Growth isn't easy, regardless of what kind of business you're running. SaaS companies have the added complication of needing to sustain that growth over a long time. (Lucky us!)
That's because SaaS companies rely on future revenue to a much greater extent. In more traditional business models, the majority of revenue is collected at the time of purchase, and retention (or repurchase rate, for e-commerce companies) makes up only a small percentage of revenue. For SaaS companies, however, revenue is distributed evenly across an extended period of time.
If a customer is unhappy, they'll quickly move on to greener pastures, causing you to lose money on the up-front sales and marketing investment you made to gain that customer in the first place. If too many customers are churning before you're able to earn back that investment—a time period often extending into months or even years—your business simply won't be sustainable.
This makes customer retention critical for SaaS companies. Decisions you make today drive future performance, and traditional business metrics aren't always able to account for the challenges of a business that relies on recurring revenue.
The key metrics for SaaS founders to understand, then, are all centered around generating future growth. Understanding key SaaS growth metrics like customer lifetime value, customer acquisition costs, and churn rates can make a big difference to future results.
Let's dive in.
The 6 SaaS growth metrics that matter
Churn rate is by far the most important metric for SaaS founders to understand.
There are two types of churn you'll need to consider: customer churn and revenue churn. Customer churn measures the number of customers or accounts leaving your service each month as a percentage of your overall customer count. Revenue churn measures the amount of revenue paid by customers leaving your service each month, as a percentage of overall revenue.
For most SaaS companies, it's more helpful to measure revenue churn, since it provides a better indicator of the health of the business than customer churn.
For very early-stage SaaS companies, tracking churn isn't massively helpful—when you have only 100 customers, it isn't too difficult to find 2 or 3 new customers to replace those who have churned. However, as the company grows, minimizing churn becomes a much more critical goal. That 3% churn rate, translated to a million customers, means losing 30,000 customers every month. Replacing that many customers on a monthly basis is simply unsustainable.
Churn also compounds over time—a 3% monthly churn rate turns into a 31% churn rate when annualized, meaning you need to replace nearly a third of your entire customer base just to maintain the same revenue. The more customers you have, the more you need to invest in retaining those customers before you can even think about growing further.
2. Monthly recurring revenue (MRR) / annual recurring revenue (ARR)
Your monthly recurring revenue measures how much revenue all your customers are generating in a single month. Multiplying this value by 12 months gives you the annual recurring revenue, or “run rate.” While you can work out your MRR manually, you can also use tools like ProfitWell to calculate all your SaaS metrics for you in real-time.
ARR = 12 x MRR
Recurring revenue is what makes the SaaS business model so appealing. As long as you continue providing value through your service, your customers keep paying you, each and every month. Unfortunately, many SaaS companies fall into the trap of undervaluing their services, and don't charge enough to make the business sustainable. By iterating on your pricing strategy until you're charging enough to allow consistent growth, your SaaS company can become self-sustaining much earlier.
3. Lifetime value (LTV)
Lifetime value is, quite simply, the total revenue generated by a customer over their lifetime. The longer customers keep using your service, the higher their lifetime value will be.
LTV = ARPA / Churn
The simplest way to calculate lifetime value is to average the monthly revenue each customer brings in across all your accounts, and multiply that average revenue per account (or ARPA) by the average number of months the customer keeps using your service. You can also divide ARPA by the revenue churn rate to get the same result:
4. Cost of acquiring a customer (CAC)
CAC is a measurement of the amount you spend on sales, marketing, and other associated costs in order to acquire a typical customer. You can work this out by taking the total amount spent on sales and marketing across a given month—including salaries and other related expenses—and dividing that by the number of customers acquired during that same period.
The cost of acquiring customers relates closely to the lifetime value you gain from each new customer—for a SaaS business to be viable, you need to be making more profit from your customers than it costs you to acquire them. In reality, the LTV needs to be much greater than the CAC to allow the business to stay profitable in the long run. A good rule of thumb is that lifetime value should be at least 3X larger than the amount spent to acquire a customer.
LTV > (3 x CAC)
One complication for most SaaS companies is that the cost of acquiring a customer is often much greater than the monthly revenue that customer generates—sometimes it takes months or even years to earn back that investment. Startups often find their growth is restricted by the amount they're able to spend on acquiring customers, and that cash flow is difficult in the first couple years.
Recovering the CAC quickly frees up cash flow that can then be reinvested into marketing—SaaS companies should be recovering this cost within twelve months to remain healthy.
