THE ULTIMATE GUIDE TO CUSTOMER LIFETIME VALUE

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1 THE ULTIMATE GUIDE TO CUSTOMER LIFETIME VALUE AUTHOR: JASPER ADAM - 1

2 TABLE OF CONTENTS 1. Introduction The Basics of SaaS Unit Economics Increasing Average Revenue Per Account Introduction Increase pricing Upselling Cross-selling Unbundling features Professional services Remove free plans Dealing with discounts Move upmarket Reducing Churn Rate Introduction Onboarding churn Bad customer experience Downgrade churn Competition No product-market fit Natural churn Failed payments Reducing Cost of Service Introduction Computing infrastructure Software Billing fees Customer support Metrics AUTHOR: JASPER ADAM - 2

3 1. INTRODUCTION The business model of the software industry has changed a lot during the past 15 years. In the beginning of this century, software was still sold mainly through a licensing model. In this model, customers pay a fee for a perpetual license to use the software. In addition to this, vendors also charge customers a fee for maintenance and support. This fee usually is somewhere between 20% and 30%. The advantages of this business model for the software vendor are obvious. The license fee gives the company a significant amount of cash up front, while the maintenance and support fees give the company an additional predictable revenue stream. This business model has created a lot of very profitable enterprise software companies. In recent times, however, the business model for software companies has changed. Software vendors now run their software in the cloud and customers pay for the right to use this software through a subscription based model. This model is much more attractive for the customer because they do not have to pay a large amount of money up front. The Softwareas-a-Service vendor will also fix bugs and update the software at no additional cost. If the customer fails to roll out the software to the end users, it can simply cancel its subscription. While this new business model is advantageous for the customer, it has some downsides for the software vendor. Every SaaS vendor has to spend a certain amount of money to acquire customers, known as the customer acquisition cost. The company then generates revenue from their customers as long as they have a subscription. There are two problems with this. The first problem is that customers have the option of cancelling their subscription, known as churning, before the SaaS vendor can make a profit from them. As a result, some customers will never be profitable for the vendor at all. This means that the vendor has to recover the cost of acquiring and serving these customers from all the other customers before it can make an overall profit. The second problem is that growing a SaaS business takes a significant amount of capital. Due to the fact that customers only become profitable after a certain period of time, it takes a lot of capital to acquire them and wait until these customers become profitable. This payback period on the customer acquisition cost creates a huge cash flow problem for SaaS businesses trying to grow quickly. Because of this, most SaaS businesses have to raise a lot of capital: they have to scale up as fast as they can to gain as much market share as possible. AUTHOR: JASPER ADAM - 3

4 Fortunately, SaaS companies can take various actions to minimize the problems inherent in this subscription model. In this guide, we will look at the best practices for optimizing customer lifetime value. Any SaaS company that successfully implements these best practices should be able to significantly improve their unit economics and ultimately become a very profitable, sustainable business. 2. THE BASICS OF SAAS UNIT ECONOMICS As described in chapter one, SaaS businesses are different from other companies because the revenue for the product is received over a long period of time. This difference means that SaaS businesses are more complex than other businesses, which means traditional ways of measuring profitability are not relevant. For a SaaS company, there are two main factors that really drive profitability. These factors are the customer acquisition cost (CAC) and the customer lifetime value (LTV). For information on how to calculate these, please see chapter six. The customer acquisition cost answers the question How much money are we spending to acquire a customer? while the customer lifetime value answers the question How much money do we make per customer?. Together, these factors make up the unit economics of a SaaS business. It is crucial for a SaaS business to get these unit economics right; if you can t make the economics work, you will not have a viable, long-term business. As a rule of thumb, SaaS businesses should try to have a LTV to CAC ratio of at least 3, preferably more. The best SaaS businesses can have a ratio of more than 6. Another important health metric is time to recover CAC. This measures how long it takes to recover the cost of acquiring a customer. The rule of thumb here is to recover CAC in 5 to 7 months. It should be noted these rules are simply guidelines. If your business does not meet these rules, it doesn t necessarily mean your business is not viable. A key issue SaaS businesses face is the cash flow problem. The cash flow problem is the result of spending significant amounts of money to acquire customers up front, while these customers only become profitable after a period of time. This results in heavy losses in the early years. The severity of this cash flow problem is heavily linked to how fast a company wants to grow. A SaaS business that wants to grow quickly will have to spend a lot of capital. If a SaaS business decides to grow by only spending its own cash flow, it will grow much slower than a business that raises outside capital. AUTHOR: JASPER ADAM - 4

