Bessemer Cloud Computing Law #5: Play Moneyball with the 5 C’s

October 2, 2012
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Consumer internet companies like Google and Amazon were built on deep consumer data and analytics.  Complex manufacturing businesses like Intel measure production inefficiencies down to the particle level.  Elite athletes and sports teams measure performance in excruciating detail to try to highlight areas for improvement and competitive advantage.  As we know from other industries and fields, you have to have a set of metrics in place before you can track and then predictably improve upon them.

Tobias Lütke
CEO, Shopify
“The beautiful thing about running an online business is that you have almost unlimited data about your customers and your business. We have a primary set of metrics, but are then constantly running analyses in areas like churn, CAC, CLTV, and cohort performance to find new insights into the business. In our offices we have big screens hanging everywhere which share these numbers with the entire company.”

Although enterprise software companies have long organized themselves around a clear set of business metrics – including bookings, maintenance & support fees, and revenue – the new software economy of Cloud Computing is just starting to converge on its own set of metrics.  After surveying hundreds of leading public and private Cloud Computing companies, 5 key “C” metrics now rise above the others as essential top level performance indicators: CMRR, Cash Flow, CAC, CLTV, and Churn.  We recommend EVERY cloud business track and report on these as a starting point, plus additional metrics that are relevant to your teams and functions as appropriate.

  1. CMRR, ARR, & ARRR – Committed Monthly Recurring Revenue, Annual Recurring Revenue, and Annual Run Rate Revenue. Many 1st generation cloud businesses turned to TCV (Total Contract Value) or ACV (Annual Contract Value) as their top level metric as a carry-over from the legacy software world of tracking “bookings.”  In the Cloud Computing world, these metrics can be easily manipulated and are often misleading, and therefore we recommend much more focused metrics around the recurring revenue in a normalized time period.

TCV and ACV are flawed for many reasons, most notably with regard to duration and services.  For very late stage companies (like with standard contract terms and service ratios, these metrics can still be workable, but for highly dynamic private companies they can be highly misleading.

If your renewal rates are strong, then contract duration isn’t a major variable whereas cash collection and the size of the monthly subscription will massively impact your business (see points on Cash Flow and Churn below).   Therefore, a focus on TCV has a tendency to encourage sales professionals to focus on longer term (often multi-year) deals to push up TCV, instead of pushing on the more important elements of monthly subscription value and cash pre-payments.  ACV does help to reduce this over-emphasis on duration by just focusing on the first year of the deal, but shares the second major flaw that TCV is also burdened with, which is an over-emphasis on services revenue as part of the “contract value.”

To be very blunt with our perspective: professional services revenue is bad for cloud businesses in most cases.  It’s low gross margin revenue that slows down your implementations and can only scale in proportion to your services headcount.  For these and many other reasons, Wall Street investors and your customers hate to see a large mix of services revenue in cloud businesses.  You should focus your product development, sales, and client success teams on reducing the implementation friction, time, and cost as much as possible.  In most cases, you shouldn’t reward your sales team on “contract value” by giving them quota relief and commissions against services revenue.

To address these concerns, many cloud businesses now focus on Monthly Recurring Revenue (MRR), which represent the combined value of all of the recognized recurring subscription revenue on a monthly basis. We recommend companies actually take this a step further and track the forward view of Committed Monthly Recurring Revenue (CMRR) as the primary internal business metric. MRR is a great base metric, but CMRR is more insightful because it includes all MRR, plus signed contracts currently committed and going into production, and minus “churn,” which is the MRR that is no longer committed from customers that have turned off the service, or are anticipated to do so in the future. 

To prove the point - here are two deal options, which would you pick?

Deal A: 6 month prepaid contract; renews monthly; $10k monthly subscription; $10k services.  (TCV:  $70k, ACV: $130k, CMRR: $10k)

Deal B: 3 year contract; 3 months prepaid; $5k monthly subscription; $80k services.  (TCV: $195k, ACV: $140k, CMRR: $5k)

Despite lower TCV and ACV, Cloudonomics says you should pick Deal A every time.  Deal A will gross ~$370k of revenue over 3 years, whereas Deal B will only gross ~$260k.  Deal A will also likely be much higher gross margin given the lower services ratio.  In fact, there are only two reasons to even consider Deal B and those related to churn risk and cash flow, but we also attempt to correct those misconceptions later in this paper.  In almost every case, CMRR is the single most effective metric.

For businesses that don’t operate with long term contracts – such as PaaS businesses with monthly or consumption based contract terms – “Committed” is the calculated MRR at that instant (as committed to by the CFO, VPS, and CEO combined) based on the current customers in production with their existing consumption levels adjusted for seasonality or known usage trends.  This is meant to be the best true baseline number of expected product/subscription/usage revenue for the month, without adding any new customers, upselling any new products, or expanding usage beyond the current footprint, but subtracting out all known churn.

