Category: SaaS

Compounding Revenue’s Value in the Future

When talking to entrepreneurs about revenue growth, I look to emphasize the value of compounding revenue now and how it plays out over an extended period of time. It’s easy to think that it’s no big deal that we missed our sales number for the quarter or had a lower renewal rate than expected. Only, when you really dig in, a lost dollar today translates into many lost dollars of revenue and enterprise value over the long run. Similarly, an extra dollar of revenue sold today translates into much more revenue and enterprise value over time.

Let’s look at an example. Say you were able to beat the sales plan and the net dollar retention plan adding an additional $1 million in new recurring revenue in a calendar year. With an extra $1 million in recurring revenue:

  • Year 1 after exceeding goals
    • Extra ~$800,000 to grow the business (assume 80% gross margin)
    • Hire two additional sales reps and increase marketing spend (assume 50% of the extra $800,000 goes to sales and marketing)
    • Add $1M of new annual recurring revenue from the new reps (assume the two reps each have a $500,000 quota and hit it)
  • Year 2
    • Extra $1,600,000 to grow the business (year 1 gross margin plus the gross margin added by the new reps assuming 100% net dollar retention)
    • Hire four additional sales reps and increase marketing spend
    • Add $2M of new annual recurring revenue from the new reps
  • Year 3
    • Extra $3,200,000 to grow the business (it keeps layering on the previous year!)
    • Hire eight additional sales reps and increase marketing spend
    • Add $4M of new annual recurring revenue from the new reps

In this example, by the end of the third year after the year of an extra $1M in annual recurring revenue, the business has added $8M of new annual recurring revenue. $8M of annual recurring revenue pays for dozens of employees and adds $40M – $80M of enterprise value in today’s market (assumes 5-10x run rate multiples).

The next time someone questions the importance of renewing an existing customer, or signing a new customer, remind them that $10,000 of recurring revenue today is worth up to $800,000 of enterprise value after three years. Every dollar counts.

The Email Inflection Point in the Product/Market Fit Journey

When we launched the initial marketing automation product for Pardot, the feature set was quite simple. We had a minimal analytics that would track the individual lead’s movement around the site, a basic form capture to collect contact information, rudimentary CRM integration to sync data, and that was about it. Over time we added core modules like landing pages, automation rules, complex CRM integrations, and dynamic customer journeys. Only, the initial plans didn’t call for email marketing.

In fact, we actively didn’t want to do email marketing. Who wants to be an email service provider (tools like Sendgrid didn’t exist then)? Who wants to deal with deliverability? Who wants to fight spammers? The initial strategy was to have integrations to Mailchimp and Constant Contact such that modules like the forms manager could trigger an autoresponder and an automation rule could trigger a 1-to-1 email.

Quickly, we realized something was wrong.

Our approach delivered a poor, incomplete experience to our customers. Email was too important to be siloed from the marketing automation system. Email was too powerful as a marketing channel to not be a first-class module.

After endless internal debates about email, we finally decided to become an email service provider. Now, we enabled email to be a core feature throughout the platform. Now, marketers didn’t have to switch between as many different systems to run their marketing programs.

Email was a major inflection point in our product/market fit journey. Prior, customers liked the software but our product/market fit was modest. After adding email marketing, and a few rounds of refinement, our product/market fit was excellent and customers raved about the solution.

Major strategy changes often seem daunting. By focusing on the customer, and going down a much more difficult path technically, we delivered a superior experience. And, in the end, that was one of the most important product decisions we ever made.

When the Opportunity is Bigger Than Expected

Three years into Pardot we were humming along and had just cracked the $1M annual recurring revenue milestone. Customers were loving the product and saying things like, “I don’t how I did my job before using Pardot” — a great sign we had a must-have product, not a nice-to-have. After listening to customers talk about the value they received, internally we started debating raising the price to match the value.

Then, of course, worries emerged:

  • Would prospects pay the higher price?
  • Would sales cycles lengthen?
  • Would sales velocity slow down?

And, naturally, the sales reps didn’t like the idea because they feared they’d make less money.

After getting internal feedback and input we made the call and doubled prices. What happened next was unexpected: sales and revenue grew even faster than planned.

At that point, it dawned on me the opportunity was bigger than expected.

Marketing automation was a billion dollar market in the making.

We were at the right place, at the right time, with the right team.

But, honestly, at the start of Pardot we thought it was a decent idea but didn’t know if it was good or great.

We didn’t know if the timing was right.

We didn’t know if the Great Recession would slow us down.

Three years into the business we knew we were on to something big — even bigger than expected.

Reforecasts and Communication

Two years ago I was sitting down with an entrepreneur debating what to do next. It was early in the hyper growth stage of the startup and things were growing fast. Only, with limited operating history, growth expectations were even greater than reality, and there was no way the annual forecast was going to be achieved.

Accountability was tied to the forecast.

Goals/OKRs were tied to the forecast.

Bonuses were tied to the forecast.

What to do?