5 Data and graph by David Skok. Source: The graph above visualizes the cash flow problem. The higher the growth rate, the higher the loss. Of course, once the revenue generated from customers catches up to the expenses of acquiring new customers, the higher growth in customer acquisition will lead to a higher growth of cash flows as well. This is why optimizing unit economics as much as possible is so crucial for success in SaaS businesses. Improving unit economics has the potential to drastically reduce the severity of the cash flow problem. With a higher LTV to CAC ratio, you will recover the customer acquisition cost faster, resulting in much lower losses before hitting profitability. Besides reducing the cash flow problems, there are other benefits to optimizing unit economics too. The higher growth rate resulting from optimal unit economics leads to a higher valuation for your business, as well as more market share. Finally, the beauty of SaaS unit economics is that even small improvements in one of the variables can result in huge improvements for the company in terms of growth or profitability. The graph below shows what happens to the cash flow of a SaaS business in different scenarios. AUTHOR: JASPER ADAM - 5

6 Data and graph by David Skok. Source: As you can see in the graph above, the company with a CAC recovery period of 6.3 months will hit profitability after 19 months and grow quickly from that point on. The company with a CAC recovery period of 12.5 will only hit profitability after approximately 43 months and grow at a moderate pace after that. The company with a CAC recovery period of 18.8 months will not even hit profitability within 55 months. Clearly, the unit economics of a SaaS businesses have a huge impact on its success. That is why it is so crucial for every SaaS business to focus on improving it. In this guide, we will focus on customer lifetime value and how you can increase it as much as possible. AUTHOR: JASPER ADAM - 6

7 3. INCREASING AVERAGE REVENUE PER ACCOUNT 3.1 INTRODUCTION The average revenue generated per customer is an important factor in the lifetime value of your customers. Unfortunately, many SaaS businesses do not spend a lot of time thinking about even the most basic aspects of it. Even the most obvious drivers of ARPA, such as pricing, are often not well thought out. Never thinking about how you can increase your ARPA can result in leaving a lot of money on the table. In this chapter, we will take a look at some of the options a SaaS company has to increase revenue. 3.1 INCREASE PRICING The price of a subscription to your software is the biggest lever you have on the average revenue generated per customer, so it is absolutely crucial to get this right. Unfortunately, many SaaS businesses have not put much thought into the pricing for their plans at all. Ideally, you should be changing your pricing at least every few months. You are constantly developing your product, which increases its value, so it makes sense to increase your pricing as well to reflect this. By not regularly changing pricing, you are almost certainly leaving money on the table. Thinking about how to change your prices is a good exercise since it forces you to think about your customers, what their needs are, what features your product offers to solve these needs and how much value you are creating for them. Because of the impact the changing of prices can have on your business as well as your customers, the decision to change prices should not be made lightly. Make sure to do enough research before implementing any changes. To increase the chances of successfully changing your prices, you should use the following process: Step 1: Conduct market research In this part of the research process you should be trying to find out how much value your product creates for every customer segment. Look at competitor s pricing pages, talk to customers, do industry research, All these things will help you to get an idea of your product s value. Step 2: Create new plans In this step, you should create new plans based on the information from step 1. You should determine which factor your pricing will revolve around (amount of users, storage space, ) and what price point every plan will have. AUTHOR: JASPER ADAM - 7

8 Step 3: Dealing with existing customers Dealing with existing customers can be tricky when it comes to raising prices. Raising your prices too much might lead to a lot of unhappy customers. Before communicating price changes, think about the following options at your disposal for dealing with your existing customer base: Grandfathering: existing customers keep their subscriptions at the existing price points. Grandfather discount: existing customers receive a discount for the new plans. This discount eventually expires after a period of time. No discounts: existing customers receive no special treatment and have to pay the new prices. Step 4: Communicate & implement changes The final step involves communicating and implementing the changes. Before communicating, make sure your customer service department is ready to deal with any questions customers might have. However, if you have done your research and you have communicated properly, you should not be getting too many complaints. The communication itself is very important. You should be transparent about why you have decided to increase pricing. Maybe you completely screwed up the initial pricing and now you need to increase prices to have a sustainable business. Maybe you ve implemented a lot of new features and the increase in prices simply reflects the increased value these features provide. Whatever the reason, honesty is the best policy. You should be reviewing and changing your prices regularly. You ll become better at the process of raising prices. You will also not be leaving money on the table anymore. Additionally, your customers will get used to it and sometimes even buy annual plans to lock in a certain price point, giving you up-front payments. Finally, make sure the implementation of the price changes happens without any problems. Make sure to set up automatic billing or invoicing properly. The last thing you want to do is screw up something so important to your business as charging your customers. AUTHOR: JASPER ADAM - 8

