Friday, May 08, 2015

A closer look at the 6 things to pre-empt 90% of Due Diligence

Since last week's post about 6-7 things to pre-empt 90% of Due Diligence was liked/shared/retweeted quite a bit, I'd like to follow up with some additional details on what exactly SaaS Series A/B investors will look for when you supply them with the data and material that I've mentioned. In my post I suggested that you should prepare a key metrics spreadsheet, a chart with your MRR movements, a cohort analysis, a financial plan, an analysis of your customer acquisition channels and, if you're selling to bigger customers, information about your sales pipeline and details about your largest customers. Let's go through these items one by one and try to anticipate some of the questions potential investors will think about.

As a caveat, I'm going to mention some benchmark numbers but it's very important to note that none of these numbers can be viewed in isolation. There is not one number which will determine if investors want to invest. It's always about many puzzle pieces which together form a picture of the strength of your company.

Key metrics spreadsheet


  • What's your visitor-to-signup conversion rate? Typically this metric is in the 1-5% range. If you're significantly below that, that doesn't have to be a red flag – there can be good reasons for a lower rate – but it may raise questions.
  • What's your signup-to-paying conversion rate? In my experience, most good SaaS companies convert 5-20% of their trial signups into paying customers (but again, there can be exceptions).
  • What's your lead velocity? Are you getting more and more new trials/leads every month?
  • What's your account churn rate and more importantly your MRR churn rate? The best SaaS companies have an account churn rate of less than 1.5% per month and a negative MRR churn rate (which doesn't mean that you can't have a great company with somewhat higher churn or that you have to be at negative MRR churn at the time of your Series A/B).
  • How fast and how consistently have you been growing MRR? Have you been adding an ever-increasing amount of net new MRR month over month?
  • How has your ARPA developed? Have you been able to increase it?
  • Are you able to sell annual plans?
  • How long did it take you to get to $1M ARR? The best SaaS companies get there within 12-15 months after launch (but again, lots of exceptions ... there are companies that start slowly and skyrocket later).
  • How much have you been spending on customer acquisition? As a rule of thumb, most SaaS companies should target a CAC payback time of 6-12 months, although in some cases there can be good reasons to spend significantly more.
  • What are your CoGS and what's your Gross Profit Margin? As a pre Series A startup you're probably not great at tracking/attributing CoGS ... which I think is OK.

MRR movements

  • How much MRR have you been gaining by acquiring new customers? Have you been able to add MRR by expanding existing accounts as well? 
  • How much MRR have you been losing due to churn or downgrades?
  • Mamoon Hamid of Social+Capital has coined the term "Quick Ratio" for the ratio between added MRR and lost MRR, and he's looking for companies with a Quick Ratio of > 4. If your Quick Ratio is significantly below that, is it trending in the right direction?

Cohort analysis

  • How does your account and MRR retention look like for some of your older customer cohorts? Do you have low or even negative MRR churn?
  • Taking a "vertical" look at the cohort analysis, are you getting better and better over time, i.e. do your younger cohorts look better than older ones?
  • What's your estimated CLTV based on this cohort data?
  • How does usage activity look like on a cohort basis? Is there a lot of "hidden churn" (customers who got inactive and are likely to cancel soon)?

Financial plan

  • Is your plan both ambitious and realistic? Most investors are looking for T2D3 type growth, i.e. once you've reached around $1M in ARR you should try to grow 3x y/y for two years.
  • Is your plan a coherent continuation of your historic/present numbers, both methodically and with respect to your key assumptions? Projecting a sudden, drastic improvement of your key drivers is understandably much harder to sell to investors.
  • Are your key assumptions plausible, and what's the impact of somewhat more pessimistic assumptions?
  • Did you sanity check the outcome of your model? If the result of your model is that you'll be a money printing machine within two years, that's usually a sign that you're underestimating future costs. :)

Customer acquisition channels

  • How did your customers find you? Organic, paid, both? Ideally you have strong organic growth (which is strong proof of product/market fit) as well as some success with paid customer acquisition channels (which can be scaled more easily).
  • How does your conversion funnel look like for different sources of traffic? What are your costs per lead and per customer for different marketing channels?
  • How close are you to building a (somewhat) predictable and repeatable sales and marketing machine? Do you have a sense for the scalability of your customer acquisition channels

Sales pipeline

  • How does your current pipeline look like? Do your short-term targets look realistic based on your "in closing" pipeline? Does your overall pipeline support your mid-term targets?
  • How has your pipeline developed? Has it become stronger and stronger over time?
  • Are you starting to get a handle on closing probabilities and closing timelines?

