The SaaS business model & metrics: Understand the key drivers for success

it's a real pleasure to be here it's a great city and it's interesting to see how web summit is impacting this city one of my portfolio companies a company called salsify just decided to relocate their European headquarters here to Lisbon and that's pretty different we used to see everybody going to Dublin before that so it's nice to see the the recognition of what the city has to bring so I have a great topic to talk to you about this morning the SAS business model and metrics and in case you're wondering why this is so important

I love this quote from Lord Kelvin if you can't measure it you cannot improve it and clearly all of us want to improve our SAS businesses so understanding metrics is important for that but metrics also play another role which is once you start regularly measuring a series of numbers what you'll find is that your team will realize the importance of those numbers and start to work on improving them so they can act as a very powerful way to align your entire management team and company around a direction you wanted head in but that also makes

it really important that we understand which metrics to actually highlight and try to simplify those down to the smallest number possible and that's what my goal today is to help you understand which are the important metrics and there is one warning I will give you which is the metrics change depending on what stage you're at and I don't have time today to explain that detail but I will be in my following presentation at 12 o'clock on the startup University talking a lot about these stages and what you might think how things change them but let's

also talk about another thing here which is I have looked at many many businesses over a lot of years and I've never found a business that was as sensitive to small changes in key variables than a SAS businesses and so that makes it really important to try to understand what these specific variables are that unlock growth for us and again that's my goal for you today so one thing I think most of you probably already know is that if you are going to look at public SAS companies and you wanted to compute valuation if we

look at valuation on the y-axis here what we have to use to compute valuation is to look at a combination of two factors what is the growth rate as a percentage and what is the operating profit as a percentage of revenue and add those two percentages together and that will give us the x-axis and that's the best predictor of profitability so in other words what this tells us is that you have to not only grow fast but also be profitable but alternatively if you're growing less fast you can get away with that by being much

more profitable so this is talked about often as the rule of 40 because you want your growth rate plus your profitability to be equal to 40% so you could be growing at 50% and losing 10% per year or you could be growing at 10% but making 30% profit and both of them would be acceptable and hit the rule of 40 then so that tells me something that I've been very focused on any of you read my blog here will know that I talked a lot about these three words here your goal is to produce a

repeatable scalable and profitable growth machine and these are really really easy words to say but actually turn out to be very hard to achieve in practice and they are very powerful words though because if you can figure out a way to grow your business in a way that's scalable so you can do it as much as you want to and it's also profitable you have in effect defined and built a cash generating machine where you can put in $1.00 of investment and a few years later get out many more dollars so this is something that

growth investors really love now the key indicator that you've successfully managed to get repeatable and scalable growth is that you are able to grow your bookings and here it's important to recognize that I'm not talking about revenue or ARR but your bookings reliably and consistently quarter after quarter so if you grow your bookings you don't grow your bookings your business will still grow but it will grow with a flat curve like that and what we're looking for is an exponential growth curve because you are successfully in charge of how to grow your bookings you understand

how to make your your growth process scalable and how to scale it so that brings us to the question of how do we measure bookings it's really quite different in a SAS business and the right way to measure bookings is to look at net new AR AR and that new AR AR is made up of three components the AR AR that you get from brand new customers the expansion AR AR that you get from your existing customers and we subtract from that the revenue that we will lose from churned customers that we lost during the

quarter so these four components or three components Plus Ones summary total are the key foundation metrics for running a SAS business if you're not tracking these reliably and regularly then this is an important thing to take notice of and this is the chart that I recommend that every founder use on a monthly basis to understand their business so this graphs those three components plus the sum of them which is the dark red line there and again remember our goal is to see that dark red line growing and we need to have the other components that

understand why it isn't growing or what is contributing to its growth and what we can do better there and it's really important to have it as a time series not just to look at a single point in time because you want to look at whether it's growing or not growing so any of you who read my blog know that one of the things that I really like to try and do is take complex things and simplify them and today I'm going to try to simplify the whole SAS business model down to one concept for you

which is you can think of a SAS business as being a funnel and if you run the whole business around this idea of a funnel I think it really helps have everybody recognize what you're trying to do and the SAS world we need to extend the funnel because it's super important that we retain customers to gain recurring revenue over a long period of time so we're going to look at a funnel that includes the backend of onboarding and retaining and expanding customers as well now the beautiful thing about funnels is that they're governed by really

very very simple math and that's what helps to simplify my job today the first piece of math is that to calculate bookings we simply have to take the number of leads coming in the top of our funnel multiply it by our conversion rate and then that'll tell us how many deals closed at the end of the funnel and then if we multiply that by our average deal size we have our bookings number so that tells me we should be very focused on lead flow and conversion rate in the early days and later on we can

worry about deal size I wouldn't worry about that too much in the very early days of your company so let's take an example here of a very simple business this is one way you drive your customers to the website and then you ask them to do a free trial and you hope to close them after that so what I would recommend here is that the metrics you're looking at are the number of visitors coming to the top of your funnel and then the number of people that are going into trials and then the number of

