Wednesday, August 10, 2011

What we look for in early-stage SaaS startups

I recently wrote that investors (myself included) should do a better job of making their investment criteria transparent to founders. Today I'd like to tell you a bit more about what we at Point Nine Capital are looking for in SaaS startups (other sectors are something for another blog post).

To put it as simple as possible, the health of a SaaS business is mainly determined by two factors: Customer lifetime value (CLTV) and customer acquisition costs (CAC). One could almost say that CAC and CLTV are for a SaaS company what wholesale price and sales price are for a retailer. Just like a merchant needs to buy products and sell them at a higher price, a SaaS business needs to acquire customers at costs that are lower than the customers' lifetime value. Costs of goods sold are minimal for a company selling software over the Web, and costs like product development decrease as a percentage of revenue when you get to bigger scale. So for a bigger SaaS player, sales and marketing costs are the driver of profitability.

There are of course lots of other metrics and factors that you can look at in a SaaS company: How good is the product, how big is the market, how strong is the competition, what's the churn rate, is the company growing organically, how good is the team, to name just a few. But the interesting thing is that most of these other aspects are factored into CLTV and CAC already: If CAC are low, the product has to be good, otherwise it wouldn't be that easy to sell (exceptions apply). If CTLV is high, churn can't be that big. Similarly, if there are stronger competitors in the market, aggressively marketing a better product, it's unlikely that the company's CAC will be low. And if a company has a great CAC/CLTV ratio, the team almost has to be great because you have to execute well in all areas in order to achieve that.

Of course I'm not saying that everything is captured in those two metrics, and because they are based on present and historic data they won't reveal future developments of the industry that you're looking at. But at the minimum, looking at these two metrics is a great start when you as an investor evaluate a SaaS company.

Provided that there is some data on these two metrics, that is.

But early-stage SaaS companies which are still in public beta or just went live don't have this data yet. Getting meaningful data on your CLTV takes time, since calculating it based on the monthly churn rate of your first few customer cohorts isn't reliable. And it takes even more time until you get an idea of your CAC because you have to set up marketing programs, try various things, recruit and train sales people and so on, and of course improve the product, the on-boarding experience etc. along the way. I'd say it'll take you at least 6-12 months following your product's launch until you may have reasonably reliable data on CAC and CLTV if everything goes well – and much longer if you've got hiccups along the way.

As early-stage investors, we aim to invest in a company earlier than that so we have to look for other things – leading indicators for great CAC/CLTV ratios in the future, so to speak:
  • Visitor-to-trial conversion rate. If it's high, it indicates that your target audience is interested in your product. It also says a lot about your ability to communicate the value of your product clearly and with few words, which is essential for products that are sold online. And obviously, the higher your visitor-to-trial conversion rate is, the lower is your CAC, all other things being equal.
  • Trial-to-paying-account conversion rate. An extremely important metric, for obvious reasons. If people pay for your product, that's the best sign that you're delivering real value to them. And again, higher conversion means lower CAC.
  • Engagement and retention of your early users. It's hard to get meaningful churn data within just a few months because companies often don't terminate their accounts right away when they stop using a SaaS product, especially if your product has a low price point. Therefore we have to look at usage metrics such as daily or weekly logins and various application-specific metrics to find out if a product is really used by its customers, which of course is the basis for a viable business and high CLTV in the future.
  • Enthusiasm of your early users. Having a number of early users who are absolutely in love with your product is extremely valuable, even if it's a small number in the beginning. BoldThose users will recommend your product to everyone they know, give you great testimonials, help you get your first case studies, get the word out on Facebook and Twitter and maybe even help other customers in your support forums. And for us, these VIP users are a strong signal that you're solving a real pain and hence a strong indicator of product/market fit (which is the basis for low CAC and high CLTV).
  • Your team. Last but not least and at the risk of stating the obvious, we only invest when we're extremely confident in the founder team. That doesn't mean that you have to be a serial entrepreneur or that we expect decades of experience (as much as we appreciate that!). As early-stage investors we're happy to work with young entrepreneurs who are smart, dedicated, talented and results-driven. We're happy to help you complete your team and coach you in areas like sales & marketing, SaaS metrics or fundraising which you may have limited expertise in. The one area where we think you do have to excel is your product. You have to be able to create an awesome product and a beautiful website that sells your product. You also have to "get" modern SaaS – that whole idea around consumerized business applications that are powerful yet easy-to-use and can be sold online using a low-touch sales model. We strongly believe that this need to be in the DNA of the founder team.

There are other factors that we look at, such as market size and competition, but the ones described above are among the most important ones. I hope this helps a bit – if you have any questions please leave a comment or email me.


nikiscevak said...

Christoph, I'd be really interested to know what you consider high conversion rates for the first few points (visitors to trial, trial to paid, churn rate)?

Christoph Janz said...

Thank you for your comment, nikisczevak. It of course depends on a variety of factors and you have to take into account various aspects such as the product's price point. But as a rule of thumb, a good visitor-to-trial conversion rate is 2-3%, a good trial-to-paid conversion rate is 15-30% and a good churn rate is 1.5-3% p.m.

Mike said...

Very nice summary, Christoph. Being one of your investments I can tell it's always refreshing to work with a simple framework that allows you to look at facts and base your decisions on metrics rather than opinions. We are very lucky our investors think and act that way!

Jeb said...

Great post, thanks. Would you ever invest in a SaaS startup in alpha, without any metrics towards LTV?

In other words, would you consider other metrics, such as % of active users, as a proxy for CLTV in certain circumstances?

Christoph Janz said...

Yes, Jeb, I'm open to that in principle.

Unknown said...

Hi Christoph.
Congratulations for the great post!
I have a question: do you have different standards for the values ​​of CLTV and CAC because of the market type - B2B or B2C - in which the startup operates?

Christoph Janz said...

Daniel, thank you for your comment. I don't think there's a reason to work with a different standard for CAC in B2C markets per se but in reality, for Internet companies the CLTV of a B2B customer is usually an order of magnitude higher than the CLTV of a B2C customer – and that determines how much you can spend to acquire the customer.

Daniel said...

Thanks for the insight. This article is very helpful!

Anonymous said...

Although I'm not an angel, I'm interested in "business ideas" (as a hopefully successful SaaS architect).
Not more than my personal experience tells, that nine out of ten "ideas" lack of a tiny but crucial fact: They have implemented what one could call "faillure garants" (what is something different to lacking of success factors!). One faillure garant often met, is the absence of a bullet proof defensive strategy for a good USP (e.g. like, if possible, having secured one's USP by international patents). One might argue, that out there exist very strong techniques, especially for well driven large competitors (which have efficient tools to lever out the subjectively felt "savety" for a small company with a 'subjectively good felt' patent strategy), but to me the large firms seem to be too heavy and slow in means of software developing speed, and the small, flexible and fast firms, have no tools nor know how (won't tell) for cracking patents efficiently. In other words: Despite the existance of the patent cracking tools, in my opinion any startup must have developed a quite sophisticated defensive strategy for their USP - best before their roll out.
If I were a VC, I'd have a very close eye on that, but I'm not and possibly I performed an error in reasoning. Could you please tell me why you don't care so much, as it seems?

Cheers, Nik.

Swati Jain said...

Great article! I have a question. What do VCs look for in a SaaS company when they are looking to exit?