In the original post I said as a bonus tip that if you're an enterprise SaaS company, you should put together some additional information about your largest customers. Here's another bonus tip: Include information about your NPS (which is hopefully very high) and how it has developed over time.

Ideally, all these puzzle pieces together, along with the size and attractiveness of the opportunity you're going after and the strength of you and your team, will form the picture of a SaaS startup which has clear product/market fit, enthusiastic customers, strong initial traction, continuously improving metrics and which is on its way to building a repeatable, scalable and profitable customer acquisition engine.


Friday, May 01, 2015

6 things to pre-empt 90% of Due Diligence

The founder of a portfolio company recently asked me what kind of numbers and other material he'll need when he goes into his next round of fundraising. He wanted to make sure that when he starts talking to new potential investors, he'll have answers ready to most of the questions he'll be asked.

That was a great question. By putting together a comprehensive set of data you can pre-empt 90% of the questions which investors will ask you when they assess a potential investment. This has a number of important advantages:

  • It saves you time because you'll have to answer fewer individual questions and requests in a piecemeal fashion.
  • It can speed up the fundraising process dramatically if investors get almost everything they need at once (or almost immediately upon request).
  • It makes you look better, because it shows that you're on top of things.
  • Almost all of the numbers (good) investors ask for are things that you should be highly interested in anyway, since they are important for understanding and running your business.

What kind of numbers you should prepare of course depends on the industry and stage you're in. I'm going to assume that you're a SaaS company and that you're going for a Series A or a Series B round. In this case, the following things will help you pre-empt a lot of DD questions:

1) A spreadsheet with your key metrics, since launch, on a monthly basis. It should include funnel metrics (visitors, signups, conversions etc.) as well as key financial metrics (MRR, CoGS, CACs etc.). If you haven't seen it yet, I put together a template for a KPI dashboard some time ago, which should serve as a good start.

You are probably tracking most of these numbers already anyway, so you can use a copy of your internal dashboard, but make sure that it's clean, comprehensible and that you're using the right terms.  If your dashboard contains any ambiguous metrics, add footnotes with precise definitions to make sure that an outsider understands exactly what he's looking at.

2) A chart with your MRR movements, since launch, on a monthly basis. That is, a chart that shows your new MRR, expansion MRR, contraction MRR, churn MRR and reactivation MRR for each month since launch.

MRR movements in ChartMogul
If you have a very wide range of customer size, consider breaking down the MRR movement analysis by your customer segments, because in that case the aggregate numbers across all customers may not tell the full story. So if you're selling to both SMBs and bigger enterprises, consider showing one MRR movement chart for the SMB customer segment and another one for the enterprise customer segment.

Make sure to provide the raw data along with these charts (and any other charts you provide) to allow the viewer to do his or her own calculations.

3) A cohort analysis, showing each monthly customer cohort since launch and how the cohort’s MRR has developed over time. I created a template for that, too. If you're selling to both SMBs and enterprise customers, you should again consider doing a separate analysis for each of the two segments.

Also consider adding a cohort analysis which is based on an activity metric. Think about what your key usage indicator is, then run a cohort analysis that shows the development of that number over time.

4) A financial plan for the next three years. The plan should follow the same logic as your historic KPI dashboard and should be relatively simple. Don't hard-code many numbers and make it easy to understand which assumptions the model is based on. Here are a few additional tips, and here's a template for a financial plan I built some time ago.

5) An overview of your customer acquisition channels. That is, a breakdown of your website visitors, leads and customers by source and data about your customer acquisition costs. 

Try to add some data points or estimates on the scalability of your customer acquisition channels. I know this is very hard and sometimes impossible, especially for inbound marketing driven companies, but some projections are probably better than having none at all.