This single metric gives you the purest forward view of the “steady state” revenue of the business based on all the known information today.  The monthly focus also tends to drive many positive behavioral changes within a team including a monthly sales and development cadence, better sales compensation plan and cash flow alignment, reduced customer price sensitivity, and heightened awareness around small MRR changes.  Many leading cloud companies therefore use CMRR as the basis for everything from the financial model to the sales commission plan.  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.

For external purposes, you will likely want to highlight slightly different versions of these metrics: the Annual Recurring Revenue (ARR) and Annual Run Rate Revenue (ARRR).  ARR is simply the currently recognized portion of this monthly revenue, multiplied twelve.  ARRR is the ARR, plus any non recurring revenue related to items such as professional services, transactions, and implementations.  These external “vanity” metrics can help drive home the run rate scale of your business, especially when used to describe the forward business model.  Your current CMRR may be $1.75M and projected to grow to $2.17M at year end, so for external audiences you may get maximum impact by summarizing the business plan by saying: “As we exit this year our Annual Run Rate Revenue (ARRR) should cross $30M, which includes $26M of Annual Recurring Revenue (ARR).”

  1. Cash Flow - Start with Gross Burn Rate and Net Burn Rate, then hopefully turn to Free Cash Flow over time. CMRR gives you a great sense for the revenue health of the business, but can very often be disconnected from the “cash health” of the business.  As any scrappy entrepreneur will tell you, a business will live or die based on its cash management in the early days, and therefore detailed cash metrics are also needed.

Gross and Net Burn Rate (cash flow) metrics are critical for cloud businesses because the working capital requirements are higher and the payment terms are often backend weighted.  Gross Burn Rate is all of the expenses paid for in the month including debt and finance charges. Net Burn Rate is simply all cash received during the month minus all the expenses, which nets out to the cash burned in the month.  These numbers are obviously lumpy based on the timing of collections and payables, so many companies further refine this by adding a “rolling 3 month average” burn rate set of metrics.  Cloud businesses typically show significant positive Free Cash Flow (FCF) long before they turn GAAP EBIT positive, so hopefully you will be able to flip your burn rate (negative cash flow) metric to a positive one as you grow, and start tracking FCF instead. 

By tracking your CMRR and Burn Rate you have a very good sense for the steady-state health of the business.  At any point you can divide your monthly Net Burn Rate into your cash balance to understand your “months of runway,” which many of our CEOs monitor routinely.  You should always have a variety of insurance plans – which we strongly recommend you discuss as a Board and keep updated – that could include cuts in the business to quickly reach cash flow breakeven.  One of the great benefits of these cloud businesses is the recurring nature of the revenue streams, which means that you can very easily model and predict the steps you would need to take to instantly bring the Gross Burn Rate of the business inline with the CMRR, so that you glide into a Net Burn Rate of zero as your working capital catches up.  Many of our companies with extremely aggressive growth plans and high burn rates talk openly about their “insurance” or “rip cord” plans, where they can always freeze hiring, slow marketing spend or make targeted cuts if their cost of capital spikes or their sales metrics deteriorate, and still work back to breakeven.

  1. CAC  – Customer Acquisition Cost Payback Period. The CAC Payback is a statement in months, of the time to fully payback your sales and marketing investment.  This is worthy of much more detail and therefore broken out further in Law #6 later in this paper.
  2. CLTV – Customer Lifetime Value. Understand your Customer Lifetime Value (CLTV), because a profitable business rests on the shoulders of profitable customers. 

CLTV is the net present value of the recurring profit streams of a given customer less the acquisition cost.  Part of the attraction of Cloud Computing business models is that once you have repaid the initial Customer Acquisition Costs (CAC), the cash flow and profit streams from customers can be quite attractive.  However, whereas the CAC ratio can at least ensure that you recover your incremental sales and marketing costs on each customer, it still doesn’t tell you if these customers are highly profitable over time.  To measure this, many customers have modified the consumer internet concept of lifetime value, into a similar cloud CLTV metric.

Michael Fertik
“We are constantly looking at our dashboard of metrics to tune the performance of our business. These metrics give us a common framework as we steadily find ways to reduce CAC and Churn, while increasing CMRR and CLTV.”

To simplify the calculation, let’s assume that a customer generates $10,000 of annual recurring revenue for a company with a CAC Payback ratio of 12 months, a 70% Gross Margin and 10% each of R&D and G&A costs. The $10,000 of revenue will generate $7,000 of gross margin and $5,000 of profit each year ($7,000 less $1,000 of R&D and $1,000 of G&A costs). Over 5 years, this customer will generate $25,000 of profit (5 years x $5,000/year). A CAC ratio of 12 months means a $7,000 upfront acquisition cost, making the CLTV equal to $25,000-$7,000= $18,000   Obviously if the retention period is longer, and/or you benefit from net positive CMRR renewal rates that actually grow your average customer relationship over time, these numbers can be much larger.

