200px200pxThe data in this post about the SaaS Quick Ratio comes from our ongoing benchmarking analysis of hundreds of B2B SaaS companies. We will be releasing more benchmarks and key findings over the next few months.
Venture capitalist Mamoon Hamid created the SaaS Quick Ratio as a simple way to evaluate the growth efficiency of early-stage SaaS startups. He picked the Quick Ratio because it takes the traditional yardstick for SaaS startup success (MRR growth) and tempers it with the one metric that hamstrings so many otherwise-promising startups (Churn Rate).
Mamoon Hamid
As VCs like Hamid begin using the SaaS Quick Ratio to decide who to invest in, it becomes increasingly important for startups themselves to know where they stand with respect to the metric. Unfortunately, there isn’t a lot of reliable data out there about the Quick Ratio and how SaaS companies can use it to benchmark their own performance.
The SaaS Quick Ratio
“What Quick Ratio should I be aiming for?”
Without reliable data about the Quick Ratio, most SaaS executives are left wondering: “What’s the right Quick Ratio for my company? How can I tell whether my company’s Quick Ratio stacks up against the rest of my industry?”
In short, what Quick Ratio should SaaS executives be aiming for?
Based on his own experience investing in early-stage SaaS companies, Hamid came up with a rule of thumb that high-growth companies should shoot for a Quick Ratio of 4 (meaning that for every dollar they lose in a month they add 4).
Because Hamid has seen the numbers behind a lot of successful SaaS startups, this yardstick is incredibly valuable for founders and executives of SaaS companies.
To learn how to calculate the Quick Ratio for your company, check out this post.
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But is Mamoon’s hypothesis in line with the data? How does the Quick Ratio actually look at growing SaaS startups?
We wanted to find out, so as part of our 2016 Sales Benchmarking Report, we took a close look at the Quick Ratios of the high-growth SaaS companies in our study. We sliced the data in every conceivable way to see what we could uncover about the optimal Quick Ratio for growing SaaS companies, and how the SaaS Quick Ratio evolves as companies grow.
Benchmarking the SaaS Quick Ratio
The first thing we wanted to do was to see if the participants in our study lined up reasonably well with Mamoon’s benchmark of 4 as a goal for promising SaaS companies. We pulled out the fastest-growing SaaS companies in our study and analyzed their Quick Ratios.
Here’s what we learned.
A Quick Ratio of 4 is Indeed Healthy
It turns out Mamoon’s instincts were generally right. When we looked at the fastest growing SaaS companies in our study (those with a CAGR of over 50%) we found an average Quick Ratio of 3.9.
These SaaS companies averaged $250k in MRR and were only losing around 3.2% of that revenue each month to churn. They are, in other words, exactly the type of SaaS startup that Mamoon looks for when deciding where to invest.
And, as their high Quick Ratio implies, they have a great chance to continue growing quickly and healthfully, and eventually become one of those fabled SaaS companies with a run rate of more than $10 million.
However, once we started digging deeper, the story became a little more complicated (and more interesting).
“The young companies in our study routinely had higher Quick Ratios than mature companies”
The younger, smaller companies in our study routinely had higher Quick Ratios than more mature companies, even when the mature companies looked just as healthy by most other metrics. Put another way: The SaaS Quick Ratio is strongly influenced by a company’s stage, and Mamoon’s golden rule of having a Quick Ratio of 4 or above seems to become much more difficult for companies with already-ramped growth engines.
But why? What is it about startup growth (or the Quick Ratio itself) that makes it so hard for scaling companies to maintain a score of 4?
The short answer is that it gets harder and harder to sustain net 4x growth at scale, especially if you can’t drive churn down to best-in-class levels. Despite having similar churn rates to the smaller companies in our study, few of the larger companies in our study could maintain a Quick Ratio of 4.
More on the Quick Ratio
But before we get to the reasons behind this conclusion, let’s explore what our study told us about how the SaaS Quick Ratio evolves through 3 critical lenses:
1. Growth-stage vs. steady-state companies
2. Sustaining a Quick Ratio of 4 as you scale
3. The increasing importance of driving down churn
Let’s take them one by one.
When we divided the participants into two main company stages ‒ those bringing in less than $5m a year in new bookings and those bringing in more ‒ an interesting story emerged: A Quick Ratio of 4 or higher is a good target for young, growth-focused companies, but as companies mature, it gets much harder for them to hit that benchmark.
Here’s how it broke down:
That difference is pretty stark. Does it mean that the companies in the $5m+ bucket are doing worse (or operating less efficiently) than the companies in the under-$5m bucket? Not really. In fact, by most metrics the companies in the $5m+ bucket had more impressive metrics: higher ASPs, larger LTVs, and more employees. So what’s going on here?