9 3.2 UPSELLING Upselling is defined as selling more of the same product to existing customers. For a SaaS business, this means getting your customers to upgrade to a higher priced plan. Ideally, the pricing for your application should be based on usage. Examples of usage are: the amount of seats in a CRM application, the amount of contacts in marketing software, the amount of projects in project management software, etc. This will make it easy to get your customers to upgrade since they will probably hit their usage limit at some point. You should first analyze every customer segment and determine what usage quota this segment will need. Once you have figured out their needs you can create pricing plans that are based on a sensible usage quota for every plan. Once that is done you should make sure that your customers can easily increase their usage. Provide customers with user manuals and guidelines on how to use your software to its full potential. Develop your application in such a way that users easily discover features. This way, more customers will end up hitting their usage quota. Additionally, you should try to make the upgrading process as easy as possible; it shouldn t take your customers more than a few clicks to upgrade plans. If you do this right, it is possible for you to achieve what is a very big deal in SaaS: getting upsell revenue to offset, or even exceed, churned revenue. Since churn is such a growth killer, offsetting this with upsell can mean a huge boost to a SaaS company s growth rate. In fact, a key element of many of the biggest and fastest growing SaaS businesses is that they effectively use upselling to negate the effect of churn. 3.3 CROSS-SELLING Cross-selling is defined as selling an additional, different product to existing customers. For SaaS businesses, this means developing and selling multiple, complementary applications to your existing customer base. This is an attractive strategy because your customers already have a relationship with your company, so they will be much more likely to consider buying from you than new, potential customers. Since the average revenue per account will increase a lot as a result of your customers paying for multiple applications, your company s unit economics can improve dramatically. To get an idea of the potential of cross-selling, you should take a look at the product portfolios of companies such as Amazon (AWS) or Atlassian. To improve the chances of success with cross-selling, you should develop applications that are complementary to the applications you are already selling. If you do this correctly, your customers can get a lot of value out of this due to the synergy between applications. AUTHOR: JASPER ADAM - 9

10 Doing some projections of the unit economics that can be achieved with cross-selling might lead you to believe that it is the best thing ever for a SaaS business. However, if something sounds too good to be true, it most likely is. The downside of cross-selling is that it is expensive to develop a new application. If the launch of this new product fails and you do not get the anticipated revenues from it, you could end up losing a lot of money. If you want to execute a cross-selling strategy, you should conduct a lot of research into the market you are entering to ensure that any R&D investment in a new product can and will show a positive ROI. 3.4 UNBUNDLING FEATURES In general, SaaS companies have different plans for the different customer segments they sell to. Since not every customer segment has the same needs, it is wise to not make every feature available in every plan. This unbundling of features allows you to capture the value these features are creating for specific customer segments. This does lead to the question which features should be included in every plan. To determine this, you can use the following process: Step 1: analyze the customer segments and their use cases Step 2: analyze usage patterns of features for every customer segment Step 3: conduct customer interviews if necessary. Once this analysis is done, you should have a good idea of which features matter for every customer segment and which features don t. You can then construct your plans in a way that makes more sense for your business as well as your customers. Features that are only needed by high end segments should be excluded from lower priced plans. This way, you can capture more value from these features. Additionally, customers on lower priced plans won t be paying for features they don t need. AUTHOR: JASPER ADAM

11 3.5 PROFESSIONAL SERVICES Every SaaS company usually focuses on a specific industry or on a specific business process. As a result, they tend to have a lot of expertise in the domain they operate in. It is possible to monetize this expertise in the form of professional services. These services can include consulting, education, support or customization. Offering professional services is a win-win situation for both your customers and your business. The customer gets a lot of value from receiving help from professionals with a lot of domain expertise. They receive valuable advice as to how to use the software to get the most value out of it. Implementing best practices can often result in a significant improvement in performance, especially if it is done in business processes that can have a big impact on the bottom line, such as sales or marketing. For the SaaS company selling professional services means an increase in the average revenue generated per customer. Since the company already has a relationship with the customer, the cost of selling professional services to these customers should be rather low. As a result, providing professional services should be quite profitable and is therefore an attractive option to consider for most SaaS companies. 3.6 REMOVE FREE PLANS Some SaaS companies choose to employ a freemium business model. In this model, the company offers its customers a plan that allows them to use the software for free. The idea is this will get customers to try the software, see the value in it and eventually upgrade to a paid plan. While this model can work, there are some problems with it. The first problem is that free users increase your costs while at the same time, they do not generate any revenue. Having a lot of free users will make your hosting costs go up, as well as your customer service costs, reducing the health of your company s overall unit economics. This is a problem because many of these users will not upgrade to a paid plan. The users acquired through the free plan who do upgrade to a paid plan will be profitable, but because of the cost of all the free users who never upgrade, the total user segment acquired through the free plan might only be marginally profitable. Second, the users who are only willing to use your software on a free plan will generally not be very influential. They will not have a large group of followers they could convince to give your software a try, so they won t bring in many additional users. AUTHOR: JASPER ADAM