6) If you're selling bigger deals, detailed information about your current sales pipeline. This should include a list of all qualified opportunities, and for each opportunity the potential deal size (in terms of MRR or ARR), pipeline stage and, if you have enough historic data to make a solid guess, closing probability and timeline. If you're a low-touch sales, high-velocity, low ARPA SaaS company you can leave this out.

Bonus tip: If you're an enterprise SaaS company, put together some additional information about your largest customers. Think of it as a little case study, with some information about how the customer found you, how the sales process looked like and how the account has developed over time.

What do you think? Does this capture most of the data Series A/B investors want to know?

[Update 5/8/2015]: I wrote a follow-up post with some additional details on what exactly SaaS Series A/B investors will look for when you supply them with the data and material mentioned above.]


Friday, April 24, 2015

Key Revenue Metrics for SaaS companies

Thanks to Nick Franklin for reviewing a draft of this post!

When I talk to SaaS startups and take a look at their metrics, it still happens quite often that some of the numbers aren’t quite clear to me and it takes some time to clarify things. I’m not referring to sophisticated reports or analyses but to the much more mundane question of what exactly people mean when they use a term like “revenues”.

It’s maybe not surprising that there’s sometimes confusion, given that there are several different ways to express revenues of a SaaS company and even more ways to label them: revenues, sales, turnover, MRR, CMRR, ARR, cash inflow, cash-in, billings, bookings, GAAP revenues, income and so on. That said, I believe most SaaS companies can focus on a small number of revenue metrics which aren’t overly complicated.

If everyone in the SaaS world can agree on the same nomenclature, I think that will make communication between founders and investors more efficient and will save all of us some time. So let’s take a look at the most important revenue metrics in SaaS.


MRR

Monthly Recurring Revenue (MRR) is, as the name suggests, revenue that you anticipate to recur on a monthly basis. If you’re selling monthly subscriptions, MRR is simply the price paid each month for the subscription. If your customers are paying you for more than one month upfront, you simply divide the amount you received by the number of months in the subscription period.

Say you’ve acquired two new customers. Customer A has signed up for a monthly subscription at $100 per month and Customer B has signed up for an annual subscription of $1100 per year. In this scenario, customer A increases your MRR by $100 whereas customer B increases your MRR by $91.67 ($1100/12).

This simple metric is the most important metric a subscription business needs to calculate, which is why ChartMogul (which for disclosure we’re an investor in) is highly centered on MRR. If you focus completely on MRR and calculate it correctly you’re in pretty good shape, so feel free to stop here and ignore the rest of this post. :-)


ARR

Annual Recurring Revenue (ARR) follows exactly the same concept. The only difference is that it measures your annually recurring revenue as opposed to your monthly recurring revenue, so your ARR is 12x your MRR.

Since both metrics are interchangeable, it doesn’t matter if you’re tracking MRR or ARR. I personally prefer MRR, but I can’t tell you why. Probably just out of habit.


Cash inflow

Cash inflow or “Cash In” is the amount of money that you’ve received in your bank account. In the example above, it’s $100 for customer A and $1100 for customer B. A related term from the accounting world is “Accounts Receivable” and refers to cash that is legally owed to you but which you haven’t received yet. Since SaaS companies are typically paid upfront, at least for a month of subscription if not a year, you usually don’t have to worry too much about this and can focus on cash inflow.


Revenues

Revenue means MRR plus any non-recurring revenue such as implementation fees, setup fees or charges for professional services. Let’s say you’re charging a customer $1000 for a data migration project that takes one month to complete, plus another $3000 for onboarding consulting in the customer’s first three months. In that case, the customer will increase your revenue by $2000 in the first month ($1000 for the data migration and $1000 for consulting) and another $1000 in month two and three each. But since these revenues aren’t recurring, don’t include them in your MRR.

Note that this definition of “revenues” is what I believe is usually the right way to look at revenues at the management and board level whereas the numbers which your accountant will produce for your financial statements will likely look slightly different. The reasons are a couple of subtleties in the way software revenues are recognized based on US GAAP and other accounting standards, which brings me to...


