SaaS Terminology: The SaaS Terms and Metrics You Should KnowUpdated:
Software has eaten the world over the past decade - just as Marc Andreessen famously predicated it would - and as the software sector has matured, so too has the way that the market values software companies.
Traditionally, software was sold more or less on a stand alone basis. For example, if you wanted access to Adobe's Photoshop, you bought a copy for hundreds of dollars and then had unfettered access to it indefinitely.
For software companies, this had the benefit of bringing in cash to the company immediately, but also had the downside of requiring the company to make fresh sales every quarter to keep up their growth rate and meet ever growing market expectations. In other words, revenue from this up-front pricing model wasn't sticky, but rather had to be earned anew every quarter.
However, as you know, over the past five-to-ten years nearly all software companies have become SaaS companies; providing their customers temporary access to their software and billing them a smaller recurring amount each month or a larger amount per year.
While this model doesn't bring in a large amount of money up-front when a sale is made, so long as customer churn is relatively minimized then revenue is much stickier and predictable.
There are three real reasons behind this shift from up-front to recurring billing...
First, prior to even just five years ago, the venture capital ecosystem was much less developed and sophisticated. What this meant is that a startup with high-growth, but also high cash burn, needed to be careful as it wasn't an absolute given that they could raise additional rounds or access growth financing.
So, for these startups bringing in a large amount of cash up-front from each new customer, as opposed to having it drip in monthly over the span of years, was much more preferable (at least until they reached some kind of profitable steady-state).
However, even in a more restrictive funding environment like what we're currently in, if a company shows strong metrics, like those we'll be discussing below, they'll easily be able to access either additional equity or debt financing to offset their large operational costs.
Second, prior to five years ago, and certainly prior to ten years ago, there was a bit of an issue for many companies around how to deliver software - especially complex software - and how to accept recurring payments efficiently. It can be difficult to remember that sophisticated and easy-to-implement recurring payment rails (i.e., Stripe) and scalable cloud storage and computing (i.e., AWS) were still in their relatively early stages not too long ago. So for many software companies, it simply made most logistical sense to sell software up-front as opposed to trying to implement a SaaS model.
Third, over the past five years or so there's been a psychological change within the market both on the public and private side. Today, significantly higher valuations are placed on companies that have MRR - because of the stickiness it represents - and this has been the leading reason why even established incumbents like Adobe and Microsoft finally bit the bullet over the past few years and went to a SaaS-first pricing model for most of their software offerings (i.e., Adobe's Photoshop, Microsoft's Office products, etc.).
Anyway, with that brief history of how the SaaS business model became more-or-less the default among software companies, let's discuss a few of the key terms and metrics you should pay attention to when looking at any SaaS company.
Customer Acquisition Cost (CAC) payback represents the number of months it'll take to recover the cost of initially acquiring a customer.
This is a critically important metric as obviously the shorter the number of months it takes to earn back the cost of acquiring the customer, the quicker you're earning pure (gross) profit off of your customer.
Indeed, one way to conceptually think about SaaS companies is through the lens of CAC payback vs. average retention. The positive spread between these two values, multiplied by gross profit margin, is a really effective way to quickly get a feel for the real earnings power of the company without muddying the waters by considering more operational costs (some of which, especially for growth companies, are quite variable QoQ or YoY).
The actual formula for CAC payback, as you can probably infer from the explanation above, is: CAC / (Average MRR * Gross Profit Margin).
The Magic Number
The "magic number" may not sound like an overly serious financial term, but it is one that should be considered whenever you're looking at a SaaS company.
What the magic number is really trying to do is quantify how much leverage you're getting out of your sales and marketing expense. Put another way, the magic number quantifies how much incremental annual revenue a company is generating from from their annual sales and marketing (S&M) spend.
This is essential for software companies as they are typified by having very low COGS, as you'd expect, but very large S&M expense. However, it's often hard to directly tie together S&M spending and customer acquisition. So, you need to try to look at broader measures, which is exactly what the magic number is designed to do.
Here's the formula:
Magic Number = ((Current Quarter's Revenue - Previous Quarter's Revenue) * 4)) / Previous Quarter's Sales and Marketing Expense
Obviously, if the magic number is in excess of one then it makes sense to put more money towards whatever sales and marketing you're doing. While the magic number is a noisy signal - as perhaps you're spending some S&M dollars inefficiently, but people just love your product so you keep getting new customers - if you have a value over one then you're probably doing something right on the S&M side of things. However, if the number is below one you should begin trying to identify how to more efficiently allocate your S&M spending.
With that said, many young startups will continue to aggressively spend on S&M despite a magic number less than one due to the belief that S&M is building brand awareness and that even if revenue isn't increasing proportionally QoQ the S&M expense will payoff in future quarters down the road. Like everything, context matters.
