Few conversations between a B2B investor and a software company get far before the mention of metrics. But following the boom times of recent years, what do investors and management teams really see as critical to measure SaaS performance today?
Antony Baker, Principal at Claret Capital Partners, and Charlotte Stephenson, Analyst, sat down with leading software investors and management teams from the Claret portfolio to understand what metrics matter most to them in 2023 and beyond. In the first of a two-part series, we break down some of the key metrics our peers and entrepreneurs have front of mind.
#1: Growth is still King
Unsurprisingly, Annual Recurring Revenue (“ARR”) growth continues to be the north star metric for management teams and investors to assess the performance of a SaaS business.
However compared to the growth-at-all-costs mindset of recent years, ARR growth is now very rarely viewed standalone – its relationship with efficiency is closely scrutinised by management teams and VCs alike.
“This year is different – another main priority is operating cashflow. So the metrics have changed, and profitability is coming at the expense of achieving as much growth as there was previously” (SaaS CFO).
Investors are laser focused on “how much capital has been consumed to get (revenues) so far” (B2B software investor). This is often tracked by measuring the number of dollars burned per net new ARR generated (over the same last 12 month period):
Whilst benchmarking every metric discussed in this piece has nuances and variances based on maturity and model, broadly 1.0x or lower is considered strong, with closer to 0.5x and below seen as top quartile.
The increased focus on efficiency has also seen the return of a less loved metric of years gone by…
The Rule of 40
*Note that alternative Rule of 40 calculations include YoY ARR growth + Free Cash Flow margin
“The one metric prevalent everywhere is the Rule of 40 – it now has a seat at the top table of metrics. Investors want to see a path to profitability – but they don’t want to see you slowing down growth either” (SaaS CFO).
The principle states that a SaaS company’s growth rate when added to its EBITDA (or FCF) margin should equal 40% or higher (i.e. a growth company up 100% year-over-year should have at worst a -60% EBITDA margin, and a more mature business with 20% year over year growth should have at least a +20% EBITDA margin). Based on data from McKinsey, a score at or above 40 will attract an increasing premium revenue multiple from investors.
Perception of the metric was mixed across investors and management teams with whom we spoke:
i) “Rule of 40 is a key measurement: the quality of R&D should be factored in but is normally ignored – what is the ROI and is it worthwhile product investment with a good payback?” (B2B software investor);
ii) “it’s really hard to get there, but even harder to sustain for more than one quarter, so it does not impact management decisions” (SaaS CFO);
iii) “the future value of our business is driven by the half with high growth and high burn…i.e. the one that scores worse on the Rule of 40 scale” (SaaS CFO).
More generally, scores above 20% are considered good, with those hitting >40% being best in class.
# 2 Net Revenue Retention (“NRR”) was almost universally key metric #2
“We are always trying to validate proof points of customer love – NRR is a leading indicator of product market fit” (B2B software investor).
Based on both expansion (from upsells) and contraction (due to cancellations and downgrades), NRR portrays how well a business both keeps and grows its customer base – for example – NRR of 130% means a company will grow 30% year-over-year without even signing a new logo. With elongated sales cycles and tighter belts worn at prospective customers, there is a greater focus on renewals and upsell than new logo wins to scale ARR in 2023 (retaining a current customer is much cheaper than acquiring a new one).
NRR is “seen as validation of the product and its ability to become big” (B2B software investor).
100% NRR is, broadly speaking, an absolute minimum for investors, with most generally seeking 110%-120%. “Best in class was maybe 130% a couple of years ago, but today a company at 115% is going well” (B2B software investor).
Of course what counts as success will be influenced by many factors, amongst others:
i) the maturity of the business and the ideal customer profile (SMB focused SaaS businesses are typically expected to have 10-15 percentage points lower NRR than businesses with enterprise customers);
ii) the number of applications its product has (NRR might be expected to be lower for a single point solution when compared to a platform solution);
iii) the size of the market (“in a small market with a lot of churn and low NRR then there might be a real problem – conversely in a huge market with a fast cadence of customers and quick payback, a higher rate of churn might be tolerable” (B2B software investor)).
NRR is not without its flaws…
The cohort and time period represented can dramatically alter the result – investors will expect to review raw cohort data over time, rather than just the best-in-class superusers from 2021. They will also look at customer contract length – whilst multiyear licences paid upfront are commonly celebrated in SaaS, longer contracts can mask the underlying satisfaction of the customers who haven’t had a chance to churn.
Investors are also wary of very high NRR (or any other super high scoring metric) – there is a ceiling to which improvements no longer have value (and even peak suspicion).
The layer below NRR is meaningful
NRR is a more powerful when used as part of a broader customer cohort analysis and understanding the drivers behind the churn.
Some investors use renewal rate as a complementary metric; i.e. how many customers have renewed as a percentage of those who’s licences have expired or come up for renewal in any given period. This therefore excludes cohorts that have not had to actively take a decision on a licence renewal.
Understanding the return on investment to a SaaS customer, and its time to value, can also help investors interpret the retention numbers and customer longevity – “with longer sales cycles and more senior decision makers in 2023, there is less friction for a CFO to sign off on a renewal for a piece of software that evidences demonstrable revenue accretion or cost savings within a 6-12 month period” (B2B software investor).
What about Gross churn?
“Gross churn isn’t a problem until it’s a problem” (B2B software investor).
Gross churn, whilst often measured alongside NRR by investors, was much less prominent in our discussions, particularly for early-stage businesses still refining their ideal customer profile. It should however not be overlooked.
The calculation includes both downgrades/downsell as well as cancelled MRR.
SMB and Enterprise customers are likely to have varying levels of annualised churn, with anything below 20% per annum for SMBs / 10% for Enterprise typically considered good, and top performers at <10% for SMB / <5% for Enterprise.
(Gross churn is usually presented monthly on MRR – to annualise this the following formula can be used).
So, ARR growth and NRR have been joined by efficiency measures at the top table of metrics in 2023, and the Rule of 40 is back in vogue. What counts as strong performance is nuanced and influenced by various factors, and in Part 2 of this series we will dig a little deeper on some of the flaws in the application of SaaS metrics, explore the contrary perspectives of management teams and investors on their use, and examine the data for patterns between these key measures.
Thanks to Andrew Whiting, Conor Scanlan, Daniela Raffel, Joe Knowles, Matthew Turk, Omar Saadoun, and Nick Harber for sharing your valuable insights with us!