12 Finally, the best argument against free plans is that you are running a business. You have costs and you need revenue to cover these costs. Your software provides value to your customers, so you are completely entitled to capture some of the value you create for them. Do not undervalue your product. Valuable customers will expect to pay anyway, so make sure to charge what your software is worth. 3.7 DEALING WITH DISCOUNTS If you are selling to businesses, it is likely that many of your customers will ask for a discount. Every purchase manager loves telling their boss they ve managed to get a discount for a new product. While giving discounts is a standard practice, it can be problematic for your unit economics. If you ve priced your product based on certain projections of ARPA, heavy use of discounts can mess up these projections because every discount given means less revenue generated from that customer. There are two ways you can reduce the impact of discounts on customer lifetime value. The first way is to train your salespeople on how to deal with customers requesting a discount. To reduce the frequency with which discounts are given, analyze which customer segments are likely to buy without a discount anyway and make sure your salespeople do not give in immediately to a request for a discount. Train your staff to point out to customers how much value your software can create for them and that the price of your software will result in a good ROI for them. To reduce the size of the discounts that are given, first analyze the churn rate of all customer segments. Then you can instruct your sales people to only give bigger discounts to the customer segments that have a long customer lifetime. If you give big discounts to customers that have a short customer lifetime, you might never make a profit from many of these customers. The second way you could deal with discounts is to raise prices for all your plans across the board. That way, you can continue giving discounts as usual, while maintaining a higher ARPA so you can reach your projected revenues. The problem with this is that it essentially punishes the customers that do not ask for a discount. Therefore, this approach is not recommended. Training your salespeople to deal with discount requests correctly is much more fair to all your customers. AUTHOR: JASPER ADAM

13 3.8 MOVE UPMARKET Many B2B SaaS companies will focus on the SMB or even the VSMB market (Very Small Business). While this can be a perfectly valid strategy, it does force you to charge low prices since most of these customers do not have large budgets. To focus on these segments means you will inevitably have a low average customer lifetime value. This is why it might be a good idea to enter some higher end segments in your market. Providing an enterprise plan will be worth it even if you only get a small amount of customers on this plan. Since these plans have high price points, even a small amount of enterprise customers can end up being a significant portion of your revenue. This might not be straightforward. Enterprise customers might have certain demands your software currently doesn t provide, such as auditing, user access control, legal compliance or customization. Additionally, if your sales and marketing processes have been set up to acquire small businesses, you might have to rethink the way you do things to acquire larger enterprises as customers. Even with these considerations, however, moving upmarket is a good idea. Enterprises are good customers; they have larger budgets, lower churn rates and have a willingness to pay. Customers with these characteristics are very interesting for a SaaS business. 4. REDUCING CHURN RATE 4.1 INTRODUCTION Churn rate has a huge effect on the economics of a SaaS company. High churn rates can reduce growth, reduce the potential company size and reduce profitability. In extreme cases it can actually make a SaaS business completely economically unviable. It is, by far, one of the most important factors SaaS businesses have to deal with. At the same time, however, it is also very misunderstood. The biggest mistake regarding churn is to ignore the fact that churn can be caused by a number reasons. If you do not understand what is causing customers to churn, it is also impossible to implement the correct actions to combat it. In this chapter, we will look at some of the most common causes of churn and what a SaaS business can do to reduce the impact of it as much as possible. AUTHOR: JASPER ADAM

