SaaS Models – How to validate your Business Case in less than 30 minutes

SaaS Models – How to validate your Business Case in less than 30 minutes

Preface

This post is the first one in a series of posts on understanding SaaS Metrics, applying benchmarks, building a recurring revenue business model, scaling the right sales plan and win funding for a SaaS business with a lean case.

I would like to thank David Skok and Steve Blank for their work which has inspired me tremendously. While presenting my own SaaS startup, accells, to investors and VCs, I came across David Skok’s blogs on SaaS metrics and Saas Models and Steve Blank’s Udacity Online Course on How To Build a Startup using the Lean Startup and Business Model Canvas approach. After we sold accells successfully to Ping Identity, I developed a strong desire to share my experience with other entrepreneurs. My goal was simple: to increase their chances for financing and success.

This is why – two years ago – I started working on Lean-Case, a simulation tool for recurring revenue models. I want you to avoid the pitfalls I have seen by using the right formulas, applying the right assumptions, making the business case look appealing, and building a model to support scenarios, continuous analysis and tracking.

SaaS Models – Validate your recurring revenue business case

This post provides SaaS entrepreneurs, Business Managers and Investors with a simulation tool to understand, create, and validate the business model for any SaaS or subscription/recurring revenue business.

All subscription businesses face an initial revenue/cash flow gap. They know that the start-up period will need funding for sales and marketing to acquire customers and that recurring revenue streams and respective cash flow will only fully open up over time. But businesses have to guess how wide and deep this cash flow gap will be. Start-ups looking for financing are unable to reassure prospective investors. Existing software vendors look with apprehension at the initial shortfall in income if they move to a SaaS model and wonder how they will ever make it to the other side.

You will learn how to easily test the viability of your SaaS business online and in less than 30 min. We are applying a simple “unit economics” model: we lay out the lifetime value (LTV) and the customer acquisition cost (CAC) for a single customer. Based on these simple inputs, you can understand the short-term and a long-term indicator for your case and get a traffic-light indication for the viability of your case (see screen).

  • The short-term indicator “Payback Period” or “Months-to-Recover-CAC” defines how fast you recover the customer acquisition cost (CAC) over the lifetime of your customer
  • The long-term indicator “LTV/CAC ratio” also referred to as “God Metric” shows how many times the LTV exceeds the CAC

 

Before jumping into Lean-Case, let us start at a higher level and understand the viability metrics Payback and the LTV/CAC Ratio in more detail.

Why understanding Payback and the LTV/CAC Ratio is so important?

Customer acquisition cost is a direct reflection of the future success of your SaaS business. If you’re too cautious about your CAC, you will likely be missing out on customers and future revenue. Yet, if you spend too freely, you won’t be profitable and will likely end up in the Deadpool.

The challenge is that you want to spend the right amount of CAC to drive new customers to your service without jeopardizing the Lifetime Value (LTV) and revenue from that customer. A great measure to gauge this balancing act is the LTV/CAC ratio, which is sometimes even referred to as the “god metric” of many successful SaaS companies.

Play with the interactive chart below to understand how CAC, Customer Lifetime in Months, Monthly Recurring Revenues per Customer and Gross Margin relate and how they impact the Payback Period and the LTV/CAC Ratio. You can enter

  • the estimated Customer Lifetime in Months
  • the Average Monthly Recurring Revenues (MRR)
  • the Gross Margin of your Service (to reduce revenues with direct costs associated with producing the goods and services sold by your company)
  • the Cost of Customer Acquisition (CAC)

The model then calculates Customer Lifetime Value (by multiplying MRR with Customer Life Time in Month and Gross Margin), Payback Period and the LTV/CAC Ratio and then gives you a red/green-traffic-light-indication of the viability metrics.

 

Input:

months

$

%

$
Output:

10.00

months

3.60

 

 

The interactive graph above shows the Customer Acquisition Cost and the Lifetime Value of a customer. The customer starts to pay monthly for your subscription service and you eventually break even (where the two lines intersect) and make your money back on the initial CAC investment. This is the Payback Period in Months. From then on is a magical period where you’re rolling in the dough and netting a profit from that customer to optimize your LTV/CAC ratio. Lifetime Value increases until the customer decides to churn and its lifetime ends.

