SaaS 102 #2 How to Evaluate a Good SaaS Company

Recently, due to the effects of the pandemic, job seekers have been more and more concerned with finding work at what they think is a good company. But how many people can actually tell a good company from a bad one?

When I interview candidates, I’ll always ask what they think is good about our company. Many people say that we do international B2B SaaS, that we’ve been profitable for a few years, that we are in the eCommerce industry, that we’re market leaders, that we have good company culture, and other similar replies.

Over the past few years, I’ve interviewed at least thousands of people. Very few of them have asked me about the following key metrics. At most, I’ve usually been asked questions like how much our revenue is, or how many customers we have. But I think everyone should know that there are several key metrics that can help you understand the strengths and weaknesses of a SaaS company in less than three minutes.

Before discussing these metrics, it’s necessary to first make sure we define them clearly. Otherwise, even if the information from these metrics is put right in front of you, you’ll still feel confused and muddled.

Once I’ve defined the metrics, I’ll get to the central point of this article, which is why these metrics are so important.

I refer to some blog posts from famous investors to help me explain, and use some classic examples. Don’t worry, these are examples that can be understood even without a large amount of professional knowledge.

The focus of this article is to learn how to read these metrics, and not how to calculate them. I’ll go into the details of how these metrics can be calculated in later articles.

What do these metrics actually mean?

1. Bookings vs revenue vs cash flow
2. Revenue recognition vs deferred revenue
3. Recurring revenue vs total revenue
4. MRR vs ARR
5. CAC
6. LTV

A simple example

Let’s use a simple example of a mobile phone contract to help us understand these key concepts. Let’s suppose the following:

• A customer signed a one-year service contract with a mobile network operator on January 1, 2020. The monthly fee was $10 USD, and the total price of the contract was $120 USD.
• The contract service period was February 1, 2020 until January 31, 2021.
• The customer paid the total contract fee of $120 USD on March 15, 2020.

1. Bookings vs revenue vs cash flow

Bookings

Booking refers to the amount that a customer has agreed to pay and is contractually obliged to pay. It’s important to remember that this metric only refers to payments that the customer has agreed to make, and doesn’t mean that the payments have already been made. In the case of our phone contract example, the booking amount is $120 USD.

Revenue

Revenue refers to payments made for services already in progress. Globally, there are two major accounting standards systems you can refer to. In the United States, the recognized system is Generally Accepted Accounting Principles (GAAP) . Internationally, it is International Financial Reporting Standards (IFRS) .?

Using the phone contract example again, once the contract is effective and the service period has started, then regardless of when the customer makes the actual payment, the phone company’s revenue will be $10 USD every month.?

This applies no matter when the customer pays, and even if the customer doesn’t pay at all. Regardless of actual payment, when the service is in progress, the company reports its revenue as $10 USD on the last day of the month. The first installment of revenue in our phone contract example would be February 29, 2020.?

Cash flow

Cash flow is a concept that’s easy to understand from its name. It means the flow of money in and out of a company. In our phone contract example, the cash flow is the actual payment, not the contract or service period. It refers to the amount actually paid by the customer, which is $120 USD, paid on March 15, 2020.

As you can see, bookings, revenue, and cash flow are three different concepts. I’ll explain more about why we need to use these three separate metrics later. For now, it’s enough that you understand the differences between the three ideas.

2. Revenue recognition vs deferred revenue

Revenue recognition

In our phone contract example, it wasn’t exactly right to say there would be $10 USD of revenue each month. It would have been more correct to use the term “recognized revenue.” The amount of recognized revenue accumulates as more revenue is recognized over time.?

So in our phone contract example, on the last day of the first month of the service period (February 29, 2020) the amount of recognized revenue would be $10 USD. On the last day of the following month (March 31, 2020), another $10 USD would be added to that amount, so the total recognized revenue would be $20 USD. The recognized revenue would continue to accumulate in that way, until the last day of the contract service period (January 31, 2021), when the total recognized revenue would be $120 USD.