14 4.2 ONBOARDING CHURN Onboarding churn happens when customers cancel their subscription due to the failure to start using your software properly and seeing the full benefits of it. When your customers are paying for a subscription to your software, but are not getting enough value out of it, they won t be your customer for long. There are two main reasons for onboarding churn: failure to integrate your software with other systems and processes, and failure to roll out the software to all of the intended end users. Both of these reasons should be analyzed to determine whether or not they are causing onboarding churn. INTEGRATION FAILURES Integration failures happen when your customers, for whatever reason, fail to integrate your software into their existing processes and systems they have in place for managing a business process. As a SaaS vendor, it is paramount that you understand how your software fits into your customer s workflow. It should be easy for them to integrate your software with the other applications they already use. Normally this is pretty straightforward, since almost all SaaS vendors have an easy to use API for data transfer between applications. ROLL-OUT FAILURES Roll-out failures happen when your customers sign up for your software, purchase a plan that has a usage quota and then fail to use the full quota they have signed up for. An example would be a subscription to a CRM application. Many plans for CRM applications have a number of seats available. If a customer signs up to a plan that has 50 seats available, but after 2 months they only have 10 active users, that might be an indication of roll-out failure. This is problematic because if your customer is paying for a quota while not fully using it, they are not getting enough value relative to the price they are paying. A roll-out failure might not necessarily lead to a complete cancellation of the subscription. The customer might also subscribe to a lower priced plan with a lower quota after realizing they have overestimated their usage needs. Either way, you would still lose revenue. The way to combat this is to make it as easy as possible for the end users to get started using your software and roll it out to all intended end users. Documentation, user manuals, set-up wizards and even gamification are all factors that can help with this. AUTHOR: JASPER ADAM

15 IMPROVING ONBOARDING SUCCESS Improving onboarding success starts with measuring how successful your customers are at integrating and rolling out your software. This requires analytics infrastructure to track all the relevant data. For tracking integration success, you want to track if your customers are integrating other applications that are essential to getting the most value out of your software. To monitor roll-out success, you want to track the feature- or quota-usage of each customer. If the data indicates a customer is failing to onboard successfully, you should be proactive and try to fix this rather than simply letting this customer cancel their subscription. A great way to improve the onboarding process is to have an onboarding-wizard within your application. This wizard should guide them through the steps they need to take to set up your application successfully. This should reduce the amount of integration failures. Another action you can take is to use drip campaigns to communicate with your customers right after they sign up. These s should contain a detailed set of instructions on how to successfully complete the onboarding process and how to use your software optimally. Additionally, you can offer onboarding services with your customer support team if some customers have custom needs. Whether this is needed will depend on the industry you are in. The downside to an onboarding service like this is that it can become expensive. In fact, this might only be profitable to do this for customers with a high priced plan. 4.3 BAD CUSTOMER EXPERIENCE If the customer experience of your product is bad, your customers will be very likely to cancel their subscription eventually. Because it is so crucial for a SaaS business to keep their customers on board for as long as possible to ensure healthy unit economics, providing a good customer experience is an absolute must. A study[1] done by Oracle provides the following insight: 86 percent of consumers will pay more for a better customer experience. 89 percent of consumers began doing business with a competitor following a poor customer experience. 79 percent of consumers who shared complaints about poor customer experience online had their complaints ignored. 50 percent of consumers give a brand only one week to respond to a question before they stop doing business with them. [1] AUTHOR: JASPER ADAM

16 As you can see, bad customer experience can increase churn significantly. It can also lead to a bad reputation, which would result in fewer people willing to use your software in the future. This is why customer service should be taken seriously. To analyze how well your company is doing regarding customer experience, you should analyze the following factors: Application performance: what is the average response time of the application? Application errors: how often do users end up dealing with bugs or error pages? Customer support tickets: how often do customers ask for support? Customer support efficiency: how fast do customers receive a response? Customer support effectiveness: how successful is your support team at resolving issues? If your company is failing to provide a good customer experience, you should fix the problem as soon as possible. There is no point investing large amounts of capital into R&D or sales and marketing if your customers will end up with a bad customer experience and eventually churn. 4.4 DOWNGRADE CHURN Downgrade churn happens when a customer switches from one plan to a lower priced plan. While this is certainly not as bad as a complete cancellation, it still means a loss of revenue for a SaaS vendor. It is important to keep track of how much revenue is being lost due to downgrades. A significant amount of downgrades might be indicative of a problem with product-market fit. Some downgrade churn is inevitable. Customers might overestimate which features or usage quota they need from your product. In this case, there is nothing you can do to prevent them from downgrading. If you notice a lot of your customers downgrading, it might be a good idea to look at the way you have segmented your customer base. Helping your customers find the best plan for them will reduce downgrade churn and improve your customers experience. In other instances, however, customers might switch to a lower priced plan because they feel they are not getting enough value out of your software relative to the cost. This might be due to your software not having the right features, or due to the price of a plan being too high relative to the value the features offer. In this instance, you need to analyze if every customer segment has the features they need and to think about whether or not your plans are priced correctly. AUTHOR: JASPER ADAM

