BESSEMER CLOUD COMPUTING LAW #2:
Get Instrument rated, and trust the 6C’s of Cloud Finance.
Any good pilot (CEO) knows that you can’t fly in cloudy weather without an instrument rating, yet many CEOs are attempting to do exactly that. Build and trust your CEO dashboard. Your key business metrics must include: 1) Committed Monthly Recurring Revenue (CMRR), 2) Cash Flow 3) CMRR Pipeline (CPipe) 4) Churn, 5) Customer Acquisition Cost (CAC), and 6) Customer Life Time Value (CLTV).
- CMRR – Committed Monthly Recurring Revenue. Experienced software executives have been taught for years that there is a single critical metric by which the health of a growth software business can be judged: "Bookings". However, in the SaaS world, "Bookings" is for suckers. It’s ambiguous at best and often very misleading. To achieve better business visibility, most top performing Cloud companies focus on Annual Contract Value (ACV) or Monthly Recurring Revenue (MRR) -the combined value of all of the current recurring subscription revenue - instead of Bookings. We recommend companies actually take this a step further and track the forward view of Committed Monthly Recurring Revenue (CMRR). The CMRR differs from the MRR in two ways: firstly, it includes both "in production" recurring revenues of the customer and the signed contracts going into production. Secondly, it is reduced by "churn" which is the MRR expected to be lost from customers that are anticipated to be stopping service in the future. This single metric gives you the most pure forward view of the "steady state" revenue of the business based on all the known information today. This 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.
- Cash Flow. To be fair, visibility into the current cash position and its likely changes has always been important for software executives, but it is even more critical for Cloud businesses because the working capital requirements are higher and the payment terms are often stretched out over the term of the contract. Given the high cost of capital for private Cloud companies, wise executives will often offer slight MRR discounts to customers in exchange for quarterly or annual pre-payment terms, and provide incentives for their sales force accordingly.
- CPipe – CMRR pipeline. Because "bookings" is a poor proxy for business health, you must also adjust your sales mindset to focus on CMRR – including comp plans, reporting, and pipeline. Based on your business size and average sales cycles, you will need to determine which pipeline time frames (monthly, quarterly, or rolling forward 2 quarters?) and stages (all qualified and above? Probable? Only Committed?) are most appropriate, and whether to show the pipeline as a total number or a factored number. Regardless, consistency and transparency are critical. Have a consistent definition of CPipe so that you can track the changes over time. Over time, this should become a reliable leading indicator for elements of CMRR, Cash flow, and CAC.
- Churn. It’s very difficult and expensive to grow subscription businesses if you have moderate customer churn-- and prohibitive if your churn is high. Cloud executives need to track churn in detail from a "logos lost" (lost customers) perspective as well as the amount of lost CMRR. Whereas the largest legacy enterprise software companies literally made billions of dollars over the last decade with "shelf-ware" projects that never got fully implemented, project failure is not an option for Cloud businesses or the customer will simply turn you off, regardless of your contract terms. The top performing Cloud companies typically achieve annual customer renewal rates above 90% - with most of the churn due to death (bankruptcies) or marriage (acquisitions) - and over 100% renewals on a dollar value basis due to up-sells into this installed base.
- CAC Ratio - Customer Acquisition Cost Ratio. How do you know if your sales and marketing investments are ultimately "profitable"? The answer to this question can be found through the CAC Ratio. We introduced this concept several years ago (and it is similar to Josh James’ "Magic Number" at Omniture/Adobe), but we’ve recently refined it further to include only NEW CMRR Gross Margin booked, to better account for businesses with slower growth and/or higher churn in these volatile markets. This single number is the key to determining your level of sales and marketing investment. It can be calculated by looking at a quarterly GAAP P&L: just divide the NEW annualized net gross margin added during the quarter (gross new CMRR x your average Gross Margin % x 4 quarters; forget the effect of churn for now), by the sales and marketing costs of the previous quarter excluding any account management costs attributed to your "farmer" organization.
- The CAC ratio determines how much of your sales and marketing investment is paid back within a year: a CAC ratio of 0.5 for example means that half of your investment is paid back per year, so it is a two year payback period. So how should you use this ratio? The punch line is that a CAC ratio of a third (0.33) or less is bad – this suggests it takes you at least three years to payback your initial customer acquisition costs – so you should slam the brakes on your sales and marketing spending until you can improve sales efficiency. At the other end, assuming your churn rates are also low, anything above one (1) means you should invest more money immediately and step on the gas (and please call Bessemer immediately because we want to fund you!) as your customers are likely profitable within the first year.
- CLTV - Customer LifeTime Value. The CLTV is the net present value of the recurring profit streams of a given customer less the acquisition cost. A profitable business will have a positive CLTV. To make the calculation simple, let’s assume that a customer generates $1 of annual recurring revenue for a company with a CAC ratio of 1.0, a 70% Gross Margin and 10% each of R&D and G&A costs. The $1 of revenue will generate $0.7 of gross margin and $0.5 of profit each year ($0.7 less $0.1 of R&D and $0.1 of G&A costs). Over 5 years, this customer will generate $2.5 of profit (5 years x $0.5/year). A CAC ratio of 1.0, means a $0.7 upfront acquisition cost, making the CLTV equal to $2.5-$0.7= $1.8. This is equivalent to ($1.8/5) = $0.36 of annualized profit or 36% profit margin. The calculation can be refined with a better allocation of the S&M costs (part are used to support current customers) and by discounting the profit streams (in this example, a 15% discount rate would reduce the CLTV to $1.23 or 25% annualized profit margin). For young companies, it may be more of an art than a science to estimate the lifetime of the customer as your churn data is still limited, but we’d conservatively take 3-4 years for SMB customers, and 5-7 years for enterprise customers.
Your specific business is likely to have additional "key" metrics that are worthy of showcasing on the top level executive dashboard, but we have found these six to be pretty universal across the vast majority of Cloud businesses. You will find yourself reviewing them at different frequency levels: CMRR, Cash Flow, CPipe and Churn tend to be highly dynamic and thus daily or weekly metrics, whereas CAC and CLTV are more strategic and thus longer term in their nature. Many of our top performing Cloud CEOs have modeled their executive team objectives and bonus plans around a subset of these metrics exclusively (typically CMRR growth, Churn, and Cash flow) and we would encourage you to consider doing the same.
Together, CMRR, Cash flow, CPipe, Churn, CAC, and CLTV make up the "6 C’s of Cloud Finance." To learn more details about calculating and using these metrics, you can download "CAC Ratio - One Number to Manage your SaaS S&M Spend"or "Measuring Growth Businesses with Recurring Revenues." at www.bvp.com/cloud.