Hello, SaaS founders and builders!
For some, SaaS metrics may be daunting but the truth is they’re really not as scary as they might appear. In fact, they’re your secret weapon, a vital navigational tool that guides your decision-making process, illuminates the path to profitability, and helps you steer clear of potential pitfalls.
Why SaaS is a different type of business
Before we get started though, it’s worth thinking about how SaaS differs from traditional businesses.
When you’re in the SaaS business, you’re not just selling a product or a one-time service. You’re essentially building an ongoing relationship with your customers where they subscribe to your service and generate revenue over an extended period — their entire customer lifetime.
This dynamic sets up a whole new perspective on profitability. If your customers are happy with your service, they stick around longer, and the revenue you can gain from them expands substantially. But, if a customer is not satisfied, they might churn quickly. In this case, the cost to acquire them (you’ll get to know this as the Customer Acquisition Cost or CAC) may not be recovered, let alone make a profit.
So, the SaaS model comes with a two key challenges:
- Acquiring customers: You’ve got to attract them to your service initially.
- Retaining customers: Then, it’s about keeping them around for as long as possible, to maximise the money they will pay you.
This dynamic underscores why customer retention is crucial and why we’ll pay special attention to metrics that help us understand retention and churn.
Ok, let’s get started!
Monthly Recurring Revenue (MRR)
MRR stands for Monthly Recurring Revenue. This metric represents the predictable revenue your SaaS business can expect to earn on a monthly basis from all its customer subscriptions.
MRR and ARR (see below) are key metrics in understanding the health of your SaaS business. Monthly recurring revenue provides a stable and predictable revenue stream which allows for more accurate forecasting and financial planning. A growing MRR is usually a strong signal of a healthy and growing business, making the company more attractive to investors.
Example: Lets say you have
- 50 subscribers paying £20/month for your Basic Plan, and
- 50 subscribers paying £40/month for your Pro Plan.
Therefore, your monthly recurring revenue is 50 x £20 + 50 x £40 = £3000
Annual Recurring Revenue (ARR)
ARR, or Annual Recurring Revenue, represents the monetary value of the recurring revenue components of your subscriptions, projected over an entire year. It can be calculated by summing your MRR for 12 consecutive months, or alternatively, by multiplying the annual contract value by the number of customers.
Example: If you have 20 customers on a £1200/year plan, your ARR would be 20 * £1200 = £24,000
Customer Acquisition Cost (CAC)
Whilst it’s great to understand how much your customers are bringing in, it’s also critical to understand how much it costs to acquire a customer in the first place.
Customer Acquisition Cost, or CAC, involves all costs associated with getting a potential customer to buy your product. This includes not only direct marketing and advertising expenses, but also overhead costs directly linked to these activities.
Here’s what might go into your CAC calculation:
- Marketing and advertising costs: This encompasses everything from digital advertising (like Google Ads, social media ads), content creation costs (blogs, infographics, video production), to traditional marketing methods like print or broadcast advertising.
- Sales and marketing team salaries: The proportion of your team’s salaries that is dedicated to customer acquisition is a key part of CAC. If your team spends half their time on customer acquisition and half on customer retention, for example, you would include only 50% of their salaries in your CAC.
- Software and tools: This includes the cost of marketing automation tools, CRM software, social media tools, email marketing platforms, and any other software used by your sales and marketing teams.
- Third-party services: If you’re using agencies or consultants for SEO, content marketing, social media management, etc., these costs should be included.
- Events and travel: If your acquisition strategy includes attending or hosting events, conferences, trade shows, or if your sales team travels to meet potential customers, these costs are included in CAC.
So to calculate CAC, add up all these costs over a specific time period, and then divide by the number of customers acquired during that same period.
Example: If in a month you spent £5000 on marketing and advertising, £3000 on sales and marketing salaries, £2000 on software and tools, £1000 on third-party services, and £2000 on events and travel, and you acquired 10 customers, your CAC would be: (£5000 + £3000 + £2000 + £1000 + £2000) / 10 = £1300
Churn
Churn refers to the rate at which customers cancel their subscriptions or stop using a service over a given period of time. Churn is a critical metric because it directly impacts a company’s MRR. You spent all that CAC on acquiring a new customer, so you really don’t want them to cancel!
Customer churn and revenue churn are both important metrics related to churn, and each offers a unique insight into the health of your business.
Let’s look at each in more detail:
Customer Churn (also known as Logo Churn)
Customer churn is the percentage of your customers that stop using your product over a given period of time. It’s calculated by dividing the number of customers lost during a period by the number of customers you had at the beginning of that period.