The lower Quick Ratio for these larger, more mature companies is further proof that the Quick Ratio looks quite a bit different when used to evaluate young SaaS startups and more mature, steady-state companies.
This shouldn’t be too surprising. When Mamoon gave his talk introducing the SaaS Quick Ratio, he explained that he started using it to evaluate giving an A or B round to relatively young SaaS companies ‒ somewhere on the spectrum between pre-revenue and a $2m annual run rate.
For these types of companies, rapid growth is the name of the game. In fact, a much-repeated startup rule of thumb is that high-growth companies should be growing at around 5% a week, or 20% a month. When your MRR is relatively low (say $20k), this type of growth is reasonable. And, even more, this type of explosive growth can cover up a variety of sins, including a relatively high revenue churn rate (like the 3% we saw in our study).
But it’s not just that young companies are able to grow more quickly; they’re also more likely to churn a lot less.
“Early in a startup’s life, most customers haven’t had time to consider churning, which makes the Quick Ratio artificially high — especially if the company is signing customers up for annual deals,” Mamoon explained recently to InsightSquared.
In these instances, the Quick Ratio doesn’t actually tell you much. SaaS companies younger than a year or two will have effectively zero churn — and therefore infinite Quick Ratios. For young companies, the Quick Ratio is purely a measure of growth, and therefore isn’t nearly as interesting as looking at the Quick Ratio of more mature companies.
This is the point when rapid growth isn’t sufficient: It becomes a story about controlling churn.
What the data revealed is that, as companies scale their growth engines, a slightly-above-average (or even “healthy”) churn rate becomes harder and harder to offset with net new revenue growth, especially when the goal is to outpace it by 4x.
Once you take a second to do the math, this conclusion becomes almost axiomatic.
At its core, the SaaS Quick Ratio is a metric for identifying nearly exponential growth. Anyone who studies revenue growth (especially for SaaS companies) knows that this type of growth becomes more difficult to maintain with every month that passes.
In our study we found that companies averaged about 3% monthly revenue churn. We modeled what it would look like for a company to maintain that churn rate and a Quick Ratio of 4 over time. For this exercise, we simplified the SaaS Quick Ratio to only measure new MRR and churned MRR (omitting upsells and downsells) and we started the hypothetical company with $200k in MRR.
Here’s how the graph looks.
MRR growth for a company with 3% monthly revenue churn and a Quick Ratio of 4.
It starts out fairly normally ‒ with the sample company adding a few tens of thousands of MRR each month. However, it doesn’t take long for the growth curve to become unprecedented. After just 6 years, the example company has an MRR of over $1 billion!
Companies that can accomplish that aren’t unicorns, they’re mega unicorns.
The Limiting Factor
I probably don’t need to tell you that there aren’t many SaaS companies with MRR in the billions. So what’s going on here? Why does the math for maintaining a Quick Ratio of 4 become so unrealistic?
The first part of the equation, as we’ve already discussed, is that meteoric growth is typically confined to young companies. That’s why there’s something called the “growth stage” after all.
But that’s not all that’s going on here. There is another variable in the Quick Ratio equation that is just important as growth. In fact, it’s the whole point of why the SaaS Quick Ratio exists.
Very, very few SaaS companies can continue to grow at that 5%-a-week clip we mentioned earlier. Those that maintain that rate are in an extremely rare class of SaaS companies.
But this shouldn’t preclude a company from maintaining a Quick Ratio of 4. After all, the Quick Ratio doesn’t mean you have to be bringing in insane amounts of new MRR each month, it only means that you have to bring in 4x as much new recurring revenue each month as you lose.
Which means that the key to maintaining a Quick Ratio for companies with mature growth engines is controlling churn.
As a company’s MRR balloons, the only realistic way to stay ahead of the benchmark of 4 is to drive down churn to best-in-class levels. But what does best-in-class revenue churn look like?
Benchmarking SaaS Revenue Churn
According to VC Tomasz Tunguz, the median SaaS business loses about 10% of its revenue to churn each year. That works out to about 0.83% revenue churn a month.
Median, of course, doesn’t mean best-in-class, though. For a revenue churn benchmark for truly remarkable SaaS companies, we turn to SaaS expert Lincoln Murphy. Murphy contends that the very best SaaS companies keep monthly revenue churn at around 0.58%. That’s only about 7% revenue churn a year.
If we’re trying to imagine a mature company that can sustain a Quick Ratio of 4, this is what we’re looking for. So, for the purposes of this article we’ll take Lincoln Murphy’s best-in-class benchmark, and use it as the gold standard of a SaaS company that could, theoretically, maintain a Quick Ratio above 4.
