You have nailed your vision, your story. You know the TAM is massive and have great customer stories to tell. The team is rock solid. Nothing can stop you.....until the dreaded digging into the data and numbers. At the end of the day investors need to believe you already have great metrics or there is a clear path to getting to them. But what metrics? Below we will cover the Top 6 most important metrics to know inside and out.
Number 6: Expected Value of Existing Pipeline
If an investor asks if you have 4x Pipeline Coverage.....run. This is one of the most arbitrary and generic sayings in the SaaS world. It is absolutely meaningless. The investor is saying whatever pipeline you have, that 25% of that will turn into ARR (regardless of how far along the pipeline is or when that will actually turn to ARR). In the B2B SaaS world, where sales cycles can be 1 year, every pipeline dollar can be early in that cycle or late in that cycle. The probability of winning early stage pipeline is significantly lower than winning late stage pipeline. On top of that the late stage pipeline will turn to ARR sooner than the early stage pipeline. 4x pipeline coverage assumes all pipeline has a 25% conversion rate to ARR and doesn't care WHEN you will win that ARR, making this have zero meaning.
Take the example below:
Company A says they have $6.1M in Pipeline that will turn to $832,500 in ARR in 1 year. That is 7.3x "coverage". Company B says they also have $6.1M in Pipeline that will turn to $5.4M in ARR in 1 year. That is 1.1x coverage. Both companies are correct in what they will hit regardless of the fact that one company has a 7x and one company has 1x coverage showing the coverage ratio does not matter. Some investors would say Company A has great pipeline coverage and Company B does not, so Company B won't hit their number. The real question should be "What is the Expected Value of your Pipeline in X months"?
Smart, savvy investors will focus on the Expected Value of your pipeline as opposed to a coverage ratio. That question alone will tell you the sophistication of the investor you're dealing with. There is another blog post on the correct way to turn "Pipeline" into "Expected ARR" called "End of Pipeline Coverage Ratios". That covers this in more detail as it entails Win Rates Over Time by Stage which can get complicated.
Number 5: Magic Number (simple) or LTV to CAC (more complex)
Two metrics trying to answer similar questions around how efficient your business is are Magic Number and LTV:CAC Ratio. I will focus on Magic Number below, but see the course "SaaS-y Metrics" to understand the details around LTV:CAC Ratio.
Magic Number is answering the question how much ARR do your Sales and Marketing $ yield for the company. Let's start with an example:
Each quarter your company generates "New Business ARR" (Renewal ARR should not be included here since Sales and Marketing Expenses are not as impactful to your Renewal ARR). To get that New Business ARR you had to invest in Marketing and Sales some period ago. Comparing these 2 numbers is the Magic Number.
One very important thing is to understand how long it takes your sales and marketing expenses to turn into New Business ARR. That time period we will refer to as the "Lag". The "average sales cycle" is a good gauge for this. When most people refer to Magic Number, they talk about a 1 quarter lag. However, the flaw is that implies a 3 month sales cycle, which is a rarity in the SaaS world.
If we were asked what is your Magic Number (with 1 quarter lag) for Q4 2021, we would get that result by doing $6M/$5M = 1.2. The 2 quarter lag would be $6M/$4.5M = 1.3. Similarly, if we asked what was your Magic Number in Q2 2021 we would get $1.5M/$4M = 0.38 (1 Quarter Lag) and $1.5M/$3.5M = 0.43 (2 Quarter Lag). Often due to seasonality you might look at the last 12 months magic number for a given time. An example would be the TTM (trailing 12 months) Magic Number for Q4 2021 would be:
($6M + $3M + $1.5M + $2M)/($5M + $4.5M + $4M + $3.5M) = 0.74 with a 1 quarter lag
($6M + $3M + $1.5M + $2M)/($4.5M + $4M + $3.5M + $3M) = 0.83 with a 2 quarter lag
($6M + $3M + $1.5M + $2M)/($4M + $3.5M + $3M + $2.5M) = 0.96 with a 3 quarter lag
($6M + $3M + $1.5M + $2M)/($3.5M + $3M + $2.5M + $2M) = 1.14 with a 4 quarter lag
A number above 1 indicates you're recovering the Sales and Marketing costs in the form of New ARR by the end of the Lag period.
A number above 0.75 should indicate further Sales and Marketing Investments, while a number below 0.5 should cause some further digging into why.
