Software as a service (SaaS) businesses shift a company’s fixed upfront software costs into variable pay-as-you-go costs that occur in the future. This makes SaaS businesses attractive for customers while also giving a relatively more predictable revenue base for the software provider.
However, when software is offered as a service, it’s no longer sufficient to evaluate the health of the business based on the traditional metrics of a license-based software provider. License providers care mainly about how many customers buy the license and how much revenue they earn from these customers.
In addition to these two core metrics, SaaS businesses need to monitor several more.
First, the shift to a pay-as-you-go model lowers long-term customer lock-in and gives the customer the chance to stop using the software each month. This makes it very important to monitor a SaaS business’ churn.
Second, customers’ ease of churning makes customer service very important. In the licensing model, customer servicing costs are largely incurred at the time of sale. However, in the SaaS model, these costs occur on a monthly basis and can eat in to your monthly recurring revenue (MRR).
Finally, the makeup of a SaaS business’ MRR is a strong indicator of the health of the business. The Social + Capital Partnership, investor in leading SaaS companies like Yammer, Box, and Slack, recommends breaking net MRR into new MRR (from new customers who begin using the software), expansion MRR (account upgrades from existing customers), contraction MRR (account downgrades from existing customers), and cancelled MRR (from existing customers who stop using the software). You can view their full presentation on what they look for in SaaS businesses here.
Especially at the early stages of a startup, it’s important for the company to be increasing its MRR by acquiring new customers rather than through account upgrades from existing customers. If expansion MRR is responsible for net MRR increasing for a startup where new MRR is otherwise outpaced by the contraction MRR and cancelled MRR, this should raise a red flag.
Social + Capital defines the quick ratio as the sum of new MRR and expansion MRR divided by the sum of contraction MRR and cancelled MRR, and looks for a quick ratio higher than 4 in its investments. Given its track record, this is probably a good target.