Most tech start-ups end up being acquired. However, for SaaS businesses, incorrect performance evaluation usually lead to low valuations or stifling of negotiations if the acquiring company does not understand the performance metrics used in the SaaS industry.
In this article, we explore the performance metrics used by SaaS businesses and what CEO’s can do to ensure their potential acquirers coming from a GAAP background will evaluate them correctly.
Most acquiring companies consider the traditional generally accepted accounting principles (GAAP) when evaluating SaaS companies. However, SaaS companies used different metrics to measure performance. This disconnect between SaaS founders and potential acquirers used to GAAP principles usually stifles negotiations.
The “subscription economy” is relatively young compared to traditional software businesses. SaaS businesses operate under a different set of conditions and make revenues from subscriptions rather than sales. For the traditional software business, revenues are calculated based on sales that have already been closed.
For example, if a vendor sells a $99 software to 1,000 customers, investors can rightly estimate the value of the customers to be $99,000. However, with SaaS business, things are different. To begin, revenues are not calculated based on past sales, but on current and anticipated subscriptions.
A number of metrics have been adopted across the SaaS industry to help founders keep track of their performance. Metrics like MRR (monthly recurring revenue), ARR (annual recurring revenue), CMRR(committed monthly recurring revenue), churn, lifetime value (LTV), cost per acquisition (CPA) and others have become standard when measuring the performance of a SaaS company.
Since no standard rules have yet been established for the various metrics, founders have to work overtime to watch the numbers that are both important to them and their potential acquirers.
Bridging the Disconnect Between GAAP and SaaS Metrics
If your goal is to be ultimately acquired, you need to think of the metrics that your potential acquirer will be looking at. At the same time, you need to keep track of SaaS metrics. The key goals of any SaaS company should be profitability, MRR, cash, months to recover CAC, growth, and others (e.g. market share).
This does not need further explanations.
2. The MRR (Monthly Recurring Revenue)
This is one of the important numbers to watch. The MRR is the total revenue that your business gets in a month from subscriptions. To be more accurate with your revenue projection, you need to subtract the number of canceled subscription for the month before computing your revenues. This calculation will give you the CMRR (Committed Monthly Recurring Revenue).
3. Months to Recover CAC (Cost of Acquiring a Customer)
To determine the capital efficiency of your business, you need to know how long it will take for you to recover the CAC. Traditional businesses like wireless carriers and banking can afford long payback periods (over a year) before they recover their CAC because capital is cheap and abundant. However, in the SaaS industry where capital is scarce and expensive, you cannot afford a long payback. If you do not make a profit from your customer within 12 months, you need to go back to the drawing board.
Growth is usually a critical factor in measuring success in the start-up world. Evidence shows that when a company begins to make traction and gain market share, there is positive performance since customers prefer to buy from market leaders. The companies also get more discussions in the press, social media and blogosphere and this indirectly helps in lowering the cost of customer acquisition.
Determining Profitability using SaaS Metrics
GAAP metrics rely on back profitability i.e. sales that have already been made. When dealing with investors used to GAAP measurement, you can present your profitability in three ways:
1) Per customer (micro economic) Profitability
This refers to the profit that your business makes on a single customer. If your customer LTV (lifetime value) is greater than the CAC, then you have a great business. Generally, the LTV should be at least 3x than CAC for your business to be on the safe side.
2) Overall Profitability
This is the standard accounting methods of looking at revenues. i.e.
(Revenue – Cost of Goods Sold – Expenses )
Your revenue should be CMRR+ Services Revenue.
3) Profitability Per Employee
To check how your company fares against others in the SaaS industry, you can look at the factors that contribute to profitability on a per employee basis. To find this figure, divide your total expenses by the total number of employees. To be profitable, your revenue per employee must be higher than the expense per employee.
While profits, recurring revenue and churn rates may be the most important metrics to a SaaS business, traditional GAAP measurements that acquirers care about most should also be recorded if you will be seeking investors in future.
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