This is part of an ongoing series of guest posts from Lauren Kelley, CEO and founder of OPEXEngine, sharing some of her insights around benchmarks for software and SaaS companies. View her first post here
Tracking performance metrics like monthly recurring revenues (MRR) and contracted monthly recurring revenues (CMRR), customer acquisition costs (CAC), renewal or churn rates, and customer lifetime value rate (CLV) is critical for driving growth at successful SaaS companies. None of these metrics are GAAP metrics, though, and there is no auditing of the numbers. Many companies do their best to follow definitions for these metrics from research on the web, anecdotal discussions with peers, and with investors or board members. The devil is in the details, however, in making sure the data truly represents the metric as intended. In addition, it is important to understand how metrics are defined when comparing one company’s non-GAAP metrics against those from another company.
At OPEXEngine, we consult closely with dozens of companies on their definitions for these metrics. Over the past eight years, we've worked with hundreds of companies, as well as with investors reviewing the performance of their portfolios and we've seen how some of these key metrics have evolved. I’d like to share a few of the issues that we’ve run into in developing accurate data for these important benchmarks.
Take for example CAC or customer acquisition costs. CAC is key to analyzing whether a company can profitably acquire new customers and grow the business. Customer acquisition costs should reflect as best as possible everything it takes for a company to acquire new customers. How do you calculate this number? Typically, some portion, or all of sales and marketing expense is divided by the number of new customers acquired in a given period. Usually, the expense data is taken from one to two quarters back from the period in which the customers were actually contracted, to account for some delay due to the length of the average sales cycle. In other words, you spent money and effort last quarter or last year, which resulted in a new customer this year, so there is a lag that you want to account for when dividing your expenses by the number of new customers acquired.
The Details of Calculating CAC
What constitutes the right inputs to calculate the cost to attract and close new customers? As in many of the non-GAAP metrics, some judgment needs to be applied. Here are some considerations. Do you only count salaried sales and marketing employees, or include full time contractors as well? Some companies pay for lunch for their employees, arguing that it makes the employees more productive and focused on their work. So, it is a productivity expense, and shouldn’t the lunches of those employees that are focused on bringing in new customers be included in the customer acquisition cost? That expense could be quite high relatively for smaller, newer companies.
Do you include recruitment costs for new sales people, which may be sitting in G&A expense, and which will make your CAC look much higher in the start-up or expansion years? Or do you exclude all one time charges like recruitment fees and only look at regular, run rate expenses to acquire new customers? Certainly travel, computer and cell phone expenses for people dedicated to “hunting” new customers should be included in CAC. How about the cost of running and promoting the annual user or company event? Is it primarily for existing customers, or do you include prospects as well? Is the user event really a theme event that promotes your brand and thought leadership to prospects? If so, then probably you should allocate some portion of this expense to CAC.
Customer Retention Rates
Another metric which can be hard to define is Customer Retention, or churn. If your company runs pilot or trial periods, and collects payment upfront, but the payment is for a short term period, do you include these customers in your churn rate, or not? Most companies do not. Customer retention rates aim to understand the retention of customers that have committed to using your service, and trial period customers by definition have not yet committed. That is not to say that it isn’t useful to track how many of these customers convert to being committed customers, but that is a different metric.
Customer Churn Rate Calculation
The customer churn rate calculation results in a different number depending on whether you track it by the date when customers renew versus taking the set of customers that were using your service in the prior period, and whether they are still using the service in the next period. One of the problems with tracking churn by the date of the renewal is that the contract period might be variable. Or, if a customer changes their contract, ie., increases or decreases the number of subscribers during a contract, many systems will then change the date of renewal to the new start date.
In addition, the churn rate can be muddied if you include new customer adds during the period being examined. For example, you start 2013 with 10 customers. In June, 2 customers cancel their contracts, and in October, you add one more customer. At the end of 2013, you have 9 customers. Is your churn rate 20% or 10% based on having 9 customers from a start of 10 customers? In order to truly understand whether you are keeping your existing customers, new customers should not be included in the churn or renewal rate, so your churn rate was 20% in this example.
In our benchmarking at OPEXEngine, we track both customer retention rate and net dollar renewal rate. Customer retention rates and dollar renewal rates usually are different numbers. You may keep a customer, but the value of their subscription has been reduced because they negotiated a new discount for the renewal, or because they reduced the number of users, or they increased the number of users and are now paying more. It is recommended to track both churn metrics, to avoid one metric hiding problems in the other.
Customer retention rate is calculated by taking the number of customers at the end of the previous period, then looking at those same customers at the end of the current period, and determining the percentage that are still using the service. For net dollar renewal rate, we look at the value of the contracts from those same customers at the end of the previous period, and then looking at the value of those same contracts at the end of the current period, and determining the percentage change. We include upsells and cross sells that increase the value of those same contracts, because when benchmarking, we are dealing with many companies that define upsells and cross sells differently, so we take the net value change. When a company is looking at dollar churn within their own company, most companies will track upsells or additional product sales to an existing company separately, in order to track their performance in marketing upsells, etc. to existing customers.
In conclusion, it is important to have a clear definition of your non-GAAP metrics, and to communicate it effectively to all your stakeholders. In addition, remember that other companies most likely will have different definitions of their metrics resulting in different numbers. Benchmarks developed without clear and consistent definitions of the data will not give apples to apples comparisons.