Late last week there was a lot of buzz around the announcement that the president and chief executive at Salesforce, Steve Cakebread, and two of his top sales executives had left the company. The news has generated blog entries with provocative titles (Is the Bloom Off the SaaS Rose? by Jeff Kaplan) and several sober assessments about the general effect the down economy is having on IT spending.

It is interesting to me that what didn’t lead the articles was a clear assessment of the metrics of a Software as a Service business and how that might be impacting Salesforce and other SaaS-based companies going after the enterprise market in this economy. The metrics of any business model are arguably “entertaining reading” for only a very limited number of people to be sure. But it is a critical subject for companies with new SaaS products or ISVs moving to SaaS to understand and be ready to measure from day one of operations.

First, let’s talk a little about marketing SaaS products. Outside of the enterprise market, SaaS products are – and should be – sold across the Internet for the most part. If your users are going to access your product across the Internet, if they don’t have large investments in existing products and infrastructure – it makes sense to leverage the network “where they are” to make sales. Of course, just like any other software company, SaaS ISV’s demonstrate at trade shows, use targeted email, and ads in magazines tied to their verticals. But with the increase in social media outlets and related marketing, there are many new doors opening to reach prospective customers in the virtual world of the Internet.

Early in its growth pattern, Salesforce used these channels quite well as it matured its product. With increasing success, more investment came and along with it – the desire to “dominate” the market. To do this, a great deal more money was spent on marketing and on bringing in a sales team that could drive “enterprise sales.” In a licensed model, the “traditional” model for enterprise software, the license fee is a large capital expenditure the customer sees as providing “future benefits.” Enterprise software sales executives are used to dealing with the objections to the high price and use various strategies to bring down the initial “bite” and trade it against maintenance fees, services and add-ons that would otherwise raise the price.

When a company like Salesforce first approaches the enterprise market, the need to “horse trade” is low. The success they find is based on prospects that may be reaching the “sunset” for their current license investment, need to increase their license commitment because of deployment increases in seats or servers or to reach newly acquired offices in other locations. These prospects are facing capital outlays for new licenses, hardware and support, against which the flexible model of a SaaS product can be persuasive. When that “low hanging fruit” is exhausted however, the cost of customer acquisition begins to rise steeply. Prospects with two to three years left on their license, a relatively new infrastructure and stable staff have relatively little impetus to “drop” their investments for a new product and perhaps risky technology and in this economy even less interest in pushing a new initiative through finance. They take more time to make a decision (lengthening the sales cycle), require more “due diligence” (raising the sales, sales support and marketing costs), and will likely counter offer with a smaller commitment for seats or subscription term to “test the waters” (lowering committed revenue). If you are a sales team engaged in a strategy of market domination, waiting until the prospect’s pain becomes more pressing may not be an option.

Because of the way a SaaS company receives its income, an expensive market domination play can be a risky strategy. To understand that – we need to dive into SaaS metrics. There are several accepted operational measures that a SaaS ISV should be aware of:

• Committed Monthly Recurring Revenue (CMRR) – Also referred to as the Monthly Committed Recurring Revenue (MCRR). The total of committed subscriptions for the period.
• Retention Rate (RR) – Also known as Churn. The percent of customers that renew their subscription at the end of the term. This includes “automatic” renewals, even though they may be a separate class in some implementations because they can always “opt-out” – although the tendency is less than in manual renewal systems.
• In Trial - The number of prospects (not users in a company or organization subscription model) subscribed in a trial period. SaaS ISVs offering trial subscriptions should also track Average Users per Customer during trial (to answer: how large are the trial prospects? Do they cover a full Line of Business? Might they need a Sales Engineer to help them evaluate?). The Average Trial Period is also of interest and depending on the sales model can be different from Time to Close.
• Average Deal Size (ADS) or the Average Revenue Per Client (ARPC)- the average Committed Monthly Recurring Revenue (CMRR) from a customer.
• Average Revenue Per User (ARPU)- Like the ARPC but broken down per user instead of per client. When the size of client implementations vary broadly across your customer base, this helps to establish your average user load and revenue. The impact of this metric depends on the subscription or revenue model of the application.
• Time to Close – The time it takes for an identified prospect to become a subscribing customer. This can be easily monitored for trial customers but requires CRM to monitor for a sales team.
• Close Rate – The percentage of In Trial customers that convert to subscribers. This can be aggregated with sales team prospects from CRM but it wise to also follow it separately to gauge pure web-based marketing and sales.
• Cost to Maintain (CtM) – The cost of services required to maintain customer instances. This should include hosting charges, hardware and software renewal, support, staff operations and outside services required to maintain customer instances outside of sales, marketing, R&D, and product development. This is an important metric because it also provides a window into Contingency Costs.
• Cost to Acquire (CtA) – The average of the cost of sales and marketing activities in a period divided by the number of customers acquired in the following period. The period is usually adapted from the Time to Close so that costs and the customer acquisition relationships are realistic.
• Customer Acquisition Cost Ratio (CAC) – A key indicator of how long it will take a customer to “payback” their Cost to Acquire. The ratio is developed by dividing the Annualized Net Gross Margin added during a quarter by sales and marketing costs of the previous quarter. Example: CAC Ratio (Q408) = [GM(Q408)-GM(Q308)]*4 Sales & Marketing Costs (Q308).
• Customer Lifetime Value Ratio (CLV) – The net present value of Annual Recurring Revenue from a customer less the Cost to Maintain and Cost to Acquire. A lifetime “horizon” needs to be assumed – usually a 3-5 year window is used unless the company has been in business long enough to make assumptions based on Churn.
• Software to Services Ratio – In a subscription only model, professional services may supplement income. In a mixed model, subscriptions can be supplemented with “value-add” services that can be transaction or on-demand based and professional services. In either case, this is a ratio of subscription revenue to services and is important when there is a low margin remaining after Cost to Maintain and Cost to Acquire are taken out. A high services ratio can compensate for the low margin if the services are considered to be high value by your customers and in high demand.
• Largest Customer % – Knowing the percentage of gross income your largest customer provides helps to assess risk. In a new company or a vertically-based SaaS, it might be also wise to assess the percentage of gross income provided by your top ten (largest) customers. The point is to assess your risk if they drop their subscription and leave you in a position of supporting sales, marketing and operations with too low a margin.

If reviewing that list made you feel like your head is about to explode – don’t worry – the next article in this series will be SaaSoNomics 102 and I’ll cover some practical examples of these metrics.

But let’s go back to Salesforce – why is it I don’t feel like the departure of their top executives is a clear indication the sky is failing on the SaaS business model? Because they have been pursing enterprise sales. The easy sales have been made, the length of time to acquire new customers and the cost of sales is rising. This means that assessing their Customer Acquisition Cost (CAC) and Customer Lifetime Value Ratios (CLV) against their Retention Ratio is likely to show their new customers will not generate a profit in a reasonable timeframe. That means a change in strategy is required to maintain profitability. Knowing that, knowing how to assess your business metrics and change direction in response is key to running a SaaS business and something we will explore with some practical examples in our next article in this series. Stay Tuned!