closed deals and plot this as a time series again super important to see are you improving over time because our goal is to show that we know how to control that growth rate then and then on top of that we really want to know how many visitors are converting to trials our conversion percentage and we need to track those over time as well and try to improve them because clearly if we can convert more visitors to trials that will really directly impact our bookings exactly in the proportion to which we make that change there now

a quick word about conversion percentages they're not that easy to calculate the way to do the calculation is you have to track a cohort like the January group of people that you saw coming to your website and watch them for several months maybe as long as five months or so to allow them to flow fully through the funnel to calculate conversion rates then once you've done that you can get your overall conversion rate for your entire funnel and this can also be very powerful because you can now look at that my lead source and you

can start to discover which lead sources provide you with a good return on investment where you can afford to spend more and plow more money into those lead sources then so so far I described a funnel that required no salespeople it was really just a marketing driven funnel but many times in fact really most times there are going to be salespeople involved and where salespeople are involved we do run into a different problem here which is a salesperson both a ramp time but also a capacity limit there's a limit to how many deals they can

work on at any point in time and as a result of that our growth comes in discontinuous units depends on the number of salespeople we have if we don't hire enough salespeople we will limit our growth because we won't have enough capacity to talk to our leads that are coming in there so I want to introduce a second formula to you and again fortunately it's a very simple formula so when you have sales people your bookings equals how many salespeople you have multiplied by the PPR the productivity per rep that's the average amount of business

that each rep produces and let's look at each of these in turn so one of the biggest lessons I've learnt is that every portfolio company I've dealt with has at least once and normally most often twice missed their sales numbers by failing to hire salespeople on time and when you're an a founder in the early days you'd normally don't worry about missing your hiring timing because you're saving money by hiring people a little bit later this is the one place where that really is important to not do because you will miss your bookings plan if

you don't hire salespeople on time and that leads me to the importance of recruiting and really would recommend to you that every one of you understand that recruiting is not one of the crucial skills you need to build to have a successful startup and you need to bring that skill in-house and not rely on third party outside recruiters for that looking at the second variable in that formula productivity per rep that's affected by the quality of people that you hire and again this goes back to why recruiting is so important you need to have great

talent coming into your organization but it's also impacted by how good of a job you do on onboarding and training and again if you come to my 12 o'clock talk in start-up university you will hear me talking a lot about how to create this training and onboarding and how important that is for founders to do as you're spending so much on these salespeople you need them to be productive so I recommend monitoring productivity per rep again with a time series graph to see how that changes and to look under the details of how productivity per

is evolving I strongly recommend that you look at a chart like this where you have every salesperson you've ever had and a green bar showing you whether they're above quota or red if they've gone below quota and what we're looking to achieve here is in the far right hand column where we have many green salespeople and that tells us that our onboarding and our hiring is working well and we're successfully getting our salespeople productive if it's not working well then we need to fix either onboarding training or hiring to get ourselves people productive them and

another chart that may be helpful to you is to look at how many of your reps are above 75% of quota and a rough goal here is 75% of them should be above that and how many of your reps are above a hundred percent of quota and here a rough goal that's useful is 50% of them should be above a hundred percent you may not get there in the early days but this is useful to have some targets to aim for to be aware of them so once we've got our funnel working we do come

to ask the question is our funnel profitable because I mentioned the evaluation of our company is driven by not just growth rate but also by profitability so to work this out well you need to use unit economics where we look at CAC and LTV CAC is the cost to acquire a customer and LTV is the lifetime value of the customer and our goal to have a viable business model is that our lifetime value needs to be significantly greater than the cost to acquire the customer so let's start by looking at the lifetime value of the

customer and this is obviously dependent on how long we can keep our customer the lifetime and the formula to compute customer lifetime it's simply 1 divided by the churn rate the customer churn rate so that tells us churn is extremely important as a variable that drives our profitability and therefore our company valuation the churn is not simple there are two forms of churn and I want to show you what the difference between the two of them is customer churn and dollar churn so I'd like you to imagine a simple story here where we start the

year with two customers one is doing $1,000 a month and the other one is doing $5,000 a month if we who's the first customer we had 50% customer churn but we we only had 17 percent dollar chance and not too bad on the dollar churn but if it goes the other way around and we lose the second customer we've lost eighty-three percent of our dollars so we need to track both of these things separately but something very cool can happen which is instead of just losing customer one if we were successfully able to grow customer

- from 5k to 7k we would actually have - 16 percent dollar churn and this is negative churn and it is a very very important concept for a SAS business so again to repeat what is negative churn it happens when the expansion revenue from your existing customers exceeds the revenue that you lost from your churned customers and it is very powerful now some of you might know I was on the board of HubSpot an early days at HubSpot we started with one product at one price point five thousand so actually with six thousand dollars per

year five hundred dollars a month and we had no way to get any expansion revenue because there was nothing else to sell him after that bought the initial product so a key lesson we had to learn was it to get expansion revenue we needed to have variable pricing axes and you can get variable pricing axes by introducing different editions of your product or by charging four users or as in hub spots case charging for some other metric like the number of leads that they were storing that was a better equator - how much value the

