When it comes to startups – especially in the Software-as-a-Service space – David Skok is something of a guru with the Midas touch. After founding several successful companies – three of which went public – early in his career, David focused on the VC space, joining Matrix Partners as a General Partner. He currently serves on the boards of several top companies, including HubSpot, Enservio and OpenSpan.
David also writes one of the most popular and widely-read business blogs around, for Entrepreneurs. His blog is an absolute gold mine, a treasure trove of hard-hitting, eye-opening and in-depth business advice for SaaS entrepreneurs and startups.
We’ve such avid readers of his blog that we decided to share the 10 most compelling SaaS lessons we learned from David. Without further ado…
1. SaaS is usually a “winner-takes-all” game where market share is absolutely critical.
This puts a huge onus on early-stage startups to grab as much of this market share as they can in their nascent days. In each specific tech market segment, the recognized leader – for instance, Salesforce.com in the CRM space – receives disproportionate advantages that strengthen its grip on the pole position. Press, analysts and potential customers pay a lot more attention to the market leader, and its top position in the market becomes self-reinforcing.
2. In the early years, faster growth leads to worse losses.
SaaS companies have to complete two sales: acquiring the customer in the first place, and then keeping the customer to maximize lifetime value. A SaaS company’s profits aren’t made on the first sale alone, which is why rapid growth in the early stage leads to heavier losses. Companies invest heavily upfront – on marketing and building up the sales force – to acquire customers, but will only see profits over a longer period of time. Eventually, there will be enough cash from the initial installed base to cover additional investments. Yet, the faster the growth in customer acquisition, the better the curve will look once it becomes positive, as evidenced by this graph below.
3. Knowing when to push down on the accelerator pedal is one of the CEO’s most important responsibilities.
In the early stages of any SaaS startup, as the business model is still being refined and the product tweaked, CEOs will be hesitant to make heavy investments, instead preferring to conserve their limited cash. However, once the company is a (relatively) proven commodity, they have to go into hyperdrive to find that rapid growth. Knowing exactly when to put the pedal to the metal – making the investments necessary to acquire customers – is the tricky part, a delicate balance of timing that the CEO must achieve.
4. LTV >3x CAC, and Months to Recover < 12 months are benchmarks for SaaS startup success.
These are not be-all-end-all benchmarks, but are good targets for early-stage startups to shoot for. If you can get your product’s LTV – the Lifetime Value of a typical customer – to be at least three times greater than its CAC – the Cost to Acquire a typical Customer – you will be on course to achieve profitability. Similarly, the most successful SaaS startups recover their CAC in less than 12 months, usually around 8 months. Of course, no SaaS startup shoots out of the gate reaching these benchmarks, but if the early leading indicators are there that these numbers are achievable targets, you’re in good shape.
5. It’s all about customer retention and preventing churn
Subscription-based businesses rely on monthly payments from their customers. When a customer decides to leave – aka churns – that hurts, because they didn’t pay a ton of money up-front. This is why customer retention is such a critical focus for SaaS companies.
Revenue churn and customer churn are vastly different metrics, but both are worth tracking. If you have 100 customers and 10 of them churn, that looks pretty bad at first glance. But what if those 10 customers are relative minnows, contributing less than 2% of the total revenue contribution of those 100 customers? That churn metric doesn’t look nearly as bad.
6. How do we get to negative churn?
Your Net Monthly Recurring Revenue (MRR) is calculated by adding your new MRR (new customers) with your expansion MRR (your existing customers), and then subtracting your churned MRR (your lost customers). Negative churn happens when your expansion revenue is greater than your lost revenue. Many SaaS companies focus on reducing their churned revenue, but where they fall short is in finding ways to actively increase their existing revenue. There are generally two ways to do this:
Create a pricing model that has a variable axis, such as paying for the number of seats used or the number of licenses required. In this type of model, as customers grow and expand their usage of your product, they will have to pay you more.
Upsell or cross-sell existing customers to additional features or more powerful versions of your product. Give them the option to upgrade as necessary.
7. The Cash Flow Trough is largely unavoidable
Early-stage SaaS startups tend to have very limited working capital and cash-in-hand, perhaps working off a small seed investment and having to stretch that funding. Yet, they also have to make substantial investments in sales and marketing in order to grow. This creates what David Skok calls the Cash Flow Trough. Understanding and being patient with the Cash Flow Trough is one of the biggest challenges to a startup founder or investor; once you can get out of this period, your profit gains will be great, as evidenced by this chart.
SaaS startups try to mitigate the impact of living in the Cash Flow Trough by asking customers for upfront payments, paying for the whole annual contract instead of monthly payments. This gives them more working capital to play with. One way to get up-front payments is to convince customers that you’ll reinvest the funds in R&D to ultimately create a better product for them. Another way is to offer small discounts in return for paying the full value of the annual contract up front.
8. Fast growth is blocked by lead flow limitations.
Marketing is one of the most important drivers of rapid early-stage growth, as they help spread the word about your company and product, while generating leads that can be converted to paying customers. However, one of the biggest blockers to fast growth is that lead sources tend to reach a natural limitation point; there is only so much juice you can squeeze out of lead sources. Marketing VPs need to get ahead of this problem by identifying new scalable sources of lead generation, while analyzing previous campaigns to pull the right ROI levers and squeeze as much lead juice as possible.
9. Want to improve your LTV:CAC? Reduce your CAC!
Many companies rightfully focus on customer retention and improving their LTV, but there are also ways of increasing that ratio by reducing the other side. Some ways of cutting your CAC include:
Improving your conversion rates by A/B testing and analyzing lead sources
Creating demo videos that answer common sales questions to reduce the time your reps spend on the phones
Listing common sales objections that arise on your website for customers to read
Providing a comparison matrix of your competitors for customers shopping around at different options
Leaning on customer references and referrals wherever possible
Moving from field sales to inside sales
10. SaaS startups fail because of these 5 common problems
The SaaS startups that fail tend to run into the same problems, usually one of these 5:
Market problems – there isn’t a compelling value proposition for your product, the timing to go to market was wrong or there is simply no demand in the market for the product.
A failing business model – early-stage entrepreneurs tend to be way too optimistic and underestimate the CAC they have to incur.
Problems with the product – there is no quicker way to churn through customers than to give them a product that is full of problems and doesn’t provide solutions they were promised.
A poor management team – bad managers will hire bad direct reports, creating an underperforming team below them.
- Running out of cash – can’t get out of the Cash Flow Trough in time? You’ll quickly run out of cash and be unable to acquire more funding.