SaaS from VC Point of View: Bessemer’s Top 10 Laws

For the past fifteen years, Bessemer Venture Partners has focused its investments in the Software as Service business model, and has investments in over a dozen projects such as  Verisign, Cyota, Postini and Trigo. The emergence of software-as-a-service, we at Bessemer Venture Partners believe, is the single most important trend in the modern software industry. This monumental shift, from software as product to software as service is just the beginning. Bessemer’s top ten laws for being “Saas-y” was developed in early 2008 to describe and incorporate the best practices and counter intuitive discoveries that Bessemer has discovered in the SaaS field.

1. Your most important monthly financial measurements are Churn, Cash Flow, and CMRR (Committed Monthly Recurring Revenue). For years, software executives have been taught that Bookings are the most important single measurement of a growth software business. That is not the case for SaaS companies, where Bookings data is highly misleading. They instead focus on Monthly Recurring Revenue, which is simply the total amount of all current recurring income from subscriptions. BVP believes that a forward view of Committed MRR is even more important than the present MRR data.

SaaS executives need to track churn in detail from a “logos lost” (lost customers) perspective as well as the amount of lost CMRR. It’s very difficult and expensive to grow subscription businesses if you have moderate customer churn, and prohibitive if your churn is high. Whereas the largest legacy enterprise software companies literally made hundreds of millions of dollars over the last decade with “shelf-ware” projects that never got fully implemented, project failure is not an option for SaaS businesses or the customer will simply turn you off, regardless of your contract terms. The top performing SaaS 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.

Cash Flow is the other key metric. To be fair, visibility into the current cash position and the change in the cash position has always been important for software executives, but is even more critical for SaaS 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 SaaS 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.

2. Customer Acquisition Cost (CAC) and Customer LifeTime Value (CLTV) are the best indicators of long term value creation. It can be argued persuasively that SaaS is a lousy business model because your costs are front-loaded and your revenue only arrives in modest monthly or annual payments. However, as we know from the cable industry, subscription businesses can be very profitable over time. The key to long term financial health is to keep customers happy so their payments keep coming, and coming, and coming…and over time add up to some really large numbers.”

3. The Sales Learning Curve is critical for any SaaS business to climb, and it must be done before you grow your sales force. Stop at three sales representatives until at least two of them are making at least $100K MRR quotas. Often, software businesses grow their sales force before they have a clear model for how the product should be sold. This problem is especially acute for SaaS businesses because of the large upfront investments in IT infrastructure necessary for the service to even be provided. Those precious cash reserves must be carefully husbanded, and not burnt through by a bloated sales department. When several sales reps are able to regularly sign contract values equal to twice their fully burdened cost of sales that is when you are ready to expand your sales force.

4. Both finding new customers and retaining old ones are critical for the health of the business. As soon as you have a customer base large enough to service, add to your sales force (“hunters“) with account managers (“farmers“) dedicated to customer retention. Both sales and account management should be paid on the basis of CMRR growth. This is especially important once a SaaS company reaches the sales inflection point.

The level of sales and marketing investment should be computed using the CAC Ratio, which can be computed with a simple look at your GAAP profit and loss statement. Simply divide your annualized gross margin added over the last three months by sales and marketing costs incurred over that period. A CAC Ratio above 1.0 indicates that you need to invest more money in sales and marketing because your customers are making themselves profit centers within a year. (BTW Monitis CAC is above 1)

You should also pay attention to Customer LifeTime Value, or CLTV, which is simply the present value of the profit stream for a customer, minus the cost of acquiring the customer. Younger companies have little track record and hence can only guess at a customer’s lifetime. BVP uses estimates of 3-4 years of SMB customers, while enterprise customers should stay for 5-7 years. The “Five C’s of SaaS Finance” are thus CMRR, Cash Flow, CAC, Churn, and CLTV.

5. Traditional IT channels, where one tries to sell the computer service to the head of the IT department do not work in a SaaS model, for the simple reason that a SaaS model makes redundant much traditional IT work, and IT managers are reluctant to manage their departments into superfluity. Instead, focus your efforts in business development towards business services channels. This will require additional work, as these new sets of partners will not be as comfortable with the technical aspects of the product, but will understand the power of a SaaS product while many ISVs and SIs will not. Focus on the marketing department, the payroll department, and businesses that need computer services but are not yet large enough to have dedicated IT departments.