Specifically, you can test how the parameters relate:

  • If you increase the lifetime value, the short-term Payback Period remains unchanged, but the long-term LTV/CAC ratio increases.
  • If you increase MRR per customer or increase the Gross Margin or decrease the CAC, the Payback Period decreases and the LTV/CAC ratio increases.

For B2B companies, the Payback Period should ideally be less than 12 months and the LTV/CAC ratio should ideally be higher than 3 meaning that for every dollar you put in your SaaS machine you’re getting three dollars out (in this case, both output parameters will turn green). This exercise should help you to understand and tune your subscription business input thresholds to enable a viable business. The thresholds do not apply to all SaaS businesses in the same way. For example, a business without a salesforce that has a touchless conversion usually has a far lower investment in sales and marketing expenses, and becomes cash flow positive far earlier. On the other hand, a business with a lower gross margin might require a longer time to break even. You should be able to adjust these thresholds to your specific expected business.

If you want to get more background on the key metrics of a SaaS business are and how to calculate them, we would like to refer you Lean SaaS Metrics – The Definitive Guide to create business impact and the associated InfoGraphic.

Check out this post from ProfitWell to calculate and optimize CAC and this post from HubSpot on how their product team thinks about the payback period. Tomasz Tunguz explains the Importance Of Payback Period For SaaS Startups and Dave Kellog sheds light on The Ultimate SaaS Metric: The Customer Lifetime Value to Customer Acquisition Cost Ratio (LTV/CAC)

Absorb the one-screen Metrics Dashboard

Now, let’s go one step further and review the Lean-Case tool.

Just launch the Lean-Case Simulation Dashboard to create your SaaS case. You can follow this post for guidance. We illustrate each step in creating your case with examples and providing short video tutorials.

Please meet Sarah and John: they work for Test Ltd. – a B2B SaaS company going to market with its own direct sales force targeting enterprises in the U.S.. It targets this segment with a Direct Sales model. Sarah and John are working as team – Sarah being a Sales Rep, John being a Sales Engineer. They are jointly making up a Sales Unit.

Lean-Case provides all relevant metrics and the simulation results for a single Sales Unit on a single dashboard screen. The Sales Unit represents the smallest element of your sales model. The definition of a Sales Units therefore depends on your chosen sales model (e.g. inside sales team, field sales rep, sales partner,.. ).

Lean Case dashboard

The Dashboard provides 3 input areas and 3 results areas to enter and validate your assumptions in less than 30 minutes.

The Input areas capture:
Sales Unit Metrics to capture the cost and quota of your Sales Unit
Average Deal Metrics to calculate the Average Contract Value
Customer Lifecycle Metrics to record the profitability of the customer’s life

Upon your inputs, you can immediately check the impact on different metrics in 3 areas

The Result areas show:
Key Deal Metrics characterizing an Average Deal
Key Unit Metrics describing key customer metrics
Key Viability Metrics showing the short-term Payback and long term viability

Once you believe to have a set of realistic assumptions, you can start simulating your model.

02_impact_analysis

Using the Simulation Widget, Lean-Case gives you direct insights how the key metrics impact the viability indicators Payback and LTV/CAC Ratio. You can simulate:

  • How Selling Cost and Sales Quota affect the viability of your case
  • How a higher Annual Contract Value (ACV) improves sales performance
  • How Cost of Leads and Pipeline Conversion impact Customer Acquisition Cost (CAC)
  • What the impact of Churn, Expansion and Gross Margin is on Customer Lifetime Value (CLTV)

 

By clicking on the checkbox in the upper right corner, you can drag and drop the Simulation Tool to any place on the Dashboard.

You can reset your original input values or save the new set of values.

 

Check this video tutorial to learn how to work the Simulation Widget.

 

When working with Lean-Case, you can at any point edit your assumptions, access definitions and examples and browse benchmarks to make meaningful assumptions. The icons next to each metric will give you access to these useful tools.

