This post is by Joel York from Chaotic Flow by Joel York
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My first serious lesson in the criticality of SaaS metrics was about six years ago when I was unexpectedly stumped in a board of directors meeting. I had just presented the booking plan for the year and one of the Director’s in the meeting said that the plan was good, but we really needed to increase our booking rate. My first reaction was something like: “Well our current booking rate is pretty strong and we’re a SaaS business, so even with no immediate improvement to bookings we’ll continue to pile up revenue quarter after quarter, right?” Wrong! I had totally neglected the impact of churn. At the time, SaaS investors and executives were still getting their heads around the SaaS recurring revenue business model, so there were very few resources to turn to for support. Yet as the person in the room primarily accountable for the top line, I had to have the answer.
Fast forward to today. In 2014, we not only have a much better understanding of the financial levers that drive SaaS business success, we are on the verge of a metrics revolution in the way SaaS businesses are managed. Unlike licensed enterprise software, the SaaS recurring revenue business model offers a much higher degree of stability, measureability and predictability. These three factors form a foundation that enables SaaS executives to take a much more analytical approach to driving SaaS business success. SaaS business executives are uncovering new operational metrics that connect SaaS customer success to SaaS financial success, and in the process are creating recurring revenue machines. Today we are witnessing the emergence of The Metrics-driven SaaS Business.
This is the first post in a new SaaS metrics series inspired by my ongoing collaboration with Bluenose Analytics. This series explores the promise of customer success metrics and their role as the glue that connects SaaS customer success to SaaS financial success. This first post discusses the unique qualities of SaaS that enable a more analytic approach to management than was possible with licensed enterprise software and introduces the concept of the Metrics-driven SaaS Business.
The SaaS Metrics Mandate
Why are metrics so uniquely important in SaaS? Every business tracks some relevant set of financial and operational metrics. What makes a SaaS business different? A SaaS business is different because of the recurring revenue subscription model. In fact, most of what follows applies equally well to any subscription business. The economics of a subscription-based business are fundamentally different from those of a transaction-based business. That difference derives from a simple probability. In SaaS, today’s customers will probably be tomorrow’s customers, as long as we keep them happy. In a transaction-based business, no such probability exists.
SaaS Business Stability
The recurring revenue subscription model creates business stability. As recurring revenue accumulates, short term bookings have less and less impact on short term revenue. Short term revenue and costs alike become a function of long-term historical bookings. The feast-or-famine, deal-centric nature of licensed enterprise software gives way to a stable recurring revenue stream and a process-centric business operation. When you know you will have customers tomorrow, you can invest in the support of those customers, as well as the acquisition of new customers, with a much higher degree of confidence. Operations become more reliable and predictable, lending themselves to standardized processes that can be continuously improved. SaaS businesses are recurring revenue machines, and machines are best managed by metrics.
SaaS Business Measurability
SaaS businesses are also uniquely measurable. The SaaS product creates an always-on, communication channel between the company and the customer that allows for direct measurement of customer interaction. This link gives SaaS businesses unique access to operational metrics that provide a much more detailed view of the customer relationship than simple financial metrics alone. Every business can count cash, but only a SaaS business can count customer clicks inside the product. Product usage data is an operational goldmine when properly collected and analyzed, enabling a SaaS business to improve customer success, reduce churn and increase upsell. Moreover, a SaaS business can integrate its business processes and communications directly into its SaaS product, giving product-related metrics new meaning that goes well beyond the number of times a customer logged in today. The more a SaaS business embeds its business operations into the product, the more measurable its business becomes.
SaaS customer success metrics provide the glue that connects SaaS customer success to SaaS financial success to create a SaaS recurring revenue machine.
SaaS Business Predictability
Together, stability and measurability give rise to a new level of predictability. The mass amounts of historical financial, operational and behavioral data available to SaaS businesses enable predictive analytics that are virtually unheard of in B2B companies. B2C companies have always had the law of large numbers working in their favor, enabling a wide array of statistical methods for planning and forecasting. B2B companies have always suffered from a dearth of data for planning purposes, forcing an overreliance on ad-hoc information and the subjective judgments of managers. In the mature Metrics-driven SaaS Business, financial forecasting is a science grounded in customer success metrics and predictive analytics.
The SaaS Metrics Universe
In the SaaS business model, the ongoing customer relationship is a continuous source of revenue, cost, business activity and risk. This contrasts sharply with traditional software where the short-term sales transaction has always taken center stage. A traditional licensed software vendor makes and sells software copies, whereas a SaaS business makes and rents ongoing service subscriptions. Each new SaaS customer brings a new thread of recurring revenue and cost which are woven into the larger tapestry of customers to create the total SaaS recurring revenue stream and associated SaaS total cost of service. This fundamental shift in the unit of value from copies to customers turns the economics of licensed software upside down.
Customers Form the Center of the SaaS Universe
In traditional licensed software, value is equated to the intellectual property of the code, and is monetized using copyrights in a fashion similar to books, music, and movies. It’s a product. Product volume is measured in copies sold and product value is measured by the price of a copy. In the SaaS business model, service volume is measured by the number of customer subscriptions and service value is measured by the recurring revenue of each subscription. A software vendor invests in developing code, and then operates a sales and marketing infrastructure that scales to sell more copies. A SaaS business invests in acquiring customers, and then operates a service delivery capability that scales to service customer subscriptions. Mathematically, the contrast looks as follows:
Software profit = ( price per copy – cost per transaction ) x copies sold – R&D costs
SaaS profit = (avg recurring revenue – avg recurring cost ) x current customers
– avg acquisition cost x new customers
Customers are the fundamental unit of measure in the SaaS business model, not transactions. Whereas profitable transactions drove financial success in licensed software, profitable customers drive financial success in SaaS. SaaS customer success is SaaS business success.
Connecting SaaS Customer Success to SaaS Business Success
Measuring and monitoring SaaS financial metrics are essential to managing a SaaS business. If SaaS executives don’t understand recurring revenue, acquisition cost, churn and upsell, then they have no ability to grow the business. As important as they are though, financial metrics only measure the ends, not the means. They say nothing about how those results were achieved, or how those results can be improved upon in the future. A smart SaaS CFO can construct a SaaS business forecast based on historical SaaS financial metrics. Reduce churn from 20% to 15%, improve upsell by 20%, reduce acquisition cost by 10% and next year looks great! Unfortunately, such a high-level model provides no insight into how to make the forecast a reality.
The emerging Metrics-driven SaaS Business digs beneath well-worn SaaS financial metrics to uncover the operational levers that drive SaaS business success. For example, it’s a verifiable fact that customers that use your SaaS product are less likely to churn than customers that don’t. So, if you want to get serious about churn reduction, then you have to get serious about measuring product use. At a minimum, you will get a better understanding of what causes customer churn. At a maximum, you will discover patterns and predictive analytics that enable you to take preventative action before they do. Customer-centric operational SaaS metrics, or simply SaaS customer success metrics, provide the glue that connects SaaS customer success to SaaS financial success. Together, SaaS financial metrics and SaaS customer success metrics provide the foundation for building the Metrics-driven SaaS business.