software was providing to the customers so that was a good lesson to learn there again I wouldn't panic if you don't have variable pricing if you're an early-stage startup it's a secondary thing that comes along later on once you've got your business running it up and running here but I believe that negative churn is crucial for success and to illustrate that I'd like to talk about this company here it has revenue loss of two and a half percent monthly and you can see that if there are 10 million of ARR in order to just get

back to ten million in the next year they will have to do another three million have to find three million just to replace the business that they're going to lose through well three millions not that big of a deal we can easily book three million somewhere along but if you take it a little bit further forward and you look at that same business when they hit a hundred million now they have to replace 30 million just to stand spilled just to stay the same size that they were before and that turns out to be a

very big problem and I was very friendly with Gayle Goodman of Constant Contact and this was the exact problem that they ran into they never were able to get to negative churn and as a result that business just struggled to grow and grow so negative churn is the answer to how you get a successful long-term task business then now the one other thing I'll show you here is if you look at a particular simple model that I created and you change you track what happens if you two have two and a half percent churn or

to an office and negative churn after 40 months the differences on the right hand side we have four hundred K and ARR versus only a hundred and fifty K on the left hand side so a very big difference in how fast your business will grow with negative churn now there's another reason why we need SAS unit economics and that is because all other businesses have been measured by a P&L and a balance sheet traditional GAAP accounting metrics but these don't work for SAS and the reason why they don't work is because we have this strange

phenomenon where we lose a lot of money in the early days acquiring our customers but we don't make that money back very quickly we make it back over a period of time so we have a negative cash flow for a long period of time with each customer we add and so that's one customer what happens if we add many customers well let's show you what happens if we add five customers a month just this is just looking at sales and marketing expense we have a cash flow trough I call this the SAS cash flow trough

and it's something that is very important for investors and board members to understand because all SAS businesses that are succeeding will lose a lot of money and that's because of this phenomenon here and what happens as well is that in in this model that I showed here the faster you grow the deeper your cash flow trough gets so this is kind of interesting and one of the board members at HubSpot was the see effort NetSuite Ron Gill and he gave me this quote for a blog post that I did the thing that surprises many investors

and boards of directors about the SAS model is that even with perfect execution the acceleration of growth will often be accompanied by squeeze and profitability and cash flow and so they saw this constant going back into negative cash flow as they just started to re-accelerate their growth there and I used to run into this problem with my partners when I would come in and talk about the fact that HubSpot was doing really well and they would say why is it losing so much money and it kept getting worse and worse and worse and I had

to explain it to them with these graphs here but it does lead you to an important question so if you're losing money at an increasing rate how do you know that you have a business that will turn the corner and be a successful business and the answer is that about 10 years ago I wrote a blog post where I came up with these guesses as guidelines which is that your lifetime value should be at least more than three times cack and you should be able to recover the CAC in under 12 to 18 months or

so they were very rough guidelines and I guessed at them but 10 years later it turns out that they've been very much time-tested and proven and I think they're really strong key guidelines is to help you find out are you actually going to turn the corner and become profitable then so one other thing that's very powerful about unit economics is you can actually use them to help you understand your customer segments so here we have HubSpot again on the left hand side the very small business segment only has a one and a half times LTV

to CAC ratio but the VAR channel that we were using to sell to the very small business actually had a five to one LTV to CAC so this helps us recognize that we had a very unprofitable customer segment but at the same time we also had 12 reps assigned to the very small business but only four reps assigned to the vast so obviously 12 months later we changed that completely we had only now two reps left selling to VSP and 25 reps assigned to selling to the VAR channel so that helps you understand where and

how to drive the business for you so last thing to recognize here is there's another kind of unit comics that can be helpful and that is for the salesperson so if you pay yourselves people about a hundred K on target my recommendation is that you set the quarter about four to six times that to be able to get very profitable salespeople and one last thing I want to talk about here is in my model I studied the impact of doing upfront annual payments and discovered that this has a huge impact on your cash flow not

your P&L because it doesn't change that but here's my model that I ran it shows that in one case you ended up with three and a half million in cash and in the other case you ended up with thirty-eight million in cash and you avoided the whole cash flow trough so if you were able to this is one of the most powerful variables then so in summary here my entire thing was to try to simplify the SAS down to recognizing that it's just a funnel and if you look at optimizing that funnel you have a

great way to create the metrics that you want so bookings we care about using the formula that I talked about we care about the bottom of the funnel customer happiness retention and churn a negative churn and we care about profitability through unit economics and gross margin and then lastly as I showed you for your cash flow collecting cash upfront is a very key metric now it's clearly a lot more than this but I only had 20 minutes to talk to you today so I had to cut things down as much as possible if any of

you are interested in looking further here I would recommend going to my blog and one very last thing that might be interesting to you is in at 12 o'clock I'm talking over on the startup University stage about nine stages to get to a repeatable scalable and profitable growth model and I will talk about how it's crucial it is to understand each of these stages and why you cannot rush ahead and how much damage you do by going ahead there so hopefully I'll see some of you with that but otherwise thank you very much for your

time and for listening to me and it's been a pleasure talking to you [Applause]