03_base-compensation

Use the icons next to each metric.

  • Benchmark Icon – to browse benchmark data and make meaningful assumptions
  • Info Icon – to get definitions, tips and examples
  • Edit Icon – to change the metric values

You will become a SaaS expert in no time!

For information purposes, you might want to refer to our Infographic on Lean SaaS Metrics and lookup definitions the Definitive Guide to SaaS Metrics.

If you are interested in exploring the benchmarks at one glance, we have compiled an extra post for you 75 Best Practice Benchmarks for your SaaS Business which you find at the MoveToSaaS Blog

At any point in time, you can save your Lean-Case and continue from there. Whenever you are ready, you can share your Lean-Case with your peers, board or investors. At a later point in time, you can also download the model data into an Excel file.

Check this video tutorial on how to work with definitions, examples and benchmarks.

Simulating Payback and LTV/CAC Ratio

You can start simulating right away using the standard Lean-Case data set. If you first want to adapt the standard Lean-Case to your own business and then run simulations on your own assumptions, please proceed directly to the next chapter.

You can simulate which impact a change of your assumptions creates for the resulting metrics. This is what’s often called a Sensitivity Analysis. A Sensitivity Analysis is a technique used to determine how different values of an independent variable will impact a particular dependent variable, e.g. which impact a change in Sales Compensation will have on the Payback Period.

You can use the Simulation Widget for this purpose.
By clicking on the checkbox in the upper right corner, you can drag and drop the Simulation Widget to any place on the Dashboard.
You can change your assumptions on input variables by dragging the slider to the left (reducing your input value by up to 100%) or to the right (increasing your input value by up to 100%). The Dashboard reflects your changes oninut and oupput variables in real-time.
By clicking the Reset Button you can return to your original input values.
If you find better input assumptions than before, you can store them by clicking the Save-Button. Be careful in using this feature, you will overwrite your original assumptions.

Check out this video tutorial to learn how to work the Simulation Tool.

Here is a 3 step sample analysis what you can do with this.

Analyze Impact on Payback Period

You can now analyze which input assumption has the biggest impact on the Payback Period and create a chart like the one below.
You can see that an increase of 20% on the Gross Margin reduces the Payback Period from 8.6 months to 7.1 months. This is a higher impact than increasing the Average Contract Value by 20%. This also reduces the Payback Period but only from 8.6 months to 7.8 months.
If you want to create such a chart yourself, this is what you have to do for each input parameter on the Simulation Tool: Use the Simulation Widget to change the value of each input parameter by -20%, -10%, 10% and 20% and capture the impact on the Payback period in a table. Before you proceed to the next parameter, make sure that you restore the original assumptions by clicking the Reset Button.
05_impact_on_LTV-CAC_ratio

Analyze Impact on LTV/CAC Ratio

Of course, you can also analyze which changes on the input assumption have the biggest impact on the LTV/CAC Ratio (see chart below).
You can see that an increase of 20% on the Gross Margin increases the LTV/CAC Ratio from 5.8 to 7.0. This is a lower impact than – for example – increasing the Conversion Rate by 20%. This increases the LTV/CAC Ratio from 5.8 to 7.7
If you want to create such a chart yourself, repeat the sames process as described above, but now capture the impact on the LTV/CAC Ratio.

04_impact_on_payback_in_months

Understand the Sensitivities

You can now draw a few conclusions and ask how sensible the Payback Period and LTV/CAC Ratio react upon a change of any of the input variables by 10% (or any other percentage).

The following chart summarizes those findings, e.g. if you increase the Sales Unit Compensation by 10%, this will have a negative impact on your Payback Period and the LTV/CAC Ration. It will increase your Payback Period by 4.7% and decrease your LTV/CAC Ratio by 3.4%.

06_sensitivity_analysys

 

Input your SaaS Case using the right assumptions

Now, let’s understand how you capture the assumptions for your own SaaS Model.
You start off every Lean-Case by defining a Customer Segment. You target this segment with your chosen sales model (e.g. direct sales). To implement this Sales Model, you have to hire new Sales Units. A Sales Unit represents the smallest component of your Sales Model (e.g. the Sales Unit of a direct sales model can be Sales Rep, the Sales Unit in a Channel Sales Model is a single partner, the Sales Unit of an online sales channel is made up by an inbound/outbound team, , …).