17 Additionally, some customers might not be using valuable features because they are unaware of them or because they are not using them effectively. To increase awareness, you can build discovery mechanisms into your software such as wizards or gamification systems. To improve effectiveness, you should provide user manuals to teach end users best practices for every use case. 4.5 COMPETITION SaaS is a profitable, high growth industry. These characteristics have attracted a significant amount of capital into the industry leading to fierce competition. All this competition will almost inevitably lead to some of your customers cancelling their subscription in favor of one of your competitors. If the competition in your industry heats up, you certainly want to keep an eye out for customers who are leaving for this particular reason. A great tool to find out why your customers are leaving, are exit-surveys. These can offer a good insight in what areas your business could make improvements. You should also follow your competitors to make sure your software is competitive with theirs. If your software is lacking in features compared to your competitors, investing in R&D is paramount to stay competitive. Fortunately, losing customers due to competition is usually a small part of a company s total churn rate and so you should not worry about it too much. Additionally, many SaaS segments are growing so quickly that it is much better to focus on acquiring new customers rather than obsessing over what your competitors are doing. It should be noted that losing customers to competitors will become a much bigger problem once SaaS segments mature. Since mature SaaS businesses cannot rely on high growth in the market to grow, they are much more likely to focus on stealing market share away from competitors. Every SaaS vendor should make sure they have a competitive product and a good customer experience to ensure they are competitive once their market matures. 4.6 NO PRODUCT-MARKET FIT Not having product-market fit refers to a situation where your software does not fit the needs of your customers. Obviously, if your customers do not get the right features they need from your software, they will inevitably cancel their subscription because it costs them more than the value they get from it. If you do not have product-market fit, you will probably notice a lot of users churning very quickly. The best way to deal with this is to conduct customer interviews; simply ask your customers why they have cancelled. You want to ask them what new features you should add or how you can improve the existing features. AUTHOR: JASPER ADAM

18 You do not have to wait until customers actually cancel to interview them. Interviewing your existing customers can help a lot as well. Ask your current customers questions such as How likely are you to recommend [your product] to a friend or colleague? or How would you feel if you could no longer use [your product]?. Based on the answers to these questions, you should get a good indication of how your customers feel about your product. Since lack of product-market fit can lead to a huge amount of churn very quickly, you should be proactive about dealing with it. In the early days of your SaaS company, this should be one of the things you should most focus on. Fortunately, once you have achieved productmarket fit, this type of churn will be a thing of the past and you can focus on other causes of churn. 4.7 NATURAL CHURN Natural churn happens when your customers cancel their subscription due to other reasons than the ones described in this chapter. There can be a variety of reasons why natural churn occurs. Some customers might go bankrupt or be acquired. Perhaps some customers will change their strategy and won t need your software anymore. At first sight, you might say that you can t do anything about natural churn because these factors are beyond your control. While this is true, you can still try to minimize the impact of it on your business. You can do this by analyzing which customer segments are most likely to be affected by natural churn. Once you have determined the worst segments, you can change your marketing and sales process so you focus on acquiring customers who are less likely to be affected by natural churn. 4.8 FAILED PAYMENTS One often overlooked type of churn is churn due to failed payments. Failed payments might occur because your customers forget to pay the invoices you send them. Alternatively, if your customers are paying with credit cards, it is possible they have entered their credit card data incorrectly, or that their credit card has expired. This type of churn can easily be reduced. Many SaaS vendors will manage their subscriptions through a payment processor such as Stripe, for example. Almost all of these payment processors have API s available that allow you to receive notifications regarding events such as failed payments. You can use these notifications to automatically send an to customers informing them the payment has failed and give them the option to fix this. AUTHOR: JASPER ADAM

19 Even if only a small percentage of churned revenue is recovered as a result of these s, it is still worthwhile to set this up. This should not take a lot of time or money, and will pay off for many years to come. Since churn is such a killer for SaaS businesses, every improvement, no matter how small, is valuable. 5. REDUCING COST OF SERVICE 5.1 INTRODUCTION One aspect of a SaaS business unit economics that is often overlooked is the average cost of service. The average cost of service is the cost of actually providing the software to your customers. While this component does generally not have a massive impact on unit economics, it can still be worthwhile to analyze it and try to reduce this cost as much as possible. In this chapter we will look at the most common costs of service and look at some actions a SaaS business can take to reduce them. 5.2 COMPUTING INFRASTRUCTURE The most obvious cost of servicing your customers is the cost of computing resources, such as storage space, processor speed, memory, or bandwidth that are necessary to run the application. Almost every SaaS business today will use one of the major cloud computing providers such as Microsoft Azure, Amazon Web Services or Rackspace. A SaaS company should analyze what resources its application needs and should then compare how the different providers compare to each other when it comes to the cost of these resources. It is also important to take into account the cost of administrating the application when choosing a hosting company. Some vendors provide easy to use tools for application administration so that any individual can manage the applications, removing the need to hire a system administrator. Other vendors might provide very cheap computing resources, but don t provide the same tools. As a result, SaaS companies might have to hire a dedicated system administrator to manage the application(s). The cost of hiring sysadmins will often offset any of the cost savings on the computing resources, and you may end up paying a lot more than you would by choosing another hosting provider. AUTHOR: JASPER ADAM