5. Expansion revenue
One way to combat the inevitable effects of churn is to focus on expansion revenue. Expansion revenue covers increases in MRR (or one-time payments) when an existing customer upgrades to a more expensive plan.
Expansion revenue is important, as it can actually push your effective churn rate into the negatives. First coined by David Skok, negative churn occurs when expansions or upsells exceed the value you're losing each month due to revenue churn. Say you have 100 customers, and in a given month you lose 10 customers to churn (we'll assume everyone's paying the same amount each month for simplicity). If you're able to drive more usage and revenue with the remaining 90 customers than you lose from the 10 churned customers, your churn rate will be negative.
Expansion revenue is often easier to gain, as well: It's much easier and cheaper to upsell customers to more powerful versions of your product than it is to acquire net-new customers.
Shifting your goals from a model that narrowly focuses on net-new acquisition to a one that prioritizes expansion revenue can have a dramatic impact on growth:
6. Net promoter score (NPS)
Unlike the financial metrics above, net promoter score is a direct measurement of how much value your customers are gaining from your product.
Measuring NPS allows you to quickly find out why customers might be dissatisfied and to use their feedback to improve your product. While early-stage startups might not have enough customers to get an accurate measurement of their NPS, the qualitative data gained from customer feedback is still helpful for determining whether you have product/market fit.
To measure NPS, you can survey your customers with a simple question: “How likely are you to recommend us to a friend or colleague?”
Customers can answer on a scale from 1 to 10, with 1 being the least likely to recommend and 10 being the most. Detractors—scores 6 or below—can then be followed up with directly to find out exactly what's making them unhappy with your service.
Measuring SaaS metrics to make better growth decisions
Now that you know which metrics actually matter, what do you do with them? How can you act on your measurements to improve your SaaS business? After all, collecting more data is only helpful if it helps you answer questions and take action.
The data that you collect for the key metrics above should help you find answers to the following essential questions:
Is my SaaS business financially viable?
For any business to be financially viable, it needs to be generating more money than it spends, and SaaS companies are no exception.
To review some rules of thumb:
- Healthy SaaS companies should have a lifetime value at least 3X higher than their customer acquisition costs.
- Healthy SaaS companies should be recovering their customer acquisition costs within 12 months.
- Healthy SaaS companies should focus on offsetting churn using expansion revenue.
By following these rules of thumb, you'll ensure your company won't be losing money on every new customer, and that the company will begin seeing positive cash flow before you run out of capital.
A great strategy for improving cash flow and increasing average lifetime value is to encourage customers to sign up for a discounted annual subscription, instead of monthly. This makes the entire first year of payments available to the company immediately, while also saving the customer money on their subscription fees.
Here at Appcues, we offer a discount for annual subscriptions, to help encourage customers to take advantage of paying yearly.
What's working well, and what could be improved?
Tracking changes in revenue churn can help identify when customers aren't happy with your product—if churn is rising each month, it's a strong sign something needs to change. To find out what changes you should make, the best option is to talk with customers who have churned or are at risk of churning—tracking NPS can help identify these at-risk customers.
(Psst—Tools like Appcues can help you reduce churn through more effective onboarding, or measure your NPS scores and find opportunities for improving your user experience.)
What are the main levers we should be focusing on?
Not all customers are created equal—the above metrics help you understand which customer segments are the most profitable, and how to best invest your resources and target your marketing message.
As mentioned earlier, earning more from your current customers is almost always easier and more cost-effective than acquiring net-new customers, so focusing on increasing expansion revenue pays off handsomely for most SaaS companies.
One great way to build this into your pricing strategy is to increase your pricing based on the customers' usage of your product—as they increase the number of seats used, for example, or the number of emails sent, the price increases. This also gives you the ability to offer your product at a lower cost to customers who might otherwise find your product's cost prohibitive.
Break down customer acquisition costs by channel, instead of only looking at the aggregate cost. While channels like PPC advertising might be quicker to ramp up, you'll typically end up spending more to acquire each new customer. You may be better off focusing on more cost-effective acquisition channels, like content marketing.
When is the right time to accelerate growth?
Without a growing stream of customers, SaaS companies cannot stay profitable. Hit the accelerator at the wrong time, though, and you'll squeeze your cash flow, reduce your profitability, and limit your possibilities for growth.
Tracking just a few key growth metrics—the ones that truly impact your SaaS company's results—can help you dramatically improve the profitability and sustainability of your SaaS business.
Once you know you're acquiring customers profitably and you're recovering your acquisition costs quickly, by all means: go full speed ahead!