US GAAP Revenues

Since I’m not an accountant and don’t even have an MBA we’re now entering territory which I’m not very familiar with, so proceed at your own risk. :) US GAAP Revenues means revenues in accordance with the “Generally Accepted Accounting Principles” adopted by the SEC. Your US GAAP revenues will usually be close to your revenues based on the definition I outlined above, but there can be some differences. For example, US GAAP revenue is typically calculated using a daily recognition model as opposed to the more practical monthly model. That means that if a customer signs up for a subscription at $100 per month on January 15th, according to US GAAP you should only recognize $50 of those $100 in January, despite the fact that that customer is adding $100 to your January MRR. Another difference is that as I’ve learned when doing some research for this article, apparently you may have to recognize things like implementation fees over the subscription period as opposed to the period in which the implementation service is being provided.

This topic is a science of its own, and if you’re interested you can read this 150 page manual from Deloitte about software revenue recognition, but the good news is that you don’t have to worry too much about it. Find a good accountant who understands SaaS and let him figure it out.


Bookings

I’ve seen several definitions of the term “bookings”. Broadly speaking, bookings are the total dollar value of all new contracts signed, but it’s not clear if the number should be annualized for contracts that are larger than one year, nor if non-recurring revenues should be included. Even worse, if your contracts have different subscription periods (e.g. one month and one year), the bookings number can be very ambiguous and misleading. I would therefore recommend to not use this metric and largely agree with the Bessemer Cloud Computing Law #2 which famously stated that “booking is for suckers”.


Billings

The term “billings” refers to the amount that you have invoiced and that is due for payment soon. If your ARPA is low and most customers pay you via credit card and/or your bigger customers usually pay you on or about the time of subscription or renewal, this metric isn’t important. If you agree on longer terms of payments with your customers, it can become important for cash flow planning purposes.


Committed MRR

Committed MRR or CMRR is a projection of your MRR in the next month or future months based on your current MRR, adjusted by guaranteed expansion MRR and anticipated churn MRR. SaaS companies sometimes have customers that start with a low price but have already agreed to a price increase in the future. CMRR is a great way to track and show this type of guaranteed expansion MRR. If you adopt the CMRR metric to show guaranteed expansion MRR, make sure that you also take into account “guaranteed churn” in order to make it consistent. That is, subtract MRR which you expect to lose from customers that you expect to stop using your software in the near future.


Closing thoughts

I believe that most SaaS companies do well by focusing on MRR and Cash Inflow plus, depending on the nature of the business, revenues and CMRR. The only thing I’d add is that if you’re selling annual subscriptions but you don’t get the full payment upfront (or similarly, if you’re for example selling 2-year-subscriptions but get only one year upfront), you should monitor your MRR broken down by contract length. That’s because there’s obviously value in selling longer subscriptions vs. shorter ones but that difference won’t show up in your MRR nor in your Cash Inflow in these cases. If you think there are any other revenue metrics that I’ve missed, please let me know.

Finally, I’m well aware that while all of these metrics are easy to understand conceptually, there are still a lot of devils in the details. The purpose of this post is to come to a common understanding of the key revenue metrics – how to deal with some of the many special cases that you’ll inevitably see (discounts, refunds, currency fluctuations, metered charges, etc) might be the topic of another post.



Tuesday, March 31, 2015

Hyper-growth in SaaS

Following his well-received guest post about cohort analysis, here comes another guest post from my colleague Nicolas. Enjoy!

Status Quo


From an investor’s perspective, SaaS companies have a lot to love: High gross margins, predictable (recurring) revenues and capital efficient operations. On the flip side, most of them follow a common thread when it comes to growth. It might be too much to label it the ‘long, slow SaaS ramp of death’, but their revenues tend to develop slower than those for consumers plays. How come? In contrast to B2C companies like Uber, Delivery Hero or Homejoy for which it was critical to get the unit economics right, scaling distribution is usually the toughest challenge for a SaaS startup after it has found product / market fit. And this is understood by the markets.

