By 2020, more than 80 percent of software companies will change their business model from traditional license and maintenance to subscription. And, with the recurring revenue model gaining popularity, the role of the CFO is shifting to keep pace. The importance that subscription renewals play in overall business performance today has caused the CFO role to expand beyond finance. CFOs are playing a larger role in strategy around customer experience and satisfaction. But that isn’t all that’s changed.
The emergence of SaaS came with the availability of real-time data that allows us to make important business decisions with a great deal of accuracy. Audits have become much easier with this data on hand and the ability to quickly and accurately show potential investors a 360-degree view of business viability has made raising capital a lot less stressful.
Understanding the differences between managing the financial operations of a traditional business model and SaaS model is critical. It’s first important to understand that traditional reporting, accounting software and approaches aren’t suited for the dynamic SaaS recurring revenue model. Because most robust finance systems that address SaaS business requirements are very expensive and simply out of reach for most emerging and growth businesses, the typical response has been to cobble spreadsheets together with traditional accounting software to create homegrown SaaS financial operations. Spreadsheets are powerful tools, but are poorly suited for managing a recurring revenue business. If you rely on them for too many processes, your financial operations are going to suffer. Before long, you’re stuck in the spreadsheet vortex and can’t get real-time metrics, lack confidence in the accuracy of your data and your metrics are inconsistently defined.
To be successful, you need four main things:
- An understanding of the key performance metrics you should be tracking and why.
- A subscription management solution that will make it easy to manage the customer financial information and scale to support the financial operations of your business through every stage as it grows.
- Quick access to those metrics and high-quality financial information so you can make smart decisions, properly manage your business and raise capital with confidence.
- GAAP financials that, when combined with the subscription metrics, provide the insight and financial maturity you need to successfully manage and grow your business, and raise capital.
Let’s look at the performance metrics that provide the visibility you need to understand and optimize your recurring revenue business:
Monthly Recurring Revenue (MRR). MRR is a measure of the predictable and recurring revenue components of your business and it’s probably the most important SaaS metric of all because it gives you the operational insight to accurately forecast, plan and measure growth. MRR also provides the operational insights you need, regardless of the subscription term length. If your business offers both annual and monthly subscription terms, MRR normalizes the varying term lengths that many SaaS businesses end up with over time and enables you to treat your data consistently, arguably the most important thing to do when dealing with subscription metrics. Not only do you need to track new MRR, but the ability to track expanded, contracted, expired and canceled revenue is essential to understand the true health of your business.
Many of the following metrics are calculated using MRR so if it’s incorrect, those metrics are likely to be incorrect as well. It’s important to get this one right.
Customer Lifetime Value (CLV). This is where that change in the CFO role I mentioned earlier comes into play. CLV is the lifetime value of a customer or estimate of the projected total value of a customer over its lifetime. The challenge of course is in the calculation of churn or renewal rate and the average MRR – all inputs into the CLV calculation. So, before you can accurately calculate CLV, you must calculate average MRR and customer churn.
Customer Lifetime Value/Customer Acquisition Cost (CAC) Ratio. CAC is another critical metric because it allows you to determine the CLV/CAC ratio. In other words, what you can expect to get in customer lifetime value for every dollar you spend to acquire that customer. You’ll need to calculate CLV and CAC separately to get this ratio. Ideally, you want CLV to be 3 to 10 times higher than CAC. This can also be a very telling metric for VCs because a customer lifetime value that is significantly greater than the cost to acquire that customer, while not completely conclusive, is a good indication that your revenue engine is working and resources are being allocated efficiently.
Moving away from simple profit and loss is inevitable in today’s subscription business and the “single source of truth” that comes with tracking these performance metrics will give you greater insight, allow you to make important decisions on the fly, identify opportunities for growth and respond more quickly to market changes.
Tim McCormick is the Chief Executive Officer for SaaSOptics.