As a former Vice President of Marketing and Chief Product Officer in the Big Tech industry, focusing on software, I’ve experienced several revolutions from PC and client/server, the worldwide web, mobile, social networks, and cloud computing.
Software as a Service (SaaS), part of cloud computing, disrupted the long-established software industry, propelling Salesforce, Adobe, ServiceNow, Paypal or Shopify as market cap leaders of the $172B cloud industry, and on their way to dominating the $456B enterprise software industry at large.
I’ve covered this post in a YouTube Video on my channel that you can find below. It is chaptered, so feel free to jump straight to the section of interest to you.
What are the 4 areas of significant change compared to the traditional on-premise software?
I’d regroup the key change factors of SaaS compared to the traditional software business in the following areas:
Licensing & Revenue Model
The biggest and foundational of the SaaS Model is its licensing & revenue model, from a transactional one to a subscription. It changes the entire dynamics from the customer lifecycle, revenue recognition and, as a consequence, the role of Sales and Support – now called “Customer Success” as you don’t help customers troubleshoot only but rather make sure they use your solution to the max, keep a smile on their face and stay with you the longest time possible.
SaaS is similar to the Mobile Telco business model. One can tell how much Mobile vendors are fighting for your subscription, and keeping you as long as possible as subscribers to increase the services they offer to you, raising what they call the ARPU (Average Revenue per User).
Customer Experience & Relationship
As a consequence, the nature of the customer relationship is very different from the one in traditional software, where the vendors would be in touch with the users only if something was wrong. Now users are always connected to the vendors to use the solution. And the buying decision-makers are not necessarily your users, to make it even more complex. You need to please both.
SaaS is also very powerful to capture the users’ feedback, as you can analyze in real-time what they do with your solution. And for a lot of SaaS solutions, if not all, you can try it and buy it online in a blink. This is where I learned at Salesforce to get back to prospects on the web within 10mn after their digital engagement at the risk of losing 80% of your leads otherwise. Your offered customer experience needs to be frictionless, immediate, and reflect your customer-centricity as customers are now in control and your competitor is just a click away.
R&D, Product Management & Delivery
As an industrial, you need to change the paradigm of developing and delivering your software. In software, you do not have manufacturing plants and a complex supply chain. Your assets are your R&D and your hosting facilities.
For your R&D, long gone are the big announcements of the impressive number of new features for the new version of the software, traditionally happening yearly at best. Now you update ALL of your customers at once, every quarter. Agile Development and SCRUM are paramount, with real-time permanent user feedback loops.
As you also host everything on the cloud, best in one instance, your delivery model is optimized from a CPU, Storage, and Network by design. You don’t need one server per customer served, but you need to be able to cope with peak consumption at a certain time of the year (end of the month for Payroll as an example, or XMAS shopping for etailers). And to complement this new paradigm, your solution needs to offer APIs to be totally and seamlessly integrated with other cloud-based solutions (Payment solutions for eCommerce platform as an example, or Social networks for CRM and Marketing automation solutions). It’s a connected world!
How to measure and optimize a SaaS business?
Now that we’ve explored the key change factors, let’s do a deep dive into success criteria and more importantly how to optimize your SaaS business. It’s about: financials, Customer Experience (CX), and Investors’ KPIs.
Net Bookings Growth
First, let’s understand the concept of Net Bookings. Not tracking it is a fatal mistake!
Net Bookings is obtained by adding bookings from your new customers or Cross-Selling, to expansion bookings coming from existing customers and substracting your churn due to customers leaving you.
What to include in Bookings
Bookings are the total dollar value of all newly signed contracts. With bookings, you want to include all items that are associated with revenue. When a customer commits to spending money with you – that’s a booking. You need to adjust that number as the commitment changes, particularly in terms of downgrades and any churn.
What you should not include in Bookings
The key to getting accurate Bookings metrics is to understand that it is an annualized recognition of revenue items coming into your business. So, you want to exclude any items that do not fall in that category. The reason for this is bookings are tracking your committed momentum from your growing customer base. While recognized revenue will be different, remember that your bookings are measuring where you’re headed.
Product, marketing, and sales team motivation
Your product, sales, and marketing teams should be motivated by bookings to continuously develop an amazing experience along with complementary features that line up with your value metric to increase committed contracts. Additionally, annual contracts are a wonderful way to boost bookings considerably.