If you are looking at the assumptions for frameworks like ‘T2D3’ and growth projections as outlined by Christoph recently, SaaS companies are typically expected to scale to $100m in revenues before approaching an IPO. You can also see this growth pattern in reality, here is a telling graph of the median SaaS revenue level pre-IPO that I borrowed from Tom Tunguz:



There is no question that growing to $100M in revenues in 7-9 years is an impressive achievement and doesn’t sound like a long, slow ramp of … anything. But if you compare that with Spotify’s estimated revenue of $1B in 2014, some 9 years after founding, you quickly see that there has been a significant difference in scale of successful consumer and enterprise businesses. This holds true for other consumer focused internet companies as well. As you can see, all but one member of this cohort have reached or are on track to reach $1B in year 6 (at the latest!):



At this point I want to stress that clearly all revenues are not equal and due to high margins, customer lock-in and predictability, $1 in SaaS revenue is really something else than say $1 in e-commerce revenue. But it’s fair to say that historically IPO prospects in the B2B field could not match the explosive revenue growth of successful B2C companies.

SaaS Growth in 2015


Something is changing though. Look at these growth curves:


(taken from this great presentation by Mamoon Hamid and slightly edited)

You guessed right, they are all SaaS businesses. And while you could argue that the revenue growth curves of Company B and C still roughly follow the slope of a long, slow SaaS ramp of death to an IPO and come in around the median we saw at the beginning of this post ($2.5M-4.5M ARR after two years and $8M-12M after three), Company A is on steroids! It’s Slack (and B and C are Yammer and Box respectively).

And while that is pretty wild, I couldn’t even fit Zenefits on there properly, because with $20M ARR in under two years and a goal of $100M after three, it’s literally off the charts. Admittedly, I can't say for sure that this reported 'ARR' is net revenues or what exactly their COGS structure looks like, but either way their pace is incredible.

Are we starting to see SaaS companies taking shortcuts and adopting consumer growth curves? Let’s quickly take a look at these two examples and see what they did differently.


Case 1: Slack


You are probably using Slack, but if not just have a look at the twitter love they get. Yes, looks like they are the hottest thing on the block since KoolAid. Although I am personally not 100% sold on all design choices, the way it handles integrations and plays nice on all platforms is quite impressive. I am sure that word of mouth and referrals are the key traffic drivers for them.

Second, it’s free. At least until you hit 10k messages. And by then it is likely that you are already locked-in. So are you going to become a paid customer? What if you commit to Slack now, but your team slowly drops off and you pay for these users anyway? Fear not as Slack will only charge you for monthly active users! Pretty clever, huh?

In summary:

  • A very good, consumerised product with native connectivity 
  • ‘Risk-free’ freemium business model

  • Bottom up growth dynamics boosted by WOM

  • A large bankroll ($180M in financing)



Case 2: Zenefits


How much are you paying for your HR software right now? How about $0, plus you can manage benefits through the platform with a few clicks? Hard to deny that value proposition (although we believe that this is not one-size-fits-all and best of breed solutions like our portfolio company Humanity will win large parts of the market).

So they ‘just’ had to push that value proposition into the market. And with push, I mean push real good, as according to LinkedIn, there are over 100+ people in sales roles at Zenefits. And that’s a company in its second year! Compare that to Atlassian or Zendesk, which didn’t have a proper salesforce until they reached thousands of customers.

In summary:

  • Freemium again, yet this time with a different spin

  • Aggressive outbound distribution
  • A large bankroll ($84M in financing)


Conclusion


So what does this mean? It’s a bit too early to predict how these two specific stories play out, but this much seems to be true:

  • It’s possible to scale SaaS companies faster than ever before
 in 2015
  • Consumerization of the enterprise is happening on the product and business model level
  • Freemium is a valid strategy in enterprise SaaS 

  • Nobody, not even suits, like large upfront commitments

  • Investors are willing to make large bets early in a company’s lifetime if it adopts consumer growth curves


It’s important to note that both cases here are horizontal SaaS solutions that are attacking broad markets. I haven’t seen a vertically focused cloud company scaling this fast, but who knows what the rest of 2015 holds. I’m curious to see how this new playbook for hyper-growth in SaaS develops.



