Why the Most Important Success Metric in SaaS is Misleading

March 5, 2015

 

What’s the first metric VCs hunt for in your pitch deck? Easy… committed monthly recurring revenue (CMRR). Everyone knows that, right? In their famous report on the laws of cloud computing, Bessemer Venture Partners rightly says, “[CMRR] is the single most important metric for a Cloud business to monitor, as the change in CMRR provides the clearest visibility into the health of any Cloud business.”

Ask any cloud / SaaS investor, and they’ll say the same thing. This is the foundational metric that everyone scours the pitch deck to find.

But is CMRR growth everything? Let’s compare two companies with nearly identical CMRR growth curves. We’ll call them Company ABC and Company XYZ. The chart below shows that indeed, both companies are on the same CMRR trajectory.

Total CRMM Over Time

So which company is more interesting? How does a VC decide which of these to invest in? Contrary to popular opinion, it is (a little) more scientific than a blindfolded dart-throwing contest.

The next logical metric to examine is Gross New CMRR per Month, or New Customer CMRR. Since each month can be viewed as a new customer cohort (upsells are excluded), this exercise tells you the size of each new cohort you’re adding (in $). Great, so let’s compare ABC and XYZ on this:

New Customer CMRR per Month

Now which company is more interesting? Uh, well, clearly ABC right? I mean, that growth though! ABC has grown the new cohort size by 2.4x in 2 years, from $10k to $24k. ABC really knows how to scale its go-to-market! Meanwhile, look at boring old XYZ. They’ve been adding $10k of new CMRR every month for two years. Womp womp. No thanks XYZ.

But wait a second…these two charts are comparing the same two companies at the same point in time. How can they be identical on one chart, and so different on the other? Since we are indeed looking at CMRR, there’s no implementation lag.

Solving for end-of-month CMRR is a pretty simple arithmetic:

End-of-Month CMRR = Beginning-of-month CMRR + New Customer CMRR + Upsell CMRR – Downgrade CMRR – Churned CMRR

We can see that ABC is adding plenty of new CMRR each month. We can conclude that the company has a churn issue of some sort. Whether full-on cancellations or downgrades, it doesn’t matter. We can intuit that Company ABC is bleeding CMRR dollars somewhere. More on their specific retention trend in a second.

Net Dollar Retention and the Leaky Bucket Issue

What’s the best way to measure churn and benchmark against other SaaS companies? The industry standard benchmark is quickly becoming “net dollar retention.” If I acquire $1 of CMRR today, what is that $1 worth over time? The true best of breed companies today are seeing that $1 grow over time, becoming $1.10 or $1.20 or much more. This phenomenon is called “net negative churn.”

To some folks (read: VCs and serial SaaS execs), I’m sure this seems elementary. If that’s the case feel free to stop reading. These are not brand new revelations, and I’m not the Christopher Columbus of net negative churn. I’m writing this because I saw a number of real businesses in 2014 that were exploding in CMRR, but on deeper inspection had major net dollar retention issues. These companies were quickly getting to $600-800k CMRR, growing well over 100% year-over-year (and profitably too!). But on the retention side, $1 was shrinking to $0.40-$0.50 as early as Month 12. The founders of said companies were overly focused on total CMRR growth, while paying much less attention (if any) to cohort-based dollar retention.

Some people call this a “leaky bucket issue.” You see this on display in the ABC vs. XYZ comparison. If you examine ABC in isolation, you may be able to rationalize the leaky bucket. After all, they’ve grown CMRR to $264k from a standing start two years ago. And these guys are so good at scaling go-to-market! The “scaling go-to-market” argument is even easier to justify when there is a good CAC ratio, which is often driven by the kind of word-of-mouth virality that signals strong product-market fit.

But when you do a side-by-side comparison and switch out your rose-colored glasses, you realize ABC has had to grow their customer acquisition by 2.4x just to keep up with XYZ, who has apparently been on autopilot.

Alright enough with the lead-in editorial, let’s look at the retention curves for ABC & XYZ side-by-side. The equation here measures CMRR in Month X as a % of CMRR in Month 1. It’s measured on a cohort basis. The denominator stays fixed, which allows you to isolate the operational trend.

 

Net Dollar Retention Curve

Wow, this is dramatic. It becomes clear why ABC has had to ramp its go-to-market so aggressively to keep in step with XYZ. ABC definitely has a leaky bucket issue — CMRR is seeing a rapid decline to 60% of its initial value by Month 12, and then slows toward an asymptote at 45% by Month 24. Our friends at XYZ on the other hand see net negative churn, growing CMRR to 120% of initial value by Month 24.

Now what happens if we assume XYZ is able to scale its go-to-market as ABC has? This would give us a true apples-to-apples comparison.

Screen Shot 2015-03-04 at 3.48.51 PM

As you would expect, we see XYZ pulling away from ABC (whose linear CMRR growth doesn’t look so hot anymore). To be precise, XYZ is now ~58% bigger than ABC ($416k CMRR vs. $264k CMRR), with the front-end growth (and ostensibly the same go-to-market investment).

What’s perhaps more pertinent is that XYZ would most certainly get funded at a premium price, while ABC would likely have to resort to an inside round from existing investors. That’s not an oversimplification — I see companies like XYZ get $10-15M rounds at market-topping valuations. I honestly don’t think I’ve ever seen anything like that for a company like ABC.

Key Takeaways

Here are the key takeaways from this study:

  • Improving retention gives you much more leverage on the go-to-market front (you’re fighting against a leaky bucket)
  • The 1-2 punch of a growing front-end and a healthy back-end is the magic formula for exponential growth and lots of VC love.

Excel Spreadsheet Template

Click here for a spreadsheet you can use to calculate your own CMRR growth and Net Dollar Retention: Download Now

SlideShare Version

 

Photo by: Brett Farmiloe