them:<\/p>\n

CAC<\/strong> = Sum of all sales & marketing expenses \/ # of new customers added<\/p>\n

Churn<\/strong> = Number of lost customers over a period \/ total # of customers at beginning of period<\/p>\n

LTV<\/strong> = Average Recurring Revenue per Customer per Year * Gross Margin * 1 \/ Annual Churn Rate\u00b9<\/p>\n

\u00b91 \/ 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.<\/p>\n

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.<\/p>\n

The Most Important SaaS Metric of All<\/strong><\/p>\n

Taken alone, the CAC and the LTV don\u2019t tell you much. But when combined, they become the most fundamental metric for any SaaS company: the LTV to CAC ratio<\/strong> (LTV divided by CAC).<\/p>\n

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.<\/p>\n

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:<\/p>\n

CAC payback period = CAC \/ (Average Recurring Revenue per Month per Customer * Gross Margin)<\/p>\n

As a rule of thumb, the CAC payback period should be 12 months or less for a healthy SaaS business.<\/p>\n

The challenge is companies don\u2019t have to report CAC, churn, and LTV. They are non-IFRS and non-GAAP measures. And sometimes management won\u2019t like to disclose them for competitive reasons.<\/p>\n

If you don\u2019t see the CAC\/LTV numbers in a company\u2019s filings, you should ask management directly. But if they are unwilling to give you them, here\u2019s an alternative way you can get the payback period on CAC:<\/p>\n

CAC ratio = Qn Sales & Marketing Expense \/ (Qn Gross Profit \u2013 Qn-1 Gross Profit) * 4<\/p>\n

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.<\/p>\n

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\u2019s 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).<\/p>\n

A Little Case Study<\/strong><\/p>\n

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!<\/p>\n

(Note that we have excluded Ackroo\u2019s latest acquisition, Dealer Rewards Canada, from calculations.)<\/p>\n

From our conversation with management, here\u2019s how the growth in merchant locations looks like:<\/p>\n

2015 Q1 – 1,000 locations
\n2014 Q4 – 900 locations
\n2013 Q4 – 675 locations<\/p>\n

Other key inputs (from Investor Presentation and discussions with management):<\/p>\n