The Software-as-a-Service (SaaS) market, expected to grow 25% in 2013 and reach $59 billion per Forrester Research, is quickly becoming the preferred software delivery platform for enterprises of all sizes from Fortune 500 to SMB. For customers, the advantages of SaaS are clear and compelling: sophisticated functionality without up-front costs, high internal adoption rates, and no hassle with installations or upgrades. For vendors, the model is low-barrier to entry and establishes recurring revenue, providing high visibility into future performance of the company. For investors or buyers looking at SaaS transactions, there is a short list of important metrics that are used to help understand value and to compare SaaS businesses.
- Recurring revenue: The concept of recurring revenue is most commonly discussed on a Monthly Recurring Revenue (MRR) basis and is arguably the most important metric for any SaaS business. MRR is computed by multiplying the total number of paying customers by the average amount paid per month. For a monthly subscription business, it is calculated using either the amount billed or invoiced; for longer term contacts, it is derived (for instance a $24,000 annual subscription contract has a monthly value of $2,000). The two ways a SaaS business can increase MRR is by growing the total customer base and/or growing the average monthly revenue per customer (ARPU).
- Churn rate: Is a measure of lost revenue. While there is no universal definition, churn rate is commonly expressed as a percentage of lost revenue or calculated as a percentage of lost clients. In general, churn can usually be attributed to low customer satisfaction; however, not all churn rates are treated equally (for instance the churn rate for an SMB or non-profit focused SaaS vendor would be expected to be vastly higher than an enterprise focused SaaS vendor given the propensity for SMBs to go out of business). For businesses with longer contracts that do not auto-renew, the major focus should be on renewals, as non-renewals add to churn.
- Gross margins: Calculated as the revenue minus the cost to produce that revenue, commonly referred to as cost-of-goods-sold (COGS). For most SaaS businesses, these costs are mainly related to infrastructure and customer support costs. Marketing, advertising, commissions, or other sales related costs would not fall under COGS. Gross margins for SaaS business often range between 60% and 95%, with the discrepancy being largely driven by the ease of use and deployment versus heavy support and installation.
- Customer acquisition cost (CAC): CAC is used to provide insights into the costs involved in acquiring new customers and corresponding payback periods. It can be measured as a dollar based ratio of the contract value ($ of customer acquisition costs per $ of monthly or annual contract value) or expressed as a payback time period based on gross margin (for example, if a company had $60 customer acquisition costs per $100 annual contract value with 80% gross margins, the payback period would be calculated as 60 ÷ 80 = 0.75x or 9 months). Included in the customer acquisition costs should be both variable and fixed costs (such as sales and marketing, salaries, commissions, overhead, etc.).
Next week we will be covering key metrics in an internet transaction.