- Make sure your product is aligned with a value metric
- Reduce Churn through quantifying your buyer personas and mapping the key features to each persona of each segment
- Annual and longer-term contracts
What is a Value Metric?
A value metric is a way a company measures the per-unit value of its product for sale. A value metric example is skis, which are sold as pairs. In SaaS, value metrics determine the pricing and subscription terms of a product. If you’re Hubspot, you’re charging for each seat per month for your CRM. If you’re selling MacBook Airs, it’s each MacBook Air one time upfront. If you’re Salesforce, you’re charging for CRM and Customer Service by the user per month, and Marketing automation by the number of users AND the number of contacts marketed to (dual metric).
By aligning your product with a value metric, you ensure that the value of your offering is in tune with each of your customer personas. This, in turn, allows you to expand the amount of revenue your customers are committing to you as their usage expands.
Reduce Churn by quantifying and mapping in-depth your customer personas
Churn is Kryptonite to your SaaS business, so make sure you work your targeted marketed segments with enough personas representing your buyers and users. Map carefully their pains and gains to key features: revisit the ones causing churn and double down on the ones resonating most with customers.
Take special care of long-term contracts
The longer the contract, the more bookings you will record. Make sure your pricing model and conditions are optimized for longer contracts along with the value metric(s). Also, ensure your sales process is especially favorable and frictionless to long-term contracts.
Watch your Customer Lifecycle KPIs: CES |CSAT | NPS
There are 3 customer lifecycle metrics, each one reflecting a phase in the customer lifecycle: Discover, Buy, Consume, Advocate. To optimize all of them, the recipe is straightforward: Trust, Simplicity, and Convenience.
- Customer Effort Score = Sum of all Customer Effort Scores ÷ Total number of respondents. For Example: Say, if you get 12 responses: 3, 7, 5, 3, 7, 7, 6, 5, 7,7, 7, 7. So, you customer effort score = Addition of all customer effort scores ÷ Total number of respondents. Customer Effort Score ranges from 0-100. Your CES is the total number of customers who agree that their interaction was easy divided by the total number of responses. For example, if 65 customers out of 100 rated you 5, 6, or 7 on the 7-point scale, your CES would be 65.
- Your CSAT score ranges from 0-100. To calculate your score, take the number of satisfied customers (those who rated you 4 or 5), and divide by the total number of responses. For example, if 62 of your 100 responses have a rating of 4 or 5, your score would be 62.
- Your Net Promoter Score can range from negative 100 to 100 ( -100 to +100). At -100, every single person who responds is a detractor. They would not recommend you, and they’re likely to leave bad reviews of your product or service. Your Net Promoter Score is calculated by: Subtracting the percentage of detractors from the percentage of promoters. The percentage of passives is not used in the formula. For example, if 10% of respondents are detractors, 20% are passives and 70% are promoters, your NPS score would be 70-10 = 60
These KPIs should be at the core of your Chief Revenue Officer, CMO, and Customer Success leaders’ performance. It means putting the customer at the core of your business.
Adapt fast to the Rule of the 40 for Investors
The Rule of 40 is a common metric used by private equity investors and strategic buyers to measure the performance of SaaS companies. Measuring the trade-off between profitability and growth, the Rule of 40 asserts that a successful SaaS company’s growth rate and profit margin should add up to 40% or more. The Rule of 40 can be a useful metric when comparing SaaS companies.
In addition to measuring, this metric is also a normalizing factor. For example, a company can reach 40% on a Rule of 40 basis in many ways. A company can have 20% revenue growth and 20% EBITDA margin; 0% revenue growth and 40% EBTIDA margin; or 40% revenue growth and 0% EBITDA margin.
Some companies may sacrifice profitability to grow, while others may be uber profitable but have not invested in growth factors such as Sales and Marketing. Using this calculation allows buyers and investors to normalize these factors across financial profiles. Yet, it fails to guide management on how to best balance the often competing priorities of rapid growth and increased profitability. But McKinsey’s research finds that barely one-third of software companies achieve the Rule of 40. Fewer still manage to sustain it. Analysis of more than 200 software companies of various sizes between 2011 and 2021 found that businesses exceeded Rule of 40 performance only 16 percent of the time.
