We often write about SaaS metrics. Whether it’s multiples, net revenue retention or unit economics, we think it’s massively important to know what are the benchmarks to correctly assess the financial health of a company, especially in a sector that is at the same time so new yet so crowded already.
In this blog, we want to focus on how some key metrics that you (should) already know become more or less important depending on the evolution stage of a company.
Just to be clear, this is a very simplistic view. In the real world, there are many more factor to keep into consideration, but we think it’s good to know when and how to shift a company’s focus towards different metrics, each requiring efforts from the relevant business units.
Growth, at least according to the current model of start-up capital funding, is the first signal to look for when investing in a successful business. Growth at the earliest stages of a company indicates that there is at least a perception that its product is addressing a need or bridging a gap in the market.
For a SaaS business this means that customers are signing up, show interest in the product and revenues are climbing week on week. For a Seed-stage company, a solid growth rate is typically above 100% Year-on-Year. Famously, Y Combinator co-founder Paul Graham looks for 5-7% weekly growth. This, thanks to the power of compounding, translates to 12.6x annually!
Focusing on growth, explains Graham helps a business remain receptive of customer needs, potentially adapting and pivoting its whole business model, as proven by some quite high-profile pivoting success stories, from the likes of YouTube and Instagram.
It’s important to note, however, that an excessive struggle generating revenue growth should be treated as the first red-flag for poor product-market fit. Adoption rates are naturally lower when a product is first launch, but if growing 100% Year-on-Year requires a marketing budget that’s ten times the revenue, then maybe there is not as much of a market gap for the product to fill.
Churn is every SaaS Founder’s worst nightmare. No matter how fast you’re growing, if your churn rate is high enough it will all be in vain. As your company approaches later stages (Series A+), this metric becomes more and more important, and will receive a lot of attention from investors.
“Churning” customers, meaning that people are cancelling or not renewing their subscriptions, is a clear indicator that although there is a need to be addressed in the market, your product doesn’t do that well enough – or at the right price. Basically, your product/market fit wasn’t right.
Churn is typically measured in three different ways.
- Customer Churn measures the rate of users canceling their subscription against the total users. This metric is good for more established services that focus on customer loyalty, while early-stage businesses can have expectedly high customer churn due to a broad marketing campaign that hasn’t been targeted narrowly enough yet.
- Revenue Churn measures the percentage of revenue lost to customers cancelling against the total revenue. This metric can be especially useful when offering a free trial, or many different pricing tiers, as it helps understand how valuable the customers that are leaving really are.
- Net Churn is similar to revenue churn, but it takes into consideration the possible upgrades or upsells of existing customers taking on additional services, therefore bringing in additional revenue that sometime offsets the income lost to churned customers.
3. Gross Margin
While a company is raising its Series A or Series B rounds, it’s widely accepted that it’s still burning through cash, sacrificing profit to gain market share, but that can’t last forever.
For later-stage companies approaching ripeness for an exit, investors would like to see that their bet is likely to return. As later-stage companies usually require more capital to scale, it’s important to have some sort of guarantees with respect to how the company is going to be profitable, and whether its business model is sustainable at all.
This is summarised by the gross profit margin, which is the difference between the revenue and the cost of providing the service, divided by the revenue.
Calculating gross margin can be tricky for some SaaS businesses, as some business activities such as customer service are in a somewhat grey area between marketing, sales and operational costs. That is part of the reason why companies such as WeWork and Uber recently faced a moment of reckoning, having to slash their respective valuations according to their real ability to make profits.
A rule of thumb often employed by investors when assessing the financial health of a SaaS business is The Rule of 40. This rule states that as long as the sum of growth rate and profit margin is 40% or above, then the company is worth investing in. The beauty of this simple rule is that it seems to apply to so many different scenario: a company with a 100% YoY growth rate with a -60% gross margin is just as valuable as one with a 20% growth rate and a 20% gross margin.
Of course, there’s nothing scientific – maybe not even data-driven – about the rule of 40%, but its utter simplicity makes it a very useful benchmark to always keep in mind as a SaaS Founder.