Test Ltd. sells to enterprise customers. It targets this segment with a Direct Sales model. Sarah and John are working as a Sales Team – Sarah being a Sales Rep, John being a Sales Engineer. They are jointly making up a Sales Unit.

The Lean-Case Dashboard provides all relevant metrics for a single Sales Unit. As described above it gives you 3 input areas to enter your assumptions and 3 result areas to check the viability of the case.

Input areas capture:
Input 1 of 3: Sales Unit Metrics to capture the cost and quota of your Sales Unit
Input 2 of 3: Average Deal Metrics to calculate the Average Contract Value
Input 3 of 3: Customer Lifecycle Metrics to record the profitability of the customer’s life

Input 1 of 3: Capture Sales Unit Metrics

Enter the yearly cost and sales quota of a single Sales Unit. The Sales Unit Metrics capture the yearly total-cost-to-company of a single Sales Unit as well as its Yearly Quota. If the Sales Unit represents a sales rep of a direct salesforce, you must capture the fully loaded cost of a Sales Rep. If the Sales Unit represents a partner channel, you must capture the commissions you pay to the partner. If the Sales unit represents an inbound/outbound sales team, you should capture the total cost of that team.

15_Sales Unit Metrics

Fig. 1: Sales Unit Metrics

The Total Cost-to-Company of Sarah and John is made up of their Base Compensation, Variable Compensation and Additional Cost. They have an annual target to achieve which is measured in Target Annual Bookings.

Check this video tutorial on editing the Sales Unit Metrics.

16_Popup Window - Sales Unit Metrics

Fig. 2: Popup Window – Sales Unit Metrics

You can edit the following Sales Unit Metrics:

To find handy definitions and examples for each metric, click on the respective link. It will take you to Lean SaaS Metrics – The Definitive Guide to create business impact. To validate your assumptions you can check the benchmarks which Lean-Case makes available in this context by clicking on the Benchmark icon next to the metric.

Input 2 of 3: Record Average Deal Metrics

The Average Deal Metrics capture all parameters to calculate the Average Annual Contract Value (ACV). Input all parameters related to the service tiers of your product to calculate the average Annual Contract Value.

17_Average Deal Parameters

Fig. 3: Average Deal Parameters

Customers of Test Ltd. can select a Basic Plan or Premium Plan, i.e. Test Ltd has 2 service tiers. 90% of deals are Basic deals with 10 users at a monthly price of $5 and 10% Premium Plan deals with an average of 20 users at a monthly price of $10.

Check this video tutorial on editing the Average Deal Metrics.

Lean-Case allows to calculate the Average Deal Parameters by entering the Service Tiers for the company’s service. A Service Tier is a paid service plan offered to customers. Lean-Case allows users to define up to 5 service tiers; for example, “Basic,” “Intermediate” and “Pro” service tiers. Per Service Tier, the user defines the share of deals in percent of all deals across all Service Tiers. This allows Lean-Case to calculate the Average Deal Parameters.

18_Popup Window - Average Deal Parameters

Fig. 4: Popup Window – Average Deal Parameters

You can manage the following Average Deal Metrics:

To find handy definitions and examples for each metric, click on the respective link. To validate your assumptions you can check the benchmarks which Lean-Case makes available in this context by clicking on the Benchmark icon next to the metric

Input 3 of 3: Enter Customer Lifecycle Metrics

Last input! Capture all metrics relevant to get-a-customer as well as to keep-and- grow him.

