The SaaS (software as a service) industry has grown substantially over the past years to a towering $170 Billion after increasing 500% over the last 7 years. What led the market down such a high growth path?

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There are multiple reasons to start or invest in a SaaS business, and as we dive deeper into the inner workings of a SaaS company, you will understand why the SaaS model has served as a hotbed of innovation, business success, and capital raises.

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SaaS models and financial health

Netflix, HBO Max, Disney Plus, Hulu…whatever your chosen show/movie entertainment delivery modality might be - these are prime examples of SaaS models. You pay a flat amount every month and get access to those platforms and their content for free! This translates to Monthly Recurring Revenue (MRR) for the company. 

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For more information on planning for different revenue models, check out Intelligent Cash Timing Rules!

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Revenue

Because MRR represents recurring business (customers who will be billed automatically unless they cancel), stakeholders are better able to predict revenue, which leads to more efficient business decisions and increased investor interest. 

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You can calculate MRR through the following formula: (Total number of billed customers X Average amount billed each month) OR you can look at your monthly revenue and subtract any implementation revenue or one-time revenues that may have contributed each month. 

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Another common form of measuring revenue at a SaaS company is done through annualizing the MRR to get the Annual Recurring Revenue (ARR). Intuitively, ARR is simply calculated as: MRR X 12.

Churn

Wouldn’t it be awesome if users never canceled their accounts? Yeah, we think so too. However, cancellation is a natural aspect of running a subscription business, so it’s important to stay on top of how many users are canceling, and why. 

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Your churn has huge implications for your business: it indicates where you will stand financially a year from now, how satisfied your customers are, and how well you’ve achieved product market fit. 

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You can measure your gross MRR Churn Rate (or the % of recurring revenue lost each month) through the following formula: Gross Churn Rate = Lost revenue / Total Revenue

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On its own, this metric is powerful for understanding the health of your customer base. It also serves as a building block for management metrics that define your business health from an operational level. 

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Customer Lifetime Value

In any other industry, the amount of revenue a customer is worth is typically realized from their first exchange - customer pays vendor, vendor provides good - all done! 

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In SaaS, the relationship between vendor and customer is not transactional, but is a living, breathing, and evolving relationship. Since the customer is consistently paying the vendor, they’ve got to find avenues for continuously maximizing the value of their platform - these take shape in providing resources, training, support, community and best practices for their industry. This all culminates in reducing churn and increasing the Customer Lifetime Value or (CLTV), which takes into account all of what the customer pays throughout the relationship with the vendor.

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Before you calculate CLTV, you need to understand just how much your average customer pays, or the Average Revenue Per User (ARPU). You can calculate ARPU as: Total Revenue / Number of Users

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If we know that an account is worth $50/mo on average with a gross churn rate of 5%, we know that the average time with us will be 20 months. Then we can multiply ARPU ($50) by the average months of subscription (20) to get $1000 - our customer lifetime value.

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Your can measure your CLTV through the following formula: ARPU / Churn Rate 

Now that you know your CLTV, it’s important that you understand how much it takes to acquire each customer so you can adjust spend accordingly - tracked by Customer Acquisition Cost (CAC).

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You can measure your CAC through the following formula: (Cost of Sales + Cost of Marketing) / Number of Customers

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On their own, CLTV and CAC don’t show you the whole picture. However the CLTV/CAC Ratio is one of the most important SaaS metrics you could measure. The CLTV/CAC Ratio is simply calculated as: Cost of Sales + Cost of Marketing / New Customers

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With lifetime value and acquisition cost factored in, this metric tells you about the return on investment from all of your sales and marketing spend, while also speaking to the stickiness of your platform. 

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Investors typically see a CLTV/CAC ratio of at least 3 as ideal. However, this depends on your industry and lifecycle stage. For example, in a high growth industry, it might make sense to spend extra in Sales and Marketing, even if that results in a 2:1 ratio. The more your company matures, the higher you want your CLTV/CAC ratio to be, but if it goes over 6, you may be underspending in Sales and Marketing. 

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⚡️ Clockwork Tip: If your CLTV/CAC ratio is low, then you’ll likely want to allocate more resources to the post-sale onboarding experience, offering dedicated customer success and support, and improving your product to drive up Customer Lifetime Value. If your CLTV/CAC is high for your company, then it may be time to consider fueling your growth engine by spending more on sales and marketing. 

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All things considered, running a SaaS company is both fun and challenging! If you have any questions about running a SaaS company and how leveraging Clockwork can make it easy, feel free to reach out to our team.

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