Sunday, March 15, 2015

In God we trust, all others bring references


In the last few weeks I talked to two entrepreneurs who both recently made a hire that didn't work out. In both cases I asked how the reference calls went, and in both cases the answer was that they hadn't done any before hiring the candidate. This made me almost angry, especially because the two entrepreneurs are fantastic founders who could have saved themselves from this costly mistake by following a simple rule: Don't hire people without taking references.

Bad hiring decisions are among the most expensive mistakes that you as a founder can make. According to this CareerBuilder survey, bad hires typically cost companies as much as $25,000-$50,000, but the true costs go much beyond cash. The (harder to calculate) opportunity costs – the fact that you've wasted time getting the wrong person up-to-speed and that your recruitment of the right candidate got delayed – usually weigh much stronger, not to mention the negative impact which a bad hire can have on your team, customers and partners.

Most people read test reports and customer reviews before buying a digital camera or an office printer, so how come they don't use the same level of diligence for a decision that is 100x more important? I can think of a few possible reasons:

"Based on the candidate's CV and my interviews I'm so confident that he/she is the right one, reference calls aren't necessary."

Assessing candidates in an interview is hard. Coming across as a great candidate in an interview process is one thing, being able to do the job is sometimes something different. Talking to people who have closely worked with the candidate for years gives you valuable additional data points for your decision. Even if you're a fantastic interviewer and you're right most of the time – if reference calls help you reduce the number of times you're wrong, they are worth it.

"I won't learn anything new, and the references provided by the candidate will only say great things anyway."

Even if people provided by the candidate will usually (but not always!) give a glowing reference, by asking the right questions you'll often find out, usually between the lines, if the reference-giver wants to be polite or if he really thinks that your candidate is awesome. Even more importantly, you should always try to get backdoor references, too.

"It costs so much time!"

Yes, it does. But think about the difference which the right hire vs. the wrong hire can make.

"It's awkward to ask people for references or to sniff around to get backdoor references."

Don't be afraid to ask even if it makes you feel awkward. Senior candidates expect you to ask for references anyway, and junior candidates will quickly learn that it's a standard practice. People will also understand that you need to take backdoor references. The only really problematic situation is if references from the candidate's current company are crucial for your decision and the candidate didn't give notice to his current employer yet. In that case you obviously can't simply call the candidate's boss and you need to find out carefully how you can get your references without doing harm to the candidate.

If I was able to convince you of the "why", check out this great post by Mark Suster about the "how":  "How to make better reference calls"


Wednesday, March 04, 2015

How fast is fast enough?

Growth is the single biggest determinant of startup valuations at IPO, as my fellow SaaS investor Tomasz Tunguz concluded based on an analysis of 25 IPOs in 2013. Growth (a.k.a. traction) is also the most important factor that attracts VCs and drives valuations in private financing rounds. Of course your team, product, technology, business model and market matter too, but when you’re past the seed stage the expectation is that these factors will have resulted in excellent growth. At the seed stage you can sell your story and vision. At the Series A and later stages, you have to back it up with numbers.

This isn’t surprising. Past growth tends to correlate with future growth, and since tech markets are winner-takes-all (or "winner-takes-most") markets, investors are obsessed about finding the fastest-growing player that has the biggest chance of dominating the market.

If growth is so crucial, how fast do you have to grow?

The answer depends on the market you’re in and the type of company that you want to build. If you’re in a small niche market – let’s say a business solution for a small vertical, localized to one country – maybe you don’t have aggressive, well-funded competitors. In that case it may be sufficient if you’re the fastest-growing player in that market, even if that means you’re growing only 20% year-over-year. There’s absolutely nothing wrong building a company like this, and you could end up with a highly profitable small business (or Mittelstand company). This is not the type of company VCs look for though, and the rest of this post is written based on the premise that you’re a SaaS startup that wants to grow to $100M in Annual Recurring Revenue (ARR).

So how fast do you have to grow in order to become a $100M company? Again using data compiled by Tomasz “Mr. SaaS Benchmarking” Tunguz we can see that the 18 publicly traded SaaS companies that were founded within the last ten years took five to eight years to reach $50M in revenues, with 14 out of the 18 being in the six to seven years range. (1) Add another one or two years for getting from $50M to $100M, and we can assume that most of these companies took seven to nine years to get to $100M.