The Get-a-Customer phase is divided into two stages to convert a lead into a paying customer:

  • Get-a-Lead – defining the cost per lead to acquire a qualified lead across lead channels
  • Convert-a-lead – efining the pipeline stages and conversion parameters to convert qualified leads from one pipeline stage to the next – and finally into paying customers

 

The Keep-and-Grow phase is split into two stages to maximize retention and profitability

  • Retain-a-Customer – defining customer churn important to calculate the customer lifetime as well as revenue expansion of paying customers
  • Deliver-Profitably – defining the profitability of a paying customer using Gross-Margins also being relevant to calculate the customer lifetime value

To fill the sales pipeline for Sarah and John with enough leads, Test Inc. spends $20 per lead. Sarah and John convert 1.0% of those leads into paying customers. They manage to grow the revenues of a customer by 1.5% per month, but 2% of customers also churn away per month. From a profitability perspective, recurring revenues are delivered at a Gross Margin of 70%, Professional Services at a Gross Margin of 20%.

24_Pipeline Conversion Parameters

Fig. 5: Pipeline Conversion Parameters

Get a Customer – Cost per Lead

The Cost per Lead defines the cost to acquire a lead across lead channels.

Cost-Per-Lead is the total amount invested in marketing activities to obtain one lead. This is calculated as the share of paid leads multiplied by the cost per paid lead.

25_Popup Window – Cost of Leads

Fig. 6: Popup Window – Cost of Leads

Lean-Case allows to calculate the Cost per Lead across various Lead Channels such as the Internet, telemarketing or conferences. Users can set up a maximum of 5 Lead Channels.

Per Lead Channel, you can define the following parameters:

This allows Lean-Case to calculate the Average Cost-per-Lead across all Lead Channels.

Check this video tutorial on editing the Cost-per-Lead Metrics.

Get a Customer – Pipeline Conversion

Via the PopupWindow Pipeline Stages, you can define the pipeline stages and conversion parameters to convert leads from one pipeline stage to the next – and finally converting a lead into into a paying customer

Lean-Case allows you to use four standard pipeline stages (Lead, Opportunity, Trial, Paying Customer).

26_Popup Window – Pipeline Stages

Fig. 7: Popup Window– Pipeline Stages

The Popup Window captures the conversion rates from one pipeline stage to another. At the given conversion rates, it calculates the number of required Leads/Opportunities/Trials you have to acquire to close one deal and the Cost per Stage to close one deal.

You can manage the following conversion rates:

  • which percentage of leads in stage 1 “Lead” are successfully converted to stage 2 “Opportunity”,
  • which percentage of leads in stage 2 “Opportunity” are successfully converted to pipeline stage 3 “Trial”,
  • which percentage of leads in stage 3 “Trial” are successfully converted into a Paying Customer

Test Ltd applies 4 pipeline stages to turn a qualified lead into a paying customer.Test Ltd turns Qualified Leads into an Opportunity, an Opportunity should be converted into a Trial and a Trial should be converted into a Paying Customer.

Check this video tutorial on editing Pipeline Conversion Metrics.

Keep and Grow a customer– Churn and Expansion

The PopupProfitability,Churn and Expansiondefines the profitability of a paying customer being relevant to also calculate the customer lifetime value and captures the revenue churn rate determining the customer lifetime and the revenue expansion rate from paying customers

27_Popup Window Profitability Churn and Expansion

Fig. 8: Popup Window– Profitability, Churn and Expansion

Check this video tutorial on editing Churn, Expansion and Gross Margin Metrics.

You can manage the following metrics:

To find handy definitions and examples for each metric, click on the respective link. It will take you to the Lean SaaS Metrics – The Definitive Guide to create business impact. To validate your assumptions you can check the benchmarks which Lean-Case makes available in this context by clicking on the Benchmark icon next to the metric.

 

Review your Unit Economics

Upon your inputs, you can immediately check the impact on different metrics in 3 areas

Result areas show:
Results 1 of 3: Key Deal Metrics characterizing an Average Deal
Results 2 of 3: Key Unit Metrics describing key customer metrics
Results 3 of 3: Key Viability Metrics showing the short-term Payback and long term viability

Once you believe to have a set of realistic assumptions, you can start simulating

Results 1 of 3: Understand Key Deal Metrics

Now let’s take a look at the results.The Key Deal Metrics summarize relevant deal-related metrics such as the Deals to Meet Monthly Target.

