The SaaS business is a complicated one. It’s relatively new and doesn’t follow the normal principles of historical business practice (i.e. focused on revenue and not so much on profits).
I’m a more traditional type of business person so it took me quite a bit of time to really understand how you can run a business purely burning cash and not worried about returning a profit. A few months ago Brad Feld shared a blog on his “40% rule” which is calculated like this: Growth Rate % + Net Profit % = 40%. Here are more details from his blog:
Assuming this is a guiding principle then with our 117% growth rate last year at BrightGauge means we could show a net loss of 77% and still be on the right track. As I struggled to come to grips with this new reality I stumbled across two great resources that I wanted to share to help others.
New Way Of Valuing
Andreesen Horowitz, the renowned VC firm, holds a regular podcast that they post on SoundCloud. One of their podcast was very enlightening on the subject titled Valuing Today’s Fast-Growing Software Companies. During the 25 minute podcast they discussed the change in valuation approach for software companies, specifically SaaS companies. The main theme was showing how the market needs to rethink their valuation approach to these types of businesses because you can’t measure them based on traditional metrics. The most basic example is revenue recognition.
When Oracle sells a big database solution in the traditional perpetual license model they get to recognize all the revenue up front and that revenue matches up with the cost to acquire that customer. So in a short time window you can easily see if the company is profitable. However when Salesforce lands a new customer, you see all the all the expenses to land them (customer acquisition cost or CAC) but you don’t get to see all the revenue in the same period and therefore have to wait for the subscription to end. This is where metrics like bookings (contract value that has yet to be recognized) and LTV (life time value) comes into play.
Know your Unit Economics
As a SaaS CEO these type of metrics can be very scary because you really won’t know if the deals you’re doing are profitable until you get further down the road. So as you enter this world its important to watch your metrics carefully on a unit basis to make sure that as you scale you can be profitable. You want to avoid the old cliche saying of “lose money on this deal but make it up in volume”
The single best resource for understanding SaaS metrics and specifically Unit Economics is the blog of David Skok called For Entrepreneurs. David is the guru of metrics but there is one post in particular for you to check out titled SaaS Metrics 2.0. This is considered the bible of SaaS metrics and a “go to” resource for anyone in the space.
Know Your Market
The biggest takeaway for me has been to make sure that if you’re in the SaaS industry you do your homework and understand your metrics. The Unit Economics are critical as you get started and start experimenting with revenue models. David’s blog is a great resource along with several others that I plan to share in future posts.