This article is part of our SaaS Business Startup Guide—a curated list of articles to help you plan, start, and grow your SaaS business!
Subscription and software-as-a-service (SaaS) businesses are everywhere these days. From the predictable to the downright weird, you can seemingly subscribe to anything.
Subscription businesses are hot because of their recurring revenue model. And, while there are pros and cons to running a subscription business, the financial benefits tend to be great. Instead of chasing after customers every month, customers pay you automatically. The compounded earnings grow your revenue quickly and you don’t have to spend nearly as much time and effort getting them to come back and buy from you again.
But starting a subscription business isn’t a trivial exercise.
One of the biggest business challenges I’ve ever faced was transitioning Palo Alto Software from the business of selling single products to a subscription revenue business. Thankfully, my wife and business partner, @mommyceo, and I had a great team to help us make the transition and we now run a growing and healthy subscription business with our LivePlan product as our foundation.
Listen to Peter and Jonathan discuss subscription services with Levi King, founder and CEO of Creditera on the fifth episode of The Bcast, Bplan’s official podcast (at 21:30):
Click here to subscribe to The Bcast on iTunes »
When we were starting LivePlan, we built out a subscription sales forecast to help us plan and to start to understand the key numbers that would drive the new business. But, beyond the forecast, we needed to know what metrics we should be tracking. How were we going to know if we were doing the right things? Just because customers were signing up didn’t mean that we would have a healthy and growing business.
Through a lot of research and discussions with other business owners and investors, we came up with this core list of metrics that help us keep our fingers on the pulse of our business. There are certainly more metrics that you can look at when you’re running a subscription business, but this a great starting point. If there are metrics that you think I should include on this list, please let me know in the comments below.
1. Churn and churn rate
Churn is the number of customers that cancel your service in a given month—when they leave, they’ve “churned out” and are no longer subscribing to your service. Churn rate is the percentage of customers that leave every month.
The best way to think about churn is to think about a leaky bucket. As you add new customers to the bucket, some customers are leaking out of a hole in the bottom of the bucket. For your business to grow, you need to add customers at a faster pace than they are canceling their subscriptions.
To calculate churn rate for a monthly subscription business, just divide the number of customers who canceled in a given month by the total number of customers that you had at the beginning of that month.
Churn Rate = # of customers who canceled ÷ total customers at the start of the month
You can impact churn rate by increasing the pace at which you add new customers and/or reducing the number of customers that cancel. While it’s always good to get more customers, it can be a better investment to focus on keeping the customers that you have. Adding features or services that keep your customers happy extends the number of months that they will continue to pay you and can be more cost effective than acquiring new customers.
To see how reducing churn rate can have a big impact on your revenue, download our subscription sales forecast worksheet or experiment with different churn variables in LivePlan.
2. MRR (monthly recurring revenue)
This is the “show me the money” number that’s key to watch and will be a core number in your profitability calculations. MRR is simply the month recurring revenue that you have at the end of each month. You calculate this number by taking your total billings from existing customers that paid you in a given month and add the first month payments you received from new customers.
As you track MRR, you want it to be growing over time. This means that you are acquiring customers at a good rate and that you don’t have too many customers canceling their service.
If MRR starts to flatten out, this means that you are losing customers as fast as you add them. At this point, you need to focus on acquiring customers faster and reducing churn rate.
3. ARPU (average monthly revenue per user/customer)
This metric is sometimes referred to as ARPA (average revenue per account), but they’re really the same thing.
This metric is simple and straight forward. It’s just the average revenue that you receive per customer on an average month.
I’ve found it’s better to calculate ARPU by dividing MRR by the total number of customers that you have. This will automatically take into account free trials, discounts you may have offered, and other things that may have reduced what a typical customer pays, rather than just using the typical list price of your product on your pricing page.
4. LTV (lifetime value)
Use this metric to track the expected revenue from an average customer over the entire time that they have subscribed to your service.
Now, you don’t have to wait months and months to figure out what the average LTV of your customers is. You can predict lifetime value by dividing ARPU by churn rate:
LTV = ARPU ÷ Customer Churn Rate
This simple model assumes that a typical customer pays you the same amount every month over the lifetime of their subscription.
5. CAC (customer acquisition cost)
This number is critical to watch in your subscription business. It’s simply what it costs you to acquire a typical customer. To calculate CAC, just divide your total sales and marketing expenses in a given month by the number of customers added during that month:
CAC = Total monthly sales and marketing expenses ÷ Number of new customers added during the month
When you’re just starting out in your subscription business, your CAC may look abnormally high since you may have people on staff that are capable of selling to many more customers than you may have in your pipeline. In this scenario, you may want to only include a portion of those salaries in your calculation. Once your team is handling the maximum number of customers possible, then you can include 100% of their costs in your sales and marketing expenses.
There are two ways that you want to use your CAC metric. First, you want to make sure that CAC is lower than LTV. In other words, you need to make more from your customers than you expect to pay to acquire them. A good way to look at this is to calculate your LTV-to-CAC ratio:
LTV: CAC Ratio = LTV ÷ CAC
Most investors are looking for a number higher than three with this ratio.
Second, you’ll want to look at the number of months it takes you to recover your CAC. You can calculate this by dividing CAC by ARPU:
Months to recover CAC = CAC ÷ ARPU
This number will tell you how many months a customer needs to be your customer to cover the cost of acquiring them.
Your foundation for success
There are many other metrics that you can track in a subscription business, but these five will get you off to a good start. If there are other metrics that you track in your subscription business, please let me know in the comments.
Noah is currently the COO at Palo Alto Software, makers of the online business plan app LivePlan. You can follow Noah on Twitter.
