Introduction to SaaS Economics

Published Jun 5, 2021

How does a Software as a Service (SaaS) business operate as a business?

How do you measure growth? What metrics should we be aware of to make decisions about the future of our product?

The great thing here is that we don’t need to be economics majors to understand the basics of SaaS business and marketing.

This is my take at explaining the significance of SaaS as well as the most important metrics to judge the health of a SaaS business.

What is SaaS?

In order to understand the significance of the SaaS space, we’ll compare traditional software sales with SaaS subscription sales.

A Shift in Software Sales

Let’s go all the way back to 2007 to discover how customers used to buy software before the cloud.

Traditional Sales. Suppose we want to buy Microsoft Office 2007. We would pay $499 per user once, and then we would keep this software forever. If we wanted to upgrade to a newer version of Microsoft Office, then we would have to buy another copy of the product.

SaaS Sales. Let’s contrast that to Google Docs. For this product, we might pay $12 per user per month. Instead of a one-time fee, we access this product on a subscription basis. As long as we pay each month, we’ll have access.

You might’ve noticed that it would take Google ~3.5 years at this price of $12 per month to make $499 from a single customer. However, the lower initial price makes Google Docs much more accessible than Microsoft Office 2007, thereby increasing the potential number of customers and increasing potential revenue.

The term “SaaS” refers to the change in the licensing and delivery model of software products. Products are sold as a subscription and access/hosted online.

A Shift in B2B Software Sales

The enterprise software market was impacted the most by the massive transition to SaaS businesses.

Traditional Sales. Beforehand, when businesses paid other businesses for their software, they weren’t just paying for the software itself. They were paying for the hardware (i.e. servers, networking, storage) needed to run that software.

Often, a business would pay $2M upfront and an extra $250k in maintenance fees over a lifetime. The cost to change software was so high because the initial payment was so large.

Software vendors received roughly 90% of their revenue at the time of purchase. The issue here is that these vendors aren’t motivated to improve their product. The only way their company grows is by acquiring new customers. They don’t lose out if existing customers stop using their software.

Shelfware: when customers buy software that goes unused, sitting on a shelf

SaaS Sales. Nowadays, there are no associated hardware fees in a SaaS subscription. Software prices can range from $2k to $20k per month with maybe a small fee upfront.

There is more incentive here to constantly improve the customer experience over time. Unlike traditional B2B sales, revenue disappears if customers disappear.

SaaS Health Metrics

Because SaaS businesses needed to realize revenue from customers over a long period of time, they had to learn to retain customers.

This meant finding metrics that speak to retention.

We’re going to look at three metrics: LTV, LTV:CAC, and Net New MRR.

LTV

Our first metric is called Lifetime Value, or LTV.

LTV. This refers to the total dollars a customer is expected to spend with a vendor over the course of their entire relationship with that vendor.

This feels arbitrary, though. How do we calculate this number?

Calculating LTV

LTV = the average spend per customer * the customer lifetime.

Average spend per customer. The average spend per customer (per month) is essentially our average Monthly Recurring Revenue, or MRR. If we want to calculate by year, it would be our Annual Recurring Revenue, or ARR.

MRR. MRR can be simplified down to our spend per customer per month, or the value of our subscription as a monthly fee.

Customer lifetime. Customer lifetime refers to how long a customer will stay subscribed.

Customer lifetime = 1 / churn rate.

Churn rate. Churn rate refers to the percent of total subscriptions that are cancelled and lost in a given period of time.

For a monthly subscription:

Churn rate = MRR cancelled during the month / total MRR at the beginning of the month

For instance, if 50% of Microsoft’s customers cancel every month, then the average customer lifetime will be 2 months. In other words, customers will remain at Microsoft for 2 months before cancelling.

That’s all fine and dandy, but what is a good LTV?

LTV:CAC

In order to identify a healthy LTV, we need to know Customer Acquisition Cost, or CAC.

CAC. This metric refers to the cost of acquiring a single customer over a given period of time.

CAC = total sales and marketing spend / new customers acquired

Total sales and marketing spend includes employee salaries, marketing campaigns, web hosting costs, and everything that goes into sales and marketing to allow them to do their job.

LTV:CAC. LTV:CAC compares the value of a customer over a lifetime to the cost of acquiring them.

If LTV:CAC < 1, then that business may not be around for long. This is like putting a single dollar into a vending machine and getting 30 cents back.

An LTV:CAC > 3 is an industry wide standard for a healthy LTV:CAC. Who wouldn’t want to put a dollar into a vending machine and get 3 dollars back?

Once a business has a repeatable sales process, LTV:CAC is a great indicator of future profit potential.

Improving LTV:CAC

Clearly, we want this ratio to increase over time, whether that means the value of a customer (LTV) increases or the cost of acquiring customers (CAC) decreases.

Increasing LTV. We want to think of ways to increase the average spend of customers. Maybe we can create room for customers to upgrade our services (i.e. starter packs, professional, enterprise). This would create a pricing model that would allow customers to gain additional value from us while we gain additional value (money) from them.

Another way to increase LTV is to decrease our churn rate. As a business, we need feedback from customers to understand and address their reasons for leaving.

Decreasing CAC. There are many ways to decrease the cost to acquire one customer. We can be more targeting with marketing and sales spend. For instance, it may be time to move away from general advertising on billboards and newspaper ads.

We may also need to segment our customers. In other words, we need to know which customers are less costly to acquire and have a higher return on investment.

There’s also always a way to make the buying experience and checkout process much smoother for the customer. An easy checkout flow without the need to talk to a sales rep lowers the cost to acquire customers. This can also be achieved with a simple freemium model for customers to try out a limited version of the product.

Net New MRR

The issue now is that LTV:CAC doesn’t tell the full story of the company’s health.

We can use LTV:CAC in conjunction with the metric Net New MRR.

Net New MRR. Net New MRR is simply the monthly recurring revenue that comes from new customers and lost customers.

This metric is a composite of different factors:

  • + New MRR: new customers
  • + Upgraded MRR: upgraded customers (higher pricing tier)
  • - Downgraded MRR: downgraded customers (lower pricing tier)
  • - Cancelled MRR: lost customers

Each component is important track together as well as on their own. They each pose different questions for our business.

  • + New MRR: Are we growing into new regions and increasing our footprint?
  • + Upgraded MRR: Are customers seeing more value from us?
  • - Downgraded MRR: Are our products packaged correctly? Why do they feel the need to downgrade?
  • - Cancelled MRR: Are our customers happy? Do we have competitors?

Net New MRR essentially equates to company and revenue growth.

If we want to grow 30% year over year, then our Net New MRR goal should be at or above 30%.

Increasing Net New MRR. To increase Net New MRR, we can increase our sales rep headcount, or we can increase Productivity Per Rep, or PPR. Instead of hiring more sales reps, we can make each one more productive and efficient at their job.

PPR per month can be calculated as follows:

PPR = new and upgraded MRR / total number of sales reps

Set Annual Targets

All that said, we want to ensure that we’re setting annual targets for each of these metrics. We want to ask these questions:

  • How fast do we want to grow Net New MRR next year?
  • How many sales reps do we need to hire? What’s our PPR target?
  • What changes are happening next year? (e.g. new products, pricing changes) and how will this impact our targets?

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