ARR Per Employee (APE)
While a simple metric, it's always useful to see how APE evolves over time. As the name of the metric implies, you calculate APE by just taking the current ARR of the company and dividing it by the number of employees the company currently has.
Often SaaS companies that have just reached escape velocity will have a great looking APE. However, as the company matures and becomes slightly bloated - as has been true of many public and private SaaS companies over the past few years - the company's APE will begin trending down heavily as the denominator begins to rise much more than the numerator.
Even though APE is a simple metric, it can be a good to keep in mind as a measure of how bloated a company is potentially becoming. For a company with declining profitability, APE can also be a good way of seeing if room exists (theoretically, at least) for higher levels of profits to be achieved through slimming down headcount.
We've seen examples of this phenomenon over the past year with companies like Snap that grew aggressively through the pandemic period - increasing headcount by nearly 38% in just the past year - that have then turned around and laid off 20% of its workforce as markets cooled and growth slowed (obviously Snap is not a SaaS company, but since they're a popular growth tech company I figured I'd include this example).
Another relatively simple metric that's critically important to pay attention to is the lifetime value of a customer (LTV) divided by the customer acquisition cost.
While a simple metric, it's one that can change dramatically in relatively short periods of time (even for quite large companies).
This is especially true during recessionary periods. The reason being that users who only occasionally utilize the software - or who otherwise view it as non-essential or easily substitutable - will be more prone to cancel as they begin tightening their belts (thus dragging down the overall LTV level). While at the same time, due to folks tightening their belts, more capital will likely need to spent to bring in new customers thus likely raising the CAC.
So, during recessionary periods you'd expect the numerator of this metric to fall and the denominator to rise (unless the denominator stays flat or declines due to the company having much lower advertising costs, which would offset the likely lower conversion rate on the product offering). You saw this occur during the early stages of the pandemic when advertising rates fell dramatically for a month or two which offset the lower conversion rates for many SaaS companies.
Beyond recessionary periods, you also often see the LTV-to-CAC decline when new entrants emerge in a company's market. This is because you could have some existing customers switch to the competitor, thus reducing the LTV, while the CAC is forced to rise due to a lower conversion rate (as potential customers may be aware of the competitor and choose them instead, or the competitor could be competing directly for ad space, which has the effect of raising the cost of advertising).
Similar to CAC payback, LTV-to-CAC is a classic SaaS metric and how it evolves over time will be watched incredibly closely by both management and market participants.
The Rule of 40
The rule of 40 is an incredibly popular metric among those in tech. While it is somewhat gimmicky, it does illustrate an important point: companies with strong growth and strong profit margins are rewarded with very high multiples by the market.
Simply put, the rule of 40 states that a growth company should aspire to have its growth rate and profit margin, when added together, be over 40%. If it achieves this, the multiple that will be applied by the market will be much higher than those that fall below the 40% threshold (give or take a bit, obviously there's nothing intrinsically special about the exact 40% threshold).
Below is a great chart from Battery illustrating how the market rewards the various trade-offs that can allow a company to get in excess of 40%. As you'd expect, the highest multiples go to companies who reach 40% or more through a combination of relatively high profit margins and relatively high growth rates.
Those companies that reach in excess of 40% by relying disproportionately on growth, or disproportionately on high profit margins, tend to get slapped with significantly lower multiples for obvious reasons (i.e., a high growth company with a low profit margin may never be able to achieve margin expansion because it may lack pricing power, etc.).
Here's a good overview on the Rule of 40 from McKinsey if you're interested in a bit more detail (although, fair warning, it contains as many consulting buzzwords as you'd expect).
Over the past number of years there's been a proliferation of SaaS terms and metrics. This can make it seem like there's a unique language revolving around SaaS companies, and to a certain degree that's true. You'll often see some of these terms - around LTV-to-CAC, for example - in pitch decks.
However, that doesn't change the reality that SaaS companies that have reached a relatively mature state can be valued the same as any other tech company and that, like everything else in finance, in the end everything boils down to thinking about valuation mostly through the lens of precedence and discounted cash flows.
With that said, given how much M&A activity in tech has revolved around SaaS companies over the past few years, I actually dedicated the last part of the Tech Investment Banking Guide to going through many more SaaS terms and metrics as it's useful to be generally aware of them (if for no other reason than you'll see them referenced often when reading tech-focused finance media).
Keep in mind that tech banking encompasses a broad set of sub-sectors outside of just classic high-growth SaaS companies (as I discuss in the TMT investment banking post). Also, keep in mind that in an interview you'll be asked more classic investment banking questions - as I discuss more in the TMT interview questions post - so don't go down the SaaS rabbit hole too heavily or prematurely to the detriment of practicing more classic banking interview preparation.