There are differing standards for how to calculate revenue recognition. It’s important to check which calculation method a company uses. In the example we just used, the method used was entering revenue as recognized once the service is completed.?

Other companies will use other methods, such as using an average daily payment amount to update the recognized revenue every 24 hours, or entering the entire due payment as recognized revenue on the day the service starts.

I won’t go into detail on when the different calculation methods should be used. My goal here is to explain that revenue recognition doesn’t have a direct relationship to the bookings and cash flow metrics.?

Deferred revenue

Deferred revenue can be understood as revenue that has not yet been recognized. From our phone contract example, if out of the bookings amount of $120 USD, only $10 USD had been added to the recognized revenue, then the deferred revenue would be the remaining amount of $110 USD??.

3. Recurring revenue vs total revenue

Using our phone example again, the invoice the customer receives after the first month of being a service user might look something like this:

Recurring revenue

In this invoice example, recurring revenue actually refers to the 10 dollars that will be added to the recognized revenue each month as part of the $120 USD contract fee. The charges for text messages, international calls, and additional data usage wouldn’t be included in the recurring revenue amount.?

Those kinds of extra charges aren’t included in the company’s recurring revenue because there’s no guarantee they will repeat the next month. A lot of users would see how much they were paying for text messages, and switch to another kind of messaging service, such as WhatsApp.?

Recurring revenue only refers to revenue that is virtually guaranteed to repeat in the future.?

Total revenue

Now, total revenue seems really straightforward. Isn’t the company’s total revenue from this invoice the “total bill amount” of $132 USD?!

Actually…no…??

If we use the recognized revenue calculation method we used above, then the revenue on February 29, 2020 will only be $22 ($10 + $4 + $3 +$5) USD.?

So, as the table shows below:

At first I wasn’t going to include definitions of recurring revenue and total revenue in this article. But then I realized that both metrics are very closely related to our company’s business. Our company also has a lot of non-recurring revenue, which means that our total revenue is greater than our recurring revenue.

And here’s a point that I want to make absolutely clear. The salary of everyone that works at AfterShip, including my own salary, comes from the money that customers pay to us. It doesn’t come from investors.?

So it’s very important to pay attention to company revenue. Without it, we can’t get paid! ??

That’s why we display our revenue figures on big screens in the company offices, so that they can be viewed by anyone at any time.

But there was one occasion when an employee came looking for me with some questions about the revenue figures. The employee said something along the lines of:

“Why do you tell us that our revenue is XXX? I’ve done the calculations several times and it’s not XXX. Are you sure our finance department is doing their jobs properly?”?

After being worried for a moment, I hurriedly explained that the figure the employee had been looking at was the recurring revenue, and not the total revenue.

4. Monthly recurring revenue (MRR) vs annual recurring revenue (ARR)

Monthly recurring revenue (MRR)

Monthly recurring revenue (MRR) refers to revenue which repeats regularly each month. In our phone contract example, the phone company’s MRR is $10 USD.

It’s important to note that “monthly” here refers to calendar months. But for a lot of companies, even though they might say their billing fees are charged monthly, they actually don’t mean calendar months. For example, if you carefully check the Shopify definition of a billing cycle, you will find it is a “30-day interval .”?

How much would the real MRR be when a customer signs up for the Advanced Shopify subscription below, which is actually $399 USD charged every 30 days?

As calendar months vary in length, MRR calculation methods also vary. I’ll explain this issue more at a later date. For now, it’s enough to just understand that the MRR metric refers to recurring revenue on the basis of calendar months.

Annual recurring revenue (ARR)

Annual recurring revenue (ARR) is revenue that repeats on an annual basis. ARR should actually be very easy to understand after reading the previous explanation of MRR. As long as MRR is calculated by calendar month, then a company’s ARR should be equal to MRR x 12.