6. By definition, your sales prospects are online – Savvy online marketing is a core competence (sometimes the only one) of every successful SaaS business. You sell a product that requires an internet connection and a web browser for access, which means your prospects are online! Numerous studies show that your customers are now doing most of their primary research online, and it should not surprise you. This is a clear example where business-to-business (B2B) marketers need to learn from their business-to-consumer (B2C) counterparts. The most innovative B2C companies are lead generation machines, leveraging search engine optimization (SEO), viral marketing, Search Engine Marketing (SEM), email marketing, and other technically-advanced methods. Yet many B2B companies don’t have a clue.”

7. Globalization obstacles hinder SaaS vendors more so than traditional software companies, which is why you should establish yourself in North America first. After you reach $1 million in CMRR, then research hiring European sales and services executives pushing customer demand. Only consider utilizing Asia for post-IPO. Saas companies consistently address concerns about latency, data access and security by replicated local datacenters, in-country customer support personnel, packaged integration and other regional software and SaaS products due to different structure and service goals throughout the industry (Monitis doesn’t follow this rule although).

8. You should have one and only one version of the code in use. That means you should have one instance of the program, one datacenter for all your tenants, and no on-premise deployment at all. The best SaaS companies follow this advice. Multiple instances and single-tenant offerings are used by legacy software businesses whose architecture cannot be redesigned on the fly, in the way that SaaS companies can. Virtualization can allow you to make multiple instances of your product, but the additional engineering complexity will raise costs and reduce ability to stay nimble. Your SaaS product should always begin by being multi-tenant and single instance. (we also think it is very critical)

9. “Service” is the most important part of a Software-as-service business, not “software”. Detailed usage data is produced by your customers every time they use your service. Use it! Product managers in a licensed software model will spend hundreds of man hours and hundreds of thousands of dollars to just create a vague picture of how the customer uses their product, without ever really knowing how the product was used every day. With a SaaS model, that data is instantly available. Use that data, analyze it, and incorporate what you have learned to evolve your product each and every day into something that the better serves the customer. Companies like Apple, Google, and Facebook have already incorporated the use of usage data into their business model and customer service strategy. Now, SaaS companies can use the same methodologies those companies use on the business of software itself.

Three different levels of Service Savvy exist, and a SaaS business should try to achieve them all. The first level requires basic monitoring to see if customers are likely to churn or can be sold additional products. This competence is required for any SaaS business, and shouldn’t be hard to achieve because you know how and how often your customers use your products. Simply track key usage metrics and determine which customers are getting the best value for their money (these are your up-sell candidates) and which ones aren’t (these may leave unless you intervene). You need to cooperate with your marketers to create internal reports about customers with low usage, and should send emails to customers whose behavior changes so that you can figure out why they have altered their usage of your products.

Second, expect to test and develop your software quickly based on feedback from your customers. Analyze the ways in which customers actually use your product instead of how they say they use it. Certain pages, features, and components get more use than others; find out why and whether they can be used to create more opportunities. Third, analyze all of the data that you collect to get benchmarks for your customers and determine best practices; you can actually help your customers’ businesses grow by helping them use your product more effectively, while your business can learn from the practices of your best customers.

10. Recognize that you’ll need a lot of capital to get started; you have to spend a lot on sales personnel and R&D, and you cannot reasonably expect to make a consistent profit for at least four years. Therefore, be ready for the long haul, and don’t have too many frills in your budget. Many SaaS companies tried to expand too fast, and wound up going out of business after promising starts. A sizable cash cushion should be baked into every operating budget, and faster growth will actually result in more cash burned. BVP believes that second-generation SaaS companies may become more efficient than those in the first generation, but they’ll still need a lot of capital to have a good chance of becoming successful SaaS businesses.

Some rules are meant to be broken, but not all rules are meant to be thrown out the window, you have to be choosy about which rules you break at which times. These laws will help you run your SaaS business better. But even though the best companies are constantly pioneering through their fields, but BVP thinks you can excel even if you decide to disregard one or two of these rules. Several companies BVP has worked with prove that you can break one of these laws and still succeed. But if you are looking at these Ten Laws and questioning more than just one or two of them, you should stop and really examine your business.