Abhishek Sharma

World has changed dramatically since 2006 (also the year when I founded my first startup – HelloIntern.com ). Back then, the first question, which VCs asked was, “how will you make money?” Today, the fashion seems to have flipped. It’s almost considered sinful to ask that question to a new founder in 2015. :)

Over the last decade, with digital transformation of our erstwhile analog world, we have seen emergence of a variety of innovative business models – including freemium, multi-sided marketplace, and very notably, SaaS (the core concept now also extended to PaaS and IaaS).

I have been quite fascinated by SaaS – particularly because of predictability in revenue-stream (for the company) and attractive optionality of pay-as-you-use (for the customers). The success of the model is proven by the number of IPOs (~50) of SaaS companies over the past decade. These IPOs have invariably struck high valuations. In fact, there is a joke in the VC world, “call yourself a SaaS company and double your early stage valuation overnight!”

Past summer, working in VC, I talked to 40+ SaaS companies. While a few appeared to be propelling steadily, many of them seemed shaky. I tried to dig in what truly classifies a scalable, sustainable, predictable SaaS business.

Following factors are the basic nuts and bolts of SaaS:

LTV (v) - customer lifetime value CAC (c) - customer acquisition cost ASP (p) - average subscription price Growth Rate (g) - growth rate of ASP per year Operating Margin (m) - % of revenue Churn (x) - annualized attrition rate of customer-base Hurdle Rate (r) - financial discount rate LTV can be computed as:

Sum of this infinite geometric progression converges only if (1+g)*(1-x)/(1+r) x+r, SaaS companies can achieve a breakout effect (i.e. by having a minimally low churn and very high growth rate) and achieve an astronomically high P/E multiplier (very rarely seen).

1. Growth Rate vs. Churn Rate balance Let's consider an example (please see the cash flow below) of a SaaS company that prices its services at $100 in year_0, incurs a CAC of $200 to win a single customer. As shown below, in the first case, company grows its ASP aggressively at 30% y-o-y but at a churn rate of 30%. In the second case, company grows ASP much slowly at 15% however at a churn rate of 5%. The LTV/CAC ratio in second case is ~13 vs. ~0.5 in first case. In the case 1, the investor can never ever recover the money back, while in case 2, the full payback is achieved in year 8. This shows that the same SaaS model with different interplay of growth and churn rates could turn from attractive to unattractive (and vice versa).

2. ASP to CAC ratio In the first case, the margin is higher than in second case (20% vs. 10%) while the CAC is also higher ($200 vs. $50). However, despite higher margin in case 1, the LTV/CAC ratio is ~1.7 vs. ~3.3 in case 2. Additionally, in case 1, it would take 9 years for VC's simple payback vs. 5 years in the other case. This highlights the importance of ASP to CAC ratio.

Success Levers for SaaS Manage CAC: Prioritize inbound marketing as possible. Try to effect virality (or referral) to reduce incremental CAC on every next customer. Having a light-touch plug-n-play solution (instead of a heavy integration platform) often cuts down the length of sales cycle and hence, CAC. Further, structuring appropriate service SLAs or self-serve arrangements could reduce ongoing servicing costs (although not factored in the model above). Lastly, prioritization of customer accounts (e.g., Large vs. SMBs) and the mapping with right sales model (e.g., field sales vs. inside sales vs. opt-in) are critical for CAC optimization.

Reduce Churn: Customer service is the key. Use of CRM, real-time complaint resolution, keeping up with changing customer requirements, and running at pace with competitive innovation could be helpful.

Scale up Margin: With scale, fixed and overhead costs could go down, leading to net margin improvement over time.

Increase ASP: SaaS companies could strive to tap cross-sell and up-sell opportunities, or increase # of licenses or seats, to grow the ASP.

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You could follow me on Twitter @oneabhishek | Cross-posted on Medium

Abhishek Sharma

Menlo Park, California, United States 20K followers 500+ connections

Experience

Nexus Venture Partners

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Education

Harvard Business School

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