08_KeyDealMetrics

Fig. 9: Key Deal Metrics

Available metrics are

To Close one deal, the selling cost (the cost for Sarah and John) is $677 and the cost to generate leads for that deal is $670. In order to meet their monthly target, Sarah and John must Close 15 deals per month. Given the conversion rate, the Cost of Leads Required (to meet the monthly target) is $9,902

To find handy definitions and examples for each metric, click on the respective link. It will take you to the Lean SaaS Metrics – The Definitive Guide to create business impact. To validate your assumptions you can check the benchmarks which Lean-Case makes available in this context by clicking on the Benchmark icon next to the metric

Results 2 of 3: Identify Key Unit Metrics

The Key Unit Metrics summarize the relevant customer key metrics: the Lifetime, Lifetime Value (LTV) on a total and annualized base and Customer Acquisition Cost (CAC).

03_Key-Unit-Metrics-

Fig. 10: Key Unit Metrics

Available metrics are

With a churn rate of 2%, the Customer Lifetime averages 50 months. Selling Cost, Cost of Leads and Partner Commission add up to a Customer Acquisition Cost of $1,488. At a Gross Margin of 70% of the Average Annual Contract Value, the Lifetime Value of a Customer is $9,867. On a 12-months basis, the Annualized Lifetime Value equals $2,368.

To find handy definitions and examples for each metric, click on the respective link. It will take you to the Definitive Guide To validate your assumptions you can check the benchmarks which Lean-Case makes available in this context by clicking on the Benchmark icon next to the metric

Results 3 of 3: Nod the Viability Metrics

As discussed above The Viability Metrics explain the short-term and long-term viability of your SaaS business case with simple traffic light indicators:

  • The short-term indicator Months to Recover CAC defines how fast you recover the CAC (ideally faster than 12months).
  • The long-term indicator LTV/CAC shows how many times the LTV exceeds the CAC (ideally more than 3 times).

01_viability_metrics

Fig. 11: Viability Metrics

Ideally, LTV should be at least three times greater than CAC. If so, the Lean-Case indicator will turn green.

Lifetime-Value to Customer-Acquisition-Cost Ratio

The Lifetime-Value to Customer-Acquisition-Cost Ratio indicates the long-term viability of your go-to-market model: Does the Customer Lifetime Value (CLTV) exceed the CAC significantly? The LTV/CAC Ratio is calculated by dividing theTotal Lifetime Value (LTV) by the Customer Acquisition Cost (CAC).

07_LTV-CAC_ratio

Payback Period / Months to Recover CAC

The Months to Recover the Customer-Acquisition-Cost Metric indicates the short-term viability of your go-to-market model: Do you recover your Customer-Acquisition-Cost (CAC) fast enough? The Months to Recover the CAC Metric is the number of months of continuing monthly recurring revenues from a customer needed in order to recover the customer acquisition cost. It is calculated by dividing the Annualized LTV by the Customer Acquisition Cost (CAC) multiplied by 12.

08_months-to-recover-CAC

Conclusion

I hope this blog helps you to understand SaaS metrics better, to find and apply benchmarks efficiently, to build a recurring revenue business model, scaling the right sales plan and winning funding for a SaaS business with a lean case.

I really want you to avoid the pitfalls I have seen by using the right formulas, applying the right assumptions, making the business case look appealing, and building a model to support scenarios, continuous analysis and tracking.

You should understand the relevance of the viability metrics Payback and the LTV/CAC Ratio .

Customer acquisition cost is a direct reflection of the future success of your SaaS business. If you’re too cautious about your CAC, you will likely be missing out on customers and future revenue. Yet, if you spend too freely, you won’t be profitable and will likely end up in the Deadpool.

The challenge is that you want to spend the right amount of CAC to drive new customers to your service without jeopardizing the Lifetime Value (LTV) and revenue from that customer. A great measure to gauge this balancing act is the LTV/CAC ratio, which is sometimes even referred to as the “god metric” of many successful SaaS companies.

If you like Lean-Case and this post, please share it with your friends.

 

Leave a comment

Your email address will not be published.