The formula is: Customer Churn Rate = (Number of customers at start of period - Number of customers at end of period) / Number of customers at start of period
Example: If you start the month with 200 customers and end with 190, your customer churn rate is (200–190) / 200 = 5%.
High customer churn could indicate issues with customer satisfaction or product/market fit. By focusing on improving customer service, onboarding processes, and product features, you can aim to reduce this metric.
Revenue Churn (also known as MRR Churn)
Revenue churn is the loss of revenue due to customers downgrading or leaving your service. Unlike customer churn, which only looks at the number of customers lost, revenue churn takes into account the size of those lost customers in terms of revenue.
The formula is, strangely, not dissimilar to calculating customer churn: Revenue Churn Rate = (MRR at start of period — MRR at end of period) / MRR at start of period
Example: If you start the month with an MRR of £20,000 and end with an MRR of £19,000, your revenue churn rate is (£20,000 - £19,000) / £20,000 = 5%.
A high revenue churn rate could indicate that you’re losing high-value customers, which can significantly impact your bottom line.
Negative Churn
So churn is not much fun.
Negative churn, however, occurs when your expansion revenue (through upsells, cross-sells or price increases) from your existing customers is greater than the revenue you’ve lost from those customers through downgrades or cancellations.
The formula is: Negative Churn Rate = (Expansion MRR — Churned MRR) / MRR at start of period
Example: If you start the month with an MRR of £20,000, lose £1,000 due to churn but gain £2,000 from customers upgrading their plans, your negative churn rate is (£2,000 — £1,000) / £20,000 = 5%.
Negative churn indicates that your SaaS business is growing organically, even without adding any new customers. This shows that your product is sticky and that customers find more and more value from your product over time.
Average revenue per account (ARPA)
How much, on average is each of your customer accounts paying you each month. We’ll see this metric appear in the calculations of other metrics shortly…
Here’s how to calculate ARPA: ARPA = Total MRR / Total Number of Customers
Example: Your total MRR is £10,000 and you have 50 customers, so your ARPA is £200.
Lifetime Value (LTV)
Lifetime Value, or LTV, is a prediction of the net profit attributed to the entire future relationship with a customer. It is an important metric as it helps businesses ascertain a reasonable cost per acquisition.
How to calculate LTV: Lifetime Value = ARPA / Revenue churn rate
Example: Your ARPA is £200. Your revenue churn rate is 5%. So your LTV is £200/0.05 = £4000.
LTV:CAC Ratio
The LTV:CAC Ratio compares the cost of acquiring a new customer (CAC) to the predicted revenue from that customer over the course of their relationship with your business (LTV).
If you spend more to acquire a customer than the revenue they generate, you’re losing money on every new customer, indicating a need for adjustment in your strategy.
The formula for this is: LTC:CAC Ratio = LTV / CAC
An ideal ratio is around 3, meaning the value of a customer is three times the cost of acquiring them.
Example: If your LTV is £300 and your CAC is £100, your CAC:LTV ratio is £300/£100 = 3, which is good! It indicates that for every pound you spend on customer acquisition, you’re making £3 in return.
Payback Period (or Months to recover CAC)
The Payback Period is the amount of time it takes for your company to recoup its investment in acquiring a customer. In other words, it’s the amount of time it takes for a customer to generate enough revenue to cover the CAC spent on getting it to buy in the first place.
The formula is: Payback Period = CAC / ARPA x Gross Margin
To calculate monthly Gross Margin, you’ll first need to determine your monthly total revenue and monthly Cost of Goods Sold (COGS), then plug these values into the Gross Margin formula: Gross Margin = (Total Monthly Revenue - Monthly COGS) / Total Monthly Revenue
COGs will vary from company to company, but might include things like hosting and cloud, infrastructure maintenance and software licenses that directly support your development team.
If you already have an annual Gross Margin and it doesn’t fluctuate significantly month-to-month, you could use that in your Payback Period calculation.
However, it’s generally more accurate to use monthly figures, especially for growing SaaS companies where financials can change quite a bit month-to-month.
Be mindful that total monthly revenue is not the same as MRR. It can include all types of revenue, such as one-time sales, consulting revenue plus recurring revenue from subscriptions and any other income.
Example: If your CAC is £100, your MRR per customer is £20, and your Gross Margin is 85%, then your payback period would be £100 / (£20 * 0.85) = 5.88 months.
We’ll dive deeper into Payback Period in our next article!
There are of course many more metrics you can measure and track, but these are a good starting point. They can give you insights into your business’s performance, help identify potential problems before they become too big, and provide clear indicators on where you should focus your resources for the greatest impact.