20 5.3 SOFTWARE All costs related to software needed by your application to achieve the desired functionality should also be analyzed. Examples of software costs are: service provider Code libraries for user interface components DNS Management Caching/load balancing Database licenses Uptime/performance monitoring tools Every one of these costs should be analyzed to see if there is a possibility to reduce the cost. Comparing vendors of every software component is an obvious step. Considering open source alternatives is also a good idea. It is not a good idea, however, to try to develop these components in-house due to the cost. It is much better to simply use one of the products that has already been developed and used in production for many years by other people. 5.4 BILLING FEES Most SaaS vendors will automate their billing with a payment processor that manages recurring billing for them. The business model of these payment processors is to charge a fee per transaction. These fees can vary from vendor to vendor. Before deciding which payment processor you will use, you should analyze the different options available to you and compare them carefully. It should be said that, while price is important, it is also important to keep in mind non-price related factors such as supported currencies, tax calculations, regulatory compliance and so on. When choosing something as important as a payment processor, you should make sure to do your research and pick the best option for your specific business needs. AUTHOR: JASPER ADAM

21 5.5 CUSTOMER SUPPORT Customer support is a necessary service you need to provide to ensure your customers get the full benefit of using your software. At the same time, as a SaaS vendor you should also try to keep the cost of this service as low as possible, which might be hard to do if you are a small SaaS vendor due to the lack of scale. The first action you can take to reduce the cost of customer support is to ensure your customers never need it. You do this by making the product easy to use. Make sure the application is designed in such a way as to encourage discovery of features. Also make sure the application is as bug-free as possible. Second, you should provide easily accessible product manuals. This way, if your customers do need support, they can check this knowledge base and find the answer they are looking for without having to contact a customer service employee. Avoiding human touch is crucial in keeping costs down. Third, you should train all your customer service employees to deal with the most common customer service problems as well as they possibly can. For example, application downtime is an obvious problem that might occur at some point for every SaaS company. It is important to have procedures in place for your employees as to how they should interact with customers if this were to occur. Finally, you should make sure you are using the right software tools to keep track of customer support request. This not only helps you deal with any problems your customers have in an efficient way, it also helps you understand with which frequency certain problems occur, giving you the information you need to improve your services where it is most needed. AUTHOR: JASPER ADAM

22 6. METRICS 6.1 INTRODUCTION If a SaaS company wants to improve its customer lifetime value, it needs to keep an eye on certain metrics so it can track the progress it is making. In this chapter, we will look at some of the most important metrics to track and how these metrics are calculated. 6.2 CUSTOMER LIFETIME VALUE Customer lifetime value is a measure of customer profitability over time. It is calculated as follows: rate customer lifetime value = (average revenue per account * gross margin %) / churn This is a key component of a SaaS company s unit economics so naturally this is one of the most important metrics. While it is important to look at the customer lifetime value of your customer base as a whole to gain some insight into the economic health of your SaaS business, it is also important to calculate this metric for every customer segment separately. This is necessary because some customer segments will have a different cost structure than others. If some segments are unprofitable, they need to be fixed or even completely abandoned. If segments are profitable, they should be optimized further and receive more sales and marketing resources. 6.3 CUSTOMER LIFETIME The customer lifetime is the average duration of the company s relationship with customers. It is calculated as follows: customer lifetime = 1 / customer churn rate There are a few reasons why customer lifetime is so crucial. First of all, new customers are usually quite expensive to acquire, therefore it makes sense to increase the lifetime of your existing customers. Second, the revenues of a customer are received gradually over a long period of time. The longer this period lasts, the more profitable the customer. Third, for some customers, profitability increases over time so the longer you keep these customers on board, the more profitable they will be. AUTHOR: JASPER ADAM