As a result, some are looking at a weighted Rule of 40 that looks like this:
As evidenced by SEG’s 2021 Annual SaaS Report, investors favored SaaS companies with higher Weighted Rule of 40 percentages. Public SaaS companies scoring greater than 40% on a Weighted rule of 40 basis posted a median EV/Revenue multiple of 22.4x. These high-performing companies include Okta, Adobe, Zoom, Twilio, and Datadog. Further, each cohort above 10% on a Weighted Rule of 40% basis posted greater median EV/Revenue multiples compared to 4Q19, indicating that investors favored growth stocks in 2020.
How to optimize the rule of 40? (Source McKinsey)
- Realistic Growth: McKinsey research found that just 1.6 percent of 200 software companies were able to sustain consistently strong revenue growth of 30 percent or higher from 2011 to 2021. For example, when a $600 million enterprise SaaS company saw revenue growth begin to settle at 15% as it became a leader in its segment, management realized they could no longer spend as freely as when the business was growing at 30 to 40% annually. So they adjusted their cost structure, with a goal of generating a 20-percentage-point improvement in free cash flow (FCF) over a two-year period, taking it to 30%. That rebalancing will keep them at the Rule of 40 and provide the means for them to invest in new, high-growth businesses.
- Net Retention: These efforts, combined with strong pricing and product support, result in median net retention rates (NRR) of 120% or more—which means these businesses are able to deliver 20% growth every year without adding a single new customer. Top performers span different end markets, including companies such as Twilio (139%), Crowdstrike (128%), and Elastic (130%). Analysis of 40 public B2B SaaS companies shows that those with NRR of 120% or more also have higher multiples—with a median EV/revenue of 21-fold compared with 9-fold for those below the 120% mark. This is because net retention is a core driver of growth and sales, as well as marketing efficiency.
- GTM Spend: Sales and marketing is one of the biggest expense areas for SaaS companies—amounting to 50% or more of revenue in high-growth businesses. Where SaaS companies with the strongest EV/revenue multiples are able to recover their customer acquisition costs in under 16 months. Measured in terms of LTM median payback period. bottom-quartile players take nearly 4 years to do the same. Top-quartile companies also generate revenue growth 3.5 times faster than the bottom quartile. they define total opportunity using a “retain-acquire-develop-optimize” (RADO) structure. RADO segmentation aligns marketing and sales efforts based on total customer opportunity. Teams “retain” accounts where the revenue growth opportunity is maxed, “develop” accounts where significant upside exists, “acquire” net new accounts that present significant opportunity, and “optimize” net new accounts with smaller opportunity.
- New Bus. Fast: For example, a $400 million SaaS company built a new $50 million annual recurring revenue (ARR) business from concept in 18 months. Given the challenge of maintaining growth over time, developing the capability to build new lines of business quickly is critical for long-term growth and value creation
McKinsey’s experience with a $500 million SaaS company shows how management teams pull this together. The company was used to seeing revenue growth of 25 to 40%, but recently the rate had slowed to 10%. After analyzing their market opportunity and competitive environment, they landed on 15 to 20% growth as a more realistic model. They also took a hard look at their existing business. With churn averaging 15 to 20% and cross- and upsell levels modestly, the company’s NRR was just 100%. Upskilling their customer success team helped put them on track to gain a ten-percentage-point improvement in NRR. They are also seeking to fast-track digitization efforts within marketing and sales—efforts that will lower costs within the function from 40% of revenue to 20 to 25%. To fund the improvements, leaders conducted cost analysis across the business, which identified $100M in savings. Leaders plan to use 25% to support its transformation and reinvest in new business lines. Together, the improvements are expected to propel the company’s Rule of 40 performance from below 10 (owing to negative free cash flow) to over 40 within the next two years.
Circular Economy Innovation
What is fascinating, is that the SaaS business model now applies to a much wider range of industries and can propel a more sustainable way of doing business.
Interviewed at the World Economic Forum, Philips CEO explains how his company is innovating to embrace a circular economy model. Their customers consume and pay for the use of their product as a service, instead of buying the product itself. It is good for the environment as products are designed for a much longer lifecycle, brilliant for customer satisfaction and loyalty, and also appreciated by shareholders that can rely on a way more predictable revenue stream. This is one of the brilliant examples of how to make People, Planet and Prosperity reunited.