It's undeniable that the software-as-a-service (SaaS) model has become the de facto standard in both enterprise and consumer software alike. Subscriptions have taken over and they aren't going anywhere soon.
As I noted in a previous article, the demand for SaaS products is showing continued growth. SaaS startups are typically a little cheaper to start and easier to get going than other kinds of companies, but they have their own set of challenges.
For SaaS founders, it can be difficult to know how your company is progressing. Here are some initial metrics to help you determine if you are on the right track.
1. Gross margin
Gross margin is a metric that should be understood by all types of business leaders, but is it equally important to SaaS founders. Simply put, the gross margin is the amount of revenue retained by the company after subtracting the cost of goods sold (COGS), usually measured as a percentage.
An easy formula to find this percentage is the remainder after subtracting COGS (revenue minus COGS) divided by the revenue.
"Gross margin is an indication of that company's ability to command pricing," said Joe Floyd, a principal at Emergence Capital Partners.
Typically, a SaaS startup will receive revenue for both software and services. It's important to remember that recurring software revenue should be measured differently than services revenue.
"The best SaaS companies at scale are going to have 80-85% gross margin on software, and on services anywhere from 30-70%," Floyd said. "It really depends how strategic the services are."
If your company's services are mainly a simple implementation of the software, Floyd said, you'll probably land closer to 30%, but if your services include proprietary thought leadership it could be closer to 70%. Be aware of offering too many services, as it could negatively affect your gross margin.
2. Customer acquisition cost
Another metric that SaaS founders should be measuring is their customer acquisition cost (CAC). Ben Brooks, of Southern Capitol Ventures describes it this way: "To me, it's all the fixed and variable costs incurred in order to bring each individual client in."
CAC is important, first off, because it gives you a better vision of what it will cost to grow your client base, essentially what it will cost to grow your business. In calculating your CAC, you can then calculate how long it will take to pay that money back, a timeframe known as the payback period.
According to Christian Jensen, a principal at Accel Partners, the payback period can be understood as how many months of gross margin it will take to pay back the costs incurred during customer acquisition. It speaks to the marketing and sales efficiency of the business, he said, and it call tell you if you have a healthy gross margin profile for future growth.
It's difficult to give an exact payback period for all companies, but there are some best practices. Brooks said that he looks for companies that can pay it back within 12 months.
"Depending on how long it takes to recover that acquisition cost, is how much funding is going to be required to get a company to profitability," Brooks said.
3. Churn rate
The churn rate of a business is the percentage of clients you lose in a year's period. Simply put, how many clients declined to renew their subscription to your product at the end of the year.
"In one word, you could call it 'turnover,'" Brooks said.
The complementary metric is retention rate, the percentage of existing clients who renew their subscriptions. For SaaS startups, that number needs to be very high.
"Early days, the only customers you should be losing are pilot customers that, basically, you sold before you had a product and maybe they didn't renew in a year because it wasn't what they wanted," Floyd said.
Regardless of the type of product you are selling, SaaS startups should have at least a 90% retention rate. The ideal, however, is to be as close to 100% retention as possible.
"Strong renewal rates and strong retention rates are the best validation that the current version of the product is doing what the brand says it would or should, or the marketing said it would or should," Jensen said.
Measuring customer retention rate and churn rate is only part of the equation. SaaS founders should also be measuring their dollar retention rate as well.
"I like to look at this both on a logo and a dollar basis — it tends to be that adding revenue quickly is wildly important, but if you're losing it at a similarly fast pace all that effort is worth very little," said Alexander Niehenke, a principal at Scale Venture Partners.
If your churn rate is greater than 0%, that means you are potentially losing revenue every year. Measuring your dollar retention is a good way to make sure this doesn't happen. Floyd said that a SaaS startup should have a dollar retention rate greater than 100%, meaning that you are taking steps to make up revenue lost to your church rate.
According to Jensen, companies should be looking for upsell or expansion opportunities within the existing customer base. Are there more users spreading through an organization, or are you releasing more sellable features that could be useful to them?
4. Annual contract value
As the SaaS model is driven by recurring revenue, it is important to look at how quickly a company is adding new contract bookings. Particularly, we use a metric called annual contract value (ACV) to separate new contract booking from renewal bookings, and to isolate the per-year value out from the total contract value (TCV) of multi-year deals.
According to Floyd, revenue growth is the main driver behind startup valuation. In a SaaS startup's early stages, he said, the growth of new ACV bookings is a good proxy for future revenue growth. Specifically, Floyd said that the best companies are tripling ACV bookings year over year, and the good companies are doubling.
Even just looking at the average ACV can prove advantageous, according to Niehenke, because it can help you better understand your customers.
"Business can succeed with a small or a large ACV, but this helps me understand the customer type and ask intelligent questions to see if the go-to-market matches the customer type," Niehenke said.
5. Sales and marketing efficiency
Because much of your success hinges on revenue growth, which usually requires growth of the customer base, it is essential to examine the efficiency of your sales and marketing.
If you look at it in terms of ACV bookings growth, Floyd said it can be measured by dividing new ACV bookings by the sales and marketing cost in the period it took to get those bookings.
Some folks look at it in terms of revenue, or revenue growth. Niehenke, who calculates it based on revenue growth, measures sales and marketing efficiency as "the change in revenue from one period to the next annualized and divided by the [sales and marketing] spend"
However you look at it, the bottom line is that you want the money you invest in sales and marketing to return more than what you put in.
"Best in class companies are going to get you two dollars of new bookings for every dollar of sales and marketing cost," Floyd said.
These metrics are, by no means, an exhaustive list of what you should be measuring as a SaaS founder, but they are a good starting point. A key thing to remember, also, is that there is a whole other set of qualitative characteristics that play into a successful startup.
"It's not like there's one metric to rule them all," Jensen said. "To build a great company, a lot of things need to be clicking."
What do you think?
What do you think are the top metrics to measure for SaaS startups? Post your insights in the comments.
Conner Forrest has nothing to disclose. He doesn't hold investments in the technology companies he covers.
Conner Forrest is a Senior Editor for TechRepublic. He covers enterprise technology and is interested in the convergence of tech and culture.