23 There are quite a few actions a SaaS company can take to increase the average customer lifetime, as described in the chapter on improving churn rate. 6.4 AVERAGE REVENUE PER ACCOUNT The average revenue per account is the average revenue generated per customer. It is calculated as follows: average revenue per account = recurring revenue / number of customers This is a key driver of customer lifetime value so it should be monitored closely. Tracking this metric for all customers will give you an idea of the overall revenue per customer. You should monitor this metric closely if you are implementing actions that should drive up revenue to see if these actions are successful. 6.5 CUSTOMER CHURN RATE The customer churn rate is the amount of customers that cancel their subscription during a given period relative to the total customer base during that same period. It is calculated as follows: customer churn rate = number of cancelled subscriptions / number of customers The churn rate is probably the most important metric of all. This metric should be calculated for both your customer base as a whole, and for each customer segment separately. The reason churn rate is so important is because of the negative effect it has on a SaaS business in multiple ways. It slows growth, reduces total potential company size, it increases time to profitability, it increases the amount of capital it takes to grow at a certain growth rate, This metric should constantly be tracked to measure any improvements or deterioration so you can double down on what is working and quickly step in when it is deteriorating. AUTHOR: JASPER ADAM

24 6.6 MRR GROWTH RATE Growth is a key driver of value for any business, including SaaS businesses, therefor this metric should be tracked closely. This metric is calculated as follows: MRR growth rate = (current MRR previous MRR) / previous MRR * 100 If growth is disappointing, you need to investigate the factors that affect MRR. How many new customers are signing up? How many customers are cancelling? What impact do upgrades and downgrades have on MRR? Implementing best practices, like the ones described in this guide, can greatly improve all these factors, which should lead to higher growth. 6.7 MRR CHURN RATE MRR churn rate is the amount of monthly recurring revenue lost due to cancellations relative to the total amount of monthly recurring revenue for the period. This metric is different from the customer churn rate, which measures the amount of customers lost, rather than the amount of revenue lost. The reason you should track both of these metrics is because monitoring just one of them might be misleading. For example, losing just 10 customers in a month might not look like a big deal, but if these were all enterprise customers on the most expensive plan, it could result in a significant amount of revenue lost. On the other hand, losing a small amount of monthly recurring revenue could seem like a minor issue, but if all this revenue was lost due to a lot of cancellations from customers on a low priced plan, it might be indicative of a problem with that customer segment. This metric is calculated as follows: MRR churn rate = MRR lost due to cancellations / MRR It is important to track this metric for every customer segment to discover and fix any problems within that specific segment. AUTHOR: JASPER ADAM

25 6.8 UPGRADE MRR Upgrade MRR is the increase in MRR due to customers upgrading to a more expensive plan. This metric will be most important to SaaS businesses that sell products that scale with usage. This metric is calculated as follows: upgrade MRR = new MRR from upgrades / MRR You should track this metric for every customer segment to see which segments have the highest likelihood of upgrading and then focus on maximizing upgrade MRR for these segments. You can improve this metric by taking the friction out of the upgrading process by having features built into your software that make upgrading as easy as possible. Your customers should not have to contact a salesperson. 6.9 DOWNGRADE MRR Downgrade MRR is MRR lost due to customers downgrading from one plan to another, less expensive plan. This metric is calculated as follows: downgrade MRR = MRR lost due to downgrades / MRR This metric gives you an indication of how much revenue is lost due to customers downgrading. If a significant amount of customers downgrade, it might mean that there is a problem with how you have structured your plans. If this metric becomes problematic, you want to analyze why your customers are downgrading and restructure your plans as necessary AVERAGE COST OF SERVICE The Average Cost of Service is the recurring cost of all expenses related to providing a proper service to a customer. It takes into account all costs related to computing infrastructure, software fees, billing and customer support. This metric is calculated as follows: ACS = service expenses / total current customers Subtracting this from the ARPA will give you a gross profit per customer. Most SaaS businesses have a gross margin somewhere between 80 to 90%. AUTHOR: JASPER ADAM

26 While this variable has a minor effect on customer lifetime value, it still makes sense to try to improve this metric much as possible. Note that this metric will usually decline as your company grows due to economies of scale CLV TO CAC RATIO The CLV to CAC ratio is a ratio that gives you an indication of the overall health of your SaaS business. It measures how much profit you are making from your customers relative to the cost of acquiring them. This metric is calculated as follows: Where CLV:CAC = customer lifetime value / customer acquisition cost rate customer lifetime value = (average revenue per account * gross margin %) / churn And customer acquisition cost = (sales expense + marketing expense) / number of new customers This ratio should be at least 3, preferably much higher CAC RECOVERY PERIOD The CAC recovery period is a number that tells you how long it takes to recover the acquisition cost of the average customer. This metric is calculated as follows: recovery period = customer acquisition cost / (average revenue per account * gross margin) Where customer acquisition cost = (sales expense + marketing expense) / number of new customers The recovery period should be as short as possible, preferably below 12 months. In fact, the most successful SaaS businesses tend to have a very low recovery period, somewhere between 5 to 7 months. AUTHOR: JASPER ADAM

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