How to Measure Subscription Metrics
Metrics Matters, Just Look at Your Business Valuation
With marketing moving largely to digital, measuring results has never been easier. But, the question remains which ones are the ones that really matter, otherwise you could go down a rabbit hole of numbers that only lead to more questions instead of answers. Fortunately, when you really dig in, only several of those metrics really matter. For our purposes here, we’ll break those numbers down and help you determine what’s right for you in your stage of company development.
While it seems obvious, you’d be surprised at how many organizations give their revenue metrics only surface attention - either making the number or not making the number. Why it’s actually important goes to the heart of your organization - product market fit, customer retention, and overall market expansion. You can’t build an empire without a solid foundation and you can’t build a real company without predictable revenue.
There are two types of revenue modern SaaS companies make - either monthly or yearly - as these are the time measures that subscriptions are sold - Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR). If you happen to be one of those companies that sells both, you can either choose the metric that represents the majority of revenue - or simply track both if your services are differentiated from each other - an enterprise vs consumer service for example.
Here are some other examples of additional revenue categories that you will likely need to take into consideration:
- Retained - retained from existing customers;
- Expansion - added from existing customers;
- New Contract – added from new customers;
- Resurrected – added from former customers;
- Contraction – lost from customer downgrades; and
- Churned – lost from churned customers
When looking at any SaaS business models, these extensions give further clarity into how well your business is doing and how happy your customers might be at a given time during the year.
Retention is analyzed by grouping customers into “cohorts” according to their sign-up period (month, quarter or year), then tracking the percentage remaining over time. Understanding the retention rates of your customers - typically at the one or two year contract anniversary - is critical to the health of the business.
There’s a couple of different ways to analyze retention:
- Dollar Retention – Also known as Net Revenue Retention (NRR), Dollar Retention measures how much revenue a customer cohort is generating in each period relative to its original value. Dollar Retention takes additional expansion/cross-sell revenue into account, and should be greater than 100% if expansion + contracted revenue exceeds churn or contracted. The leading SaaS companies will have around a 120%+ Dollar Retention rate annually. Dollar Retention of less than 100% per year is an indication of a lack of customer satisfaction and needs to investigated - fast!
- Logo Retention – Logo Retention measures those customers that stay active (non-churned). Logo Retention can never be greater than 100% since the number of logos can’t expand in retention scenarios.
3. Sales Efficiency / Key Investor Reports
As a start-up you likely have a group of investors who sit on your board and to whom you must report your quarterly results. These metrics have become much more important for investors to have a sense as to how effective your sales and marketing programs are. There’s lots of tricks that can be employed to make it seem that the company is more profitable than it is or more effective at attracting customers through higher rates of spend. These metrics help the Board or your investors to understand your overall sales efficiency by comparing the value of new customers to the cost of acquiring them:
- New Sales ARR vs S&M Expense – How much did the Sales & Marketing (S&M) departments (inclusive of all programs and personnel) spend compared to how much New Sales ARR (ARR from new customers only) was added in the same period? Ideally, New Sales ARR is equal to or greater than S&M spending.This seems obvious in that for marketing programs to truly be revenue positive they should be doing better than just breaking even or worse - losing money. The old saying that it only takes one to pay for itself isn’t quite good enough anymore. To be truly successful, a marketing program must be driving anywhere from 2-5X more in revenue than in costs.
- Customer Acquisition Cost (CAC) –divides the total S&M expense from the preceding period (month or quarter) by the number of new customers in the current quarter. The lag reflects the period for an S&M investment to generate new sales. A longer or shorter lag may be more appropriate depending on the average length of the sales cycle and the typical conversion velocity.
- New ACV vs CAC – It’s useful to compare Annual Contract Value (ACV) of new customers to their CAC. Ideally, your ACV is greater than your CAC, meaning that your customer acquisition does not cost more than their first year’s revenue - otherwise, you’re selling too low and paying too much to attract those customers.
- Magic Number – Magic Number is the Net New ARR in a quarter divided by S&M expense from the prior quarter. We would expect the ratio to be greater than one. This is one of the best ways to determine if your sales and marketing efforts are truly effective in delivering revenue or just doing lead generation. I would highly recommend that this be on of your key measures to help guide your business.
These metrics will not only help you in driving more effective programs based on net-profitability, but hopefully keep expenses in check by investing in those programs that are the most cost effective as well.
- Gross Margin – Gross Margin reflects your company’s margin after subtracting the cost of goods sold (COGS) from revenue generated in the same period. For SaaS companies, COGS typically consist of hosting costs, any data or software needed for the product to operate, and the cost of frontline operations. There can be good reasons for lower gross margins early in a company’s lifecycle, but in the long-term, SaaS companies should have a Gross Margin of at least 75%. Persistently low Gross Margins can be evidence the company is using humans to perform the product capabilities (i.e. it’s not a pure play software company) which can create a host of other problems for the company - like fraud charges for example. Watch these numbers and if they start going in the wrong direction, be prepared to have a chat with your head of products to understand why.
- Lifetime Value (LTV) – LTV is the cumulative gross profit contribution, less CAC, of an average customer in a cohort. Therefore, LTV incorporates CAC, Dollar Retention, and Gross Margin to show overall company health. If Dollar Retention is greater than 100%, LTV can increase indefinitely. However, if customers churn, LTV will flatten out and stop increasing. Healthy cohorts cross the $0 LTV line before month 12, and LTV grows to at least 3x original CAC over time.
5. Capital Efficiency
As a startup your initial ability to operate comes from the investments made by your early venture partners. Watching the amount of cash on hand, especially in the days before you’re an established player is critical to your ability to grow the business to be self-sustaining. Blow your cash too quickly, you have to make another round and further liquidate your share value. Keep your cash controls tight, you live to fight another day without having to hunt for new investors. Definitely a plus for most CEOs. No one enjoys hunting for money with your back to the wall.
- Burn Multiple – The Burn Multiple is a company’s Net Burn divided by its Net New ARR in a given period (typically annually or quarterly). This formula evaluates your burn as a multiple of ARR growth. In other words, how much cash are you burning in order to generate each incremental dollar of ARR? The higher the Burn Multiple, the more the startup is burning to achieve each unit of growth. The lower the Burn Multiple, the more efficient the growth is. For fast-growing SaaS companies, a Burn Multiple of less than one is amazing, but anything less than two is still quite good. If a startup has a high Burn Multiple but low CAC, that could indicate that S&M costs have been miscategorized.
User engagement has taken on new relevance for SaaS startups, as free trials or freemium users are more likely to convert to paid accounts when they have high engagement. Once paid, highly engaged accounts are also less likely to churn. There are two main measures of engagement:
- DAU/MAU – The ratio of daily active users to monthly active users. A good metric for most SaaS startups is 40% DAU/MAU during non-holiday weekdays, meaning that the typical monthly user visits the site at least two work days per week or 8 times per month. In general, you can see the non-holiday weekday usage by eyeballing the crests of the chart:
- DAU/WAU – The ratio of daily active users to weekly active users. A good metric for most SaaS startups is 60% DAU/WAU during non-holiday weekdays, meaning that the typical weekly user visits the site 3 out of 5 weekdays.
We hope this primer has provided you with some important insights into how to best measure and manage some of the key metrics that drive successful SaaS companies.