5. Customer acquisition cost (CAC)

Customer acquisition cost (CAC) or cost per acquisition (CPA) refers to the sales and marketing costs involved with turning a potential customer into a customer.

I should emphasize here that companies define who is a customer and who isn’t according to different criteria. Most companies define customers as paying customers. But some products don’t have a paid model, and the goal for these products is to have enough active users. One metric that might be used to measure the number of customers in such a case is the number of daily active users (DAU).

Facebook is a good example of this. Facebook users don’t need to pay Facebook any money. But Facebook will still view its users as customers because without them, it could not attract any advertising revenue or make money. Facebook will certainly bear costs in order to attract more users to open Facebook accounts, so a CAC metric still applies to Facebook and its users.

For SaaS companies which provide paid products and services, such as AfterShip, the target customers we are most concerned with are certainly paying customers.

That’s the definition of CAC explained, but how can the costs of acquiring customers actually be calculated?

Some examples of questions that might come up include:

• Should fees for advertising on Facebook or Google Ads be included?
• Should fees for offline advertising, such as ads on the side of a bus, be included?
• Should wages for sales staff be included? What about sales commission?
• Should the wages of the growth hacking team be included?
• Should the cost of providing tech support to the sales team be included?
• And other similar difficult questions…

There’s an important point to remember here. Our goal is to work out how much we need to spend to convert a potential customer into an actual customer according to our criteria. If our criteria is for the customer to become a paying customer, then as soon as the customer has made a payment any costs incurred after that will not be included in the metric. I’m not sure whether you think that makes it easier to decide what should and shouldn’t be included in CAC calculations.?

In any case, I will go more into the details at a later point in time. For now, the most important thing is to understand the concept of CAC, and not to master how to calculate CAC accurately.

6. Lifetime value (LTV)

Lifetime value (LTV) refers to the overall value of a customer over the customer's lifespan. It is the total economic value that the company gets from interacting with the customer over the entire time period they remain a customer. A simple example would be that if a customer subscribes to a company service for 18 months and pays $10 USD per month, then the total value that user provided, or LTV, would be $180 USD. (After the 18-month period, the customer started to use another company’s services, and so their customer “lifespan” ended at the end of 18 months).

As you can probably see, if a company has a higher CAC than LTV, that company is unlikely to be profitable in the long term. Even if the LTV is higher than CAC, it’s important to see how much higher it is. As CAC doesn’t include operation costs, the LTV should be quite a bit higher. One common way to look at it is that LTV should be at least three times higher than CAC for a company to be profitable.

So if LTV is, for example, $180 USD, then CAC shouldn’t be any more than $60 USD.

Summary

At the start of this article, I mentioned how job seekers all want to find a good company to work for. Once you’ve understood these key metrics for understanding the profitability of a company, you can use the metrics below to quickly ascertain a company’s strengths and weaknesses.?

1. Of course, the higher a company’s revenue, the better. But to find the true value of an SaaS company, remember to check the deferred revenue as well as the recognized revenue.

2. Monthly recurring revenue (MRR) is another metric where higher is definitely better. In fact, the larger the share of company revenue that is recurring revenue, the stronger the company.

3. When looking at the ratio between LTC and CAC, LTV should be much higher than CAC. The higher the LTV, and the lower the CAC, the better.?

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Teddy Chan is a serial entrepreneur with 20+ years of experience in SaaS and eCommerce. His latest venture is?AfterShip , a SaaS post-purchase experience platform that empowers eCommerce retailers like Wish, eBay, and Gymshark to improve their customer experience, drive sales, and increase brand loyalty.

SaaS 102 is a series of articles where I share my thoughts and experience with SaaS. My fundamental belief is that a great team with an average idea will always go further than an average team with a great idea. If you want to be part of this great and growing team, check out careers at AfterShip?here —I’m currently on the lookout for superstar sales talent.

Visit AfterShip’s homepage?here .

(Article translated by?Joseph O'Neill )