Number 4: Software Gross Margins
Software Gross Margins are determining how profitable your Software is. For every $1 in Software Revenue you receive, first we need to determine how much of that we will need to use to support that $1 in Revenue in the form of Cost of Goods Sold (COGS). For instance, it might cost you money to host your Customers data, Cloud computing costs, Support to process customer tickets, and customer success teams helping onboard and retain customers. You need to deduct these expenses that occur after you make the sale and see what percentage of the revenue you still have left.
Software Gross Margin = (Software Revenue - COGS)/Software Revenue
A number 80% or above will get you kudos from investors. Below 70% you will need to be able to explain in more detail the why. The concern here will be is it really a Software business if it costs so much money to support the customer.
Now to some flaws with this calculation;
One major issue is that many companies will break out "Services" people costs into a Services Gross Margin (which is often negative). The issue is often those services are needed to make the software successful. Numerous companies are out there posing to be software companies, but are backed by a services team doing bespoke work to make the customer successful.
Another issue is when will the costs pay off. For a company scaling, they might be hiring customer success people ahead of the recognition of the revenue. It might take time to ramp those people, so you hire aggressively ahead of the revenue coming in. In those cases your expenses will cause a lower gross margin during this investment period.
Number 3: Net and Gross Retention
Net and Gross Retention have numerous deviations and ways to be calculated. However, they are all focused on how well you can retain your customers. In the SaaS world it often costs you a lot of money to acquire a customer. See "Number 5" on this list. If you can't keep that customer then your unit economics will fail. It also will be indicative of product issues, lack of value, and lack of product market fit.
12 Month Net $ Retention looks at customers you had a period 1 year ago and looks at those same customers today (new customers added over the last 12 months are not included in this calculation). It then divides the Annual Recurring Revenue of those same customers today compared to what the ARR was 12 months ago of those customers. A number above 100% indicates that once you sign a customer up on average the amount they spend with you will be higher in the next year. You might lose customers so you will have to make up for all those lost dollars with upsell $. A number above 120% is considered the gold standard in the SaaS world. Below 100% and many questions are going to be raised about the product and value it is bringing.
12 Month Gross $ Retention is the same thing as above with 1 major difference. You can't count any upsell. This is a much more pure metric as you can't save this metric by expanding lots of customers as you can with the Net $ Retention metric. A number above 90% is very good. Below 80% is when questions will start to be raised.
12 Month Gross Logo Retention counts every customer equally. It is not subject to the variance of large deals, which makes it a much more stable metric at spotting any product issues and value being received. The other 2 metrics are skewed by the companies largest customers, whereas every customer is equal here (big or small). It will tell how strong the product is and also how easy the product is to use. Likely a lot more resources are being put on the larger customers that might drive strong Gross $ and Net $ Retention. Benchmarks are similar to Gross $ Retention.
Flaws with these metrics:
One of the major flaws with Net $ Retention is it is driven by only a few major upsells. Ideally, it is driven by consistent upsells from most customers. Most companies report the metric, but it is just as important to understand what % of upsell is driven by only a few customers. You can have world class Net $ Retention, but still have major fundamental issues with retention and expansion due to the ability to make this metric good by just having a few large upsells.
Number 2: Cash Burn
One of the simpler metrics to understand is Cash Burn. How many $ are going out the door vs how many $ are coming in the door (minus fundraising). Essentially, tells you how much the bank account is changing each month.
Number 1: Run Rate ARR Growth
To get to Run Rate ARR Growth, you first need to understand Run Rate ARR. Annual Recurring Revenue (ARR) is the portion of revenue that assuming the customer renews the software recurs each year. Professional services and one time costs are not included in the ARR because they are not recurring. We then annualize this amount. The Run Rate ARR then says if we look at all customers Active "today" or some date what is the total current ARR of them. This can be thought of as if you have 100% Gross Retention (i.e every customer renews flat) and you sign up no new customers, what your Software Revenue will be the next 12 months. The year over year growth of this number is the Number 1 thing investors look at in figuring out what multiple to apply to your Run Rate ARR to get to an evaluation.
In the first few years you go to market you should look for YoY Growth of 3x in Year 1, 3x in Year 2, 2x in Year 3, and 2x in Year 4. This is referred to as triple - triple - double -double. An example, would be in your first year if you did $1M in ARR. The "world class" expectation would be $3M in Year 2, $9M in Year 3, $18M in Year 4, and $36M in Year 5. After that world class starts to look like 70% YoY Growth. Above 50% is still very good. 40% is ok. Once you start to dip below 40% YoY ARR Growth your multiple will start to take a pretty steep hit.