SaaS and recurring revenue model: Making the numbers work
In the traditional software world, companies did most of their business via “perpetual” software licenses. This meant that customers purchased the software and the in-house hardware necessary to use the computer program. Although the customer owned the software in perpetuity, it could get very expensive and complex to deploy and maintain. In some cases, the costs and complexity of this system excluded small and mid-sized businesses from using certain software.
With SaaS, instead of purchasing the software outright, companies can effectively “rent” the software on a monthly, quarterly or annual basis—hence the term software as a service. The software is usually deployed on servers outside the organization and is accessed over the internet. The customer no longer has to worry about maintenance or hardware costs.
What makes SaaS so different?
For entrepreneurs, SaaS is an attractive business model because of the predictability of the revenue stream coming in as end users pay on a monthly, quarterly or annual basis. This revenue is called monthly recurring revenue (MRR).
In a recurring revenue model, end users will pay the service over a certain period of time, known as the customer lifetime. If customers are happy with the service, they will stick around for a long time and the seller will profit more from that customer over time. However, if customers are unhappy with the service, they will discontinue payment and churn out quickly. This will likely result in a loss for the software provider because the cost of acquiring a customer is usually pretty high.
Two key success factors for SaaS companies
In a recurring revenue model, a company’s expenses to acquire customers and deliver the service will outstrip the revenue gained in the early period. This is because customers pay on a monthly basis and over time, but the expenses to deliver the service and acquire customers is up-front. This is why the following two factors are critical to any SaaS company’s success.
1. Customer Acquisition
The acquisition and onboarding of new clients is a critical component of any business model, but it is perhaps even more critical in a recurring revenue model. SaaS companies typically spend several thousand dollars to acquire customers and in most cases will not see a payback on that acquisition cost for several months. However, the more customers you can acquire with the same level of marketing spend, the lower your payback period and the higher your return on investment for each customer acquired.
2. Customer Retention
Retaining customers is equally important to acquiring customers. If a company spends thousands of dollars to acquire a customer but then loses (churns out) that customer after a couple of months, then the SaaS company has lost money on that customer. However, if churn is low and customers stay on the platform for several years, then the SaaS company has a profitable base of recurring revenue.
Three key SaaS metrics
Using too many metrics to measure performance can be confusing and, for smaller companies, irrelevant. For SaaS companies that are just starting out, it is important to have a smaller set of metrics that you monitor closely as the business grows. I advise my clients to focus on three key metrics.
Measuring monthly recurring revenue will show you what the company will book revenue next month, but more importantly, it will illustrate the month over month growth in recurring revenue as the business expands.
2. Customer acquisition cost (CAC)
This is the cost of acquiring a new customer and will usually include all sales, marketing, and product delivery costs. This is typically measured by adding up the costs of customer acquisition in a quarter divided by the number of customers added in that period. The importance of this metric is to monitor the costs associated with customer acquisition and to provide a benchmark on how well your sales and marketing efforts are working.
3. Customer churn rate
Although there are many ways to measure churn (MRR churn, customer churn, etc.) the concept is roughly the same for all methods. It measures the loss or discontinuation of a paying customer or contract. Churn is frequently expressed as a percentage on either a monthly, quarterly or annual basis. Knowing the churn rate is critical to the success of a SaaS company as it is a telling metric on the health of the client base and the on-boarding process.