But first let’s unpack it a bit.
A 0.58% revenue churn rate means your company is losing about 1 out of every 200 dollars per month. Very few companies keep churn this low, but it is possible. It’s important to note here, though, that revenue churn already has upsells and cross-sells baked in. For the purpose of measuring Quick Ratio, this means that revenue churn goes in the denominator and just MRR from new business goes in the numerator.
Companies that are able to drive churn down to this level have a much better chance of maintaining a Quick Ratio of 4, as it means they don’t have to add insane amounts of new MRR just to keep their heads above water. (In our study, only one company was able to keep churn even close to this low rate; the average churn rate for the entire cohort was 2.7%).
Here’s how the math of maintaining a Quick Ratio of 4 looks over time if you’re able to keep revenue churn down to 0.58%.
An MRR of $1.3 million is high, but it’s not unheard of. In this way, we’ve found a formula — using a best-in-class revenue churn rate, Mamoon’s Quick Ratio benchmark of 4, and relatively high MRR growth — that spits out a high-performance, mature SaaS company.
What this formula makes clear is that maintaining a low revenue churn rate is absolutely critical for mature companies to keep a Quick Ratio of 4. And even then it’s not easy ‒ a company that starts with $200k in MRR in 2013 and maintains an average monthly revenue churn rate of just 0.58% would achieve an MRR of $1.4 million by 2021.
The Final Takeaway: Want a Quick Ratio of 4? Add Fast, then Lose Slow
Combined, our data and these models make something very clear: Achieving a SaaS Quick Ratio of 4 is a good benchmark for young, high-growth companies but the equation changes as those companies reach scale. The Quick Ratio is a two-lever equation, and once companies get to a certain size, it may be time to change their focus from ramping new MRR growth to reducing churn.
In fact, the really interesting thing about the SaaS Quick Ratio is what it tells us about the relationship between churn and MRR growth rate ‒ i.e. the two competing forces that combine to give us a single number that measures the potential of a SaaS startup.
In order to maintain a Quick Ratio of 4, a company must always balance these two forces ‒ either by using rapid growth to offset average churn (for young SaaS companies) or by driving down churn so much that explosive MRR growth is no longer necessary (for more mature SaaS companies).
Here’s a way to visualize this sliding scale:
The fundamentals of this chart ‒ that, as churn rate rises so too must MRR growth ‒ is easy to understand. What’s interesting, however, is how this plays out as companies scale. This image makes clear that the strategy achieving a Quick Ratio of 4 changes for growth-stage and steady-state companies.
Younger companies will, in general, have more luck focusing on increasing the y-axis of this chart ‒ i.e. ramping up the rate at which they add new MRR.
Larger companies, on the other hand, will likely find it easier to focus on decreasing the x-axis. They may not be able to reliably add 16% of their current MRR every month (which a revenue churn rate of 4 would require) so it is more important for them to drive down churn.
In his must-read post on the topic, Tomasz Tunguz looks at this same conclusion from the opposite vantage: How much revenue churn can you sustain given your growth rate? And, again, the growth rates he assumes (around 15%) are much more likely for young, fast-growing startups than for companies with mature growth engines.
Ultimately this all shows us something about how SaaS companies change over time ‒ namely that the KPIs SaaS startups must track become more numerous and nuanced as companies scale. In the early days, MRR growth trumps almost everything else. As long as you’re adding a lot of recurring revenue each month you’re probably doing the right thing.
But as companies scale, MRR growth alone isn’t enough. Payback period, customer acquisition cost and, especially, churn rate become increasingly important.
Ultimately, the Quick Ratio is a perfect embodiment of this well-known principle: Young SaaS companies can ride rapid growth pretty far, but at some point they need to expand their focus to include (and optimize) other KPIs, especially churn.
And it’s important to note that this doesn’t mean that the Quick Ratio becomes irrelevant as companies scale. In fact, if anything, it’s the opposite: Investors are looking for those rare companies who can maintain high Quick Ratios even at scale.
Mamoon recently discussed this with InsightSquared.
“The Quick Ratio actually becomes more relevant as a company scales,” he said. “Once churn starts to kick in around 24 months, the Quick Ratio becomes much more interesting and important. So even though a Quick Ratio of 4 becomes increasingly difficult at scale, that’s when it’s the most valuable signal, and it’s what we drive our companies toward.”
“Ultimately, it comes down to building great companies and products that customers can’t imagine leaving.”
InsightSquared’s 2016 Tech Benchmarking Report
The benchmarks on this page come from our ongoing analysis of hundreds of tech companies. We will be releasing more great content just like this over the next few months.
What’s on tap?
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