For those who may choose to get more analytical, this is equivalent to ($18,000/5) = $3,600 of annualized profit or 36% profit margin. The calculation can be refined with a better allocation of the S&M costs (the parts used to support current customers) and by discounting the profit streams (in this example, a 15% discount rate would reduce the CLTV to $12,300 or 25% annualized profit margin). It’s also worth noting that 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.

  1. Churn & Renewal Rates – Logo Churn, CMRR Churn, and CMRR Renewed.    It’s very difficult and expensive to grow subscription businesses if you have moderate customer churn-- and prohibitive if your churn is high.  As detailed financial models of CLTV and Free Cash Flow demonstrate, the single biggest driver of long term profitability for your cloud business (and thus valuation) is the renewal rate of your customers. 

Whereas the largest legacy enterprise software companies literally made tens of 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 the contract terms.  This is another reason not to overly focus your team on long term contracts, because it creates a false sense of customer lock-in regarding your unhappy customers, and may leave money on the table from lost upsell opportunities with your happiest customers.  Over time when you have successfully realized most of the upsell potential of your accounts and have built in deep ties to the account, you may want to push for longer term contracts for predictability (which Wall Street does still value), but this shouldn’t come at the expense of CMRR.

Cloud executives need to track renewal rates in detail to capture “logos lost” (lost customers) as well as the percentages of CMRR renewed and lost.  The standard approach is three key sub metrics, all related to this concept of renewal rate:

Logo Churn %: This is a percentage calculation of all your customer names (“logos”) that have churned over the measured time period.  If you started the year with 500 customers and 460 of them were still paying customers at some level at the end of the year, then you have churn of 40 customers and your annual Logo Churn is 8% (40/500).  (Note: As with all renewal metrics, you exclude all new customers signed during the time period.  They’ll be captured in your next renewal report.)

CMRR Churn %: This is a percentage calculation of all your customer CMRR that has been lost over the measured time period.  If you started the year with $500k of CMRR for your same 500 customers, and the 40 customers that churned represented $30k of CMRR at the start of the year, then your Base CMRR Churn Rate is 6% annually ($30k of starting CMRR churned/$500k of starting CMRR).

CMRR Renewal %: This is a percentage calculation of the total CMRR of your renewed customers at the end of the year, divided by the total CMRR of your existing customers at the beginning of the year.  Of your 460 renewed customers, if they have been upsold on new products and grown in their usage of the product during the year to the point where their CMRR equals $550k in total, then your Total CMRR Renewal Rate is 110% ($550k end of year CMRR just from customers who were on board at the start of the year/$500k CMRR of all customers at start of year). 

Sarah Friar
CFO, Square
“I’ve enjoyed working with the Bessemer team for over four years on the 5 C’s of cloud finance, back from my days at Goldman Sachs when we utilized some of these CLTV models in our valuation work and at when we used some of these metrics for our own performance and to evaluate the performance of our acquisitions. I’m a big believer that if it's worth doing it's worth measuring with a clear set of metrics, and we’re embracing many of these same CAC and CLTV concepts at Square as well.”

The top performing cloud companies can enjoy annual Logo Churn rates below 7% and CMRR Churn rates below 5% - with most of the churn due to death (bankruptcies) or marriage (acquisitions) - and CMRR Renewal rates well above 110% due to upsells into this installed base.

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 five to be pretty universal across the vast majority of cloud businesses.  You will find yourself reviewing them at different frequency levels:  CMRR, Cash Flow, 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.  As you approach being a public company you will likely chose to keep these metrics internal only and will instead add in “Street Metrics” including GAAP Revenue, Gross Margin, and EBITDA.

Finally, with these metrics in place, use them to drive your rolling financial budgets and forecasts.  Although you will likely want to keep your annual “Board Plan” of record locked down for the year, you should get in the habit of revising and sharing your business forecasts monthly or quarterly.  Some executives may come to a Q3 meeting and simply publish their second half Board Plan as their forecast, but that suggests the company hasn’t learned anything in the 6-9 months since that budget was originally drafted.  There may only be slight variations in expenses, CMRR, or cash flows, but get in the habit early of revising forecasts and using that as another way of sharing the positive and negative trends of the business.  In return, a collaborative Board of Directors should view the forecasts as rough projections and not overreact to information shared.  You don’t want your first attempts at forecasting to be as you get ready for your IPO roadshow.

For a PDF of Bessemer's Top 10 Laws of Cloud Computing and SaaS please click here.