$1M, T2D3, 50%?

If you want to get from 0 to $100M in revenues in seven years, your growth curve will likely look very roughly like this: Get to $1M in ARR by the end of the first year, triple to $3M in the next year, followed by another triple to $9M by the end of year three. Double your revenues in the next three years, so that you’ll reach $18M, $36M and $72M by the end of year four, five and six, respectively. Grow by another 50% in the next year and reach $108M in ARR by the end of year seven:



This is very much in line with the “T2D3” formula described by Battery Ventures in this TechCrunch post. If you want to give yourself nine years to get to $100M, your numbers will probably look roughly like this:





Could you also take the slow track?

The big question is now if this strong pattern is merely the result of investment bankers’ and public market investors’ preference for fast-growing companies or if something more fundamental is going on here. If there was a “law” which said that if you haven’t reached something close to $5M after three years, $10M after four years, and so on, you’ll likely never get to $100M, this would obviously have important implications for founders as well as investors.

My opinion is that there’s no hard law – in business you’ll find exceptions for every rule, and I think it’s definitely possible that software companies that grow slowly and eventually reach $100M exist. But I do think that the probability of ever getting to $100M does go down very significantly if you’re growing much slower than pictured above. This is because:

  • As companies get bigger, growth rates tend to go down, not up. So if your growth rate in year three is only, say, 50%, it’s unlikely that it will be 200% in the following year. It can happen and does happen, of course, but only if there’s a dramatic improvement in the business - a new product, a new distribution channel, a new business model or the like.
  • It’s hard for a slow-growing company to attract the best people. It’s not only about being “hot” as an employer (although that’s part of it, too). If you’re not growing fast, you’ll also have a hard time making compensation packages competitive with those of fast-growing companies. The positive feedback loop that is taking place here is very powerful: Momentum attracts talent and money, which you can turn into more momentum, and so on.
  • Not so many founders have the stamina and patience to stick to their company for 10, 12, 15 years - after so many years, many people understandably need a change. And while a company can of course survive its founders, it’s still a loss that doesn’t make things easier in the future.
  • Lastly, but maybe most importantly, if you can’t figure out a way to grow fast and you’re in a large market, chances are that someone else will. It also increases the chance of a new, innovative, fast-growing startup entering and possibly disrupting the market before you’ve reached significant scale.

Coming back to the original question, how fast is fast enough? If your goal is to eventually get to $100M in ARR, I think you should try to get there as fast as possible, and getting there by the end of year seven after public launch feels about right to me. This may seem like a very ambitious goal, but it would be boring if it was easy, wouldn’t it?

___________________

(1) Note that there’s somewhat of an outcome bias in these results, as companies that were founded in the last ten years but take more than ten years to go public haven’t been included. So it’s possible that a few companies with slower growth will be added in the future, but that’s unlikely to change the picture significantly, especially if you keep in mind the trend which Tomasz has described in his post: SaaS startups are growing faster than ever before, and it’s taking them less and less time to get to $50M.


Sunday, February 22, 2015

Why (most) SaaS startups should aim for negative MRR churn

If you've followed my blog for a while, you know that I have a bit of an obsession with churn. Having significant account churn doesn't necessarily have to be a big problem and can't be avoided completely anyway. MRR churn sucks the blood out of your business though. That's why I think that SaaS companies should work very hard to get MRR churn down, as close to zero as possible, or even better achieve negative MRR churn.

Before I continue, here's a quick refresher on the terms that I'm using. If you're a SaaS metrics pro you can skip the next two paragraphs.

Your account churn rate, also called "customer churn rate" or "logo churn rate", measures the rate at which your customers are canceling their subscriptions. If you have, say, 1,000 customers on February 1st and by the end of the month 30 of them have canceled, your account churn rate is 3% p.m. in Feburary. Note that this assumes that all 1,000 customers are on monthly plans and can cancel that month – if some of your customers are on annual plans, you need to calculate the churn rate of that customer segment separately.

Your MRR churn rate, sometimes also referred to as "dollar churn rate", is the rate at which you are losing MRR through downgrades and cancelations. If you have, for example, $100,000 in MRR on February 1st, and by February 28 you've lost $4,000 of these $100,000 due to downgrades and cancelations, your gross MRR churn rate is 4% in February. Assuming you have $6,000 in expansion MRR in the same month – i.e. an increase in MRR of existing customers, e.g. due to upgrades to more expensive plans or additions of seats – your net MRR churn is minus $2,000 and your net MRR churn rate is minus 2% in that month. For more details on these and other SaaS metrics, check out ChartMogul's SaaS Metrics Cheat Sheet.

Thanks for your attention, SaaS metrics newbies, and welcome back pros. The following two charts show the disastrous effect of MRR churn, using an imaginary SaaS startup (let's call it Zombie.com) with $100,000 in MRR that has a net MRR churn rate of 3% p.m. and is adding $10,000 in MRR from new customers each month:

MRR development of Zombie.com - click for a larger version

MRR development of Zombie.com - click for a larger version

The first chart shows how much new MRR from new customers Zombie.com is adding (light green), how much MRR it's losing due to churn (red) and what the net change is (dark green). The second chart shows the resulting MRR (blue) and the ratio between new and lost MRR (orange), inspired by Mamoon Hamid's great "Quick ratio" of (Added MRR / Lost MRR), which I recently learned about.

As you can see in these two charts, not only does the net new MRR of Zombie.com go down every month. It actually asymptotes to zero, which means that the company is hitting a wall at around $350,000, at which it stops growing.

The math behind this is of course trivial, since the assumption was that the company is adding a constant dollar amount of MRR every month, while churn MRR, being a constant percentage of total MRR, is growing. So what happens if instead of acquiring new customers linearly, you manage to add new MRR from new customers at an ever increasing rate?

Here's another imaginary SaaS startup, let's call this one Treadmill.io. Like Zombie.com, Treadmill.io has $100,000 in MRR in the beginning of the timeframe that I'm looking at and has a net MRR churn rate of 3% p.m. Unlike Zombie.com, Treadmill.io is adding new MRR from customers at an accelerating rate, though: In the first year it's adding $10,000 per month, in the second year $15,000 per month, then $20,000 per month, and so on. Let's look at the charts for Treadmill.io:

MRR development of Treadmill.io - click for a larger version

MRR development of Treadmill.io - click for a larger version

The MRR development of this company looks much less depressing, and after ten years it reaches close to $1.5M in MRR. However, as you can see in the first chart, as well as in the declining orange line in the second chart, churn is eating up an ever increasing part of the new MRR coming in from new customers. If Treadmill.io doesn't manage to decrease churn, it will have to acquire more and more new customers just to offset churn, and keeping net new MRR growth up might become increasingly difficult.

OK, but what if you're acquiring new customers at an exponential growth rate? Let's look at a third imaginary company called Weed, Inc. Like Zombie.com and Treadmill.io, Weed starts with $100,000 in MRR and has a net MRR churn rate of 3% p.m. The big difference is that Weed is adding new MRR from new customers at an exponential rate. Starting with $10,000 in the first month, the company is growing new MRR from new customers 10% m/m in the first year; 8% m/m in the second year; 6% m/m in year three; 4%, 3% and 2% in year four, five and six, respectively; and 1.5% from year seven onwards. 

Here are the charts for Weed, Inc:

MRR development of Weed, Inc. – click for a larger version

MRR development of Weed, Inc. - click for a larger version

Not much to complain about: After ten years, Weed, Inc. has more than $19M in MRR. The big question, though, is if a development like this is realistic. In order to offset ever increasing churn amounts, Weed needs to acquire new MRR from new customers at an extremely ambitious pace. In the last month of the ten year model that I'm looking at, Weed adds about $870,000 in new MRR from new customers, almost 5% of the company's total MRR at the beginning of that month. To acquire so many new customers, Weed needs either a viral product (very rare in B2B SaaS) or extremely scalable lead acquisition channels.

I'm not saying that it's impossible, but I believe the much more likely path to a SaaS unicorn is by getting MRR churn to zero or below – which means you have to make your product more and more valuable for your customers and acquire larger and larger customers over time.


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