This challenge is much more common than expected. Fast growing startups are inherently unpredictable. Even with bottoms-up and top-down forecasts, reality is different from the spreadsheet. At some point, trying to hit a forecast that is no longer possible is more demoralizing than motivating — it’s time for a reforecast.

A reforecast is simply redoing the budget and expectations after the year has already started to reflect new information. The key is to get all the stakeholders together, work to make the new forecast as accurate as possible, and then communicate it with the team.

Communication is the most important part.

By over-communicating, including why the reforecast was necessary, learnings from the experience, and go-forward expectations, team members are more bought in and more accepting of the changes. People don’t expect leaders to be perfect; people expect leaders to lead and be transparent.

Reforecasts are part of normal startup life. They shouldn’t happen yearly, but they do happen in the normal course of business. When a reforecast is necessary, make the changes and over-communicate with the team.

When the Startup Stalls

Last week I was talking to an entrepreneur with a stalled startup. After being in business for several years, getting to millions in recurring revenue, and having a great run, the business plateaued. What to do next? Of course, there are a number of areas that can be improved in the business, as is always the case regardless of growth, so I asked the bigger question: What do you want to do with the company?

After much back and forth, it became clear that the desire was to keep running the business and to get it back on a high growth trajectory. We talked about a number of different strategies and decided to focus on three areas: retention, customer acquisition, and the rule of 40.

Retention

Retention represents the core health of the business. Customers that are happy, successful, and finding value renew their contracts. The old adage that it’s more cost-effective to keep an existing customer than to find a new one still rings true. With a mature, no-growth business there’s even more time to focus on the existing customers and ensure they have a great experience and renew (see SaaS Enemy #1).

Customer Acquisition

Customer acquisition represents all aspects of acquiring new customers. Often, when a business slows, the customer acquisition channels haven’t scaled with the company and the law of large numbers kick in such that growth on an overall percentage goes down as the number of churned customers goes up (see Leaky Bucket). Now’s the time to analyze the customer acquisition channels deeper and look for opportunities to make improvements.

Rule of 40

The Rule of 40 states that the profitability, as a percentage, and the overall growth, as a percentage, when combined, should be 40 or higher. A business with 10% margins growing 30% annually meets the Rule of 40 while a business that’s breakeven and growing 10% annually is significantly below. Put another way: grow fast without making money or generate healthy cash flow with little-to-no growth. For a plateaued business, if it’s clear it can’t grow more, it’s time to meet the Rule of 40 by making it more profitable and focusing on operational efficiency.

Stalling startups is all too common and part of the normal course of business. By its very definition, a startup is a growth focused business, so if growth isn’t currently possible, it’s likely time to sell, look for new product ideas, or no longer be a startup.

Segment Customers, from Flies to Whales

For the last two days I’ve had the opportunity to spend time with entrepreneurs from around the world through Endeavor. In our group, we had entrepreneurs from Venezuela, Columbia, Greece, Argentina, and Saudi Arabia all sharing stories of challenge and opportunity. As part of the program, we spent time talking through their customers using a simple naming convention:

  • Flies
  • Rabbits
  • Deer
  • Elephants
  • Whales

Now, these names aren’t meant to degrade or belittle certain customers. Rather, they’re for the entrepreneur to understand what is, and what isn’t, working within segments of the business.

For each segment, here are some common metrics:

  • Cost of customer acquisition
  • Average revenue
  • Renewal rate
  • Lifetime value

Only, by looking deeper, new insights emerge.

Instead of investing resources to grow all segments, invest in the most important segments.

Segments are divided based on a variety of characteristics including:

  • Number of employees
  • Revenue
  • Potential usage (users, locations, etc.)

Initially, as the business is growing, it’s best to keep things simple. Once some level of scale is reached — say 100+ customers — it’s good to segment the customers and understand the business in a more fine-grained way.

What else? What are some more ideas on segmenting customers?

The Rise of Revenue Financing Loans for SaaS

Recently, several entrepreneurs have asked me about revenue financing loans. Revenue financing is a fancy way of saying a semi-complicated loan where payback is dictated by a number of elements including a percentage of revenue, not just a traditional interest rate. The good news is that it provides for a more aggressive, non-dilutive (usually) form of financing for Software-as-a-Service (SaaS) companies. The bad news is that it’s much more expensive than a bank loan, but still not nearly as expensive as venture capital.

Here’s how an example revenue financing loan might work:

  • Loan amount equal to 20% of current annual recurring revenue (e.g. $10M in ARR, $2M loan)
  • Loan covenant where one month’s operating costs in cash required on hand at all times (e.g. $800k of monthly expenses, with a $2M loan, only $1.2M can actually be used)
  • First 18 months interest-only monthly payments (on the full $2M, not the usable $1.2M) where the “interest” is 3% of the monthly cash receipts (hence the name revenue loan as the interest rate is directly driven by the revenue of the business)
  • 3.5 years of equal principle payments after the first 18 months plus the continued interest of 3% of the monthly cash receipts (so, the loan is paid back after five years and the interest payments keep rising assuming revenue keeps growing)
  • Additional 10% of original loan amount payment due after final payment or at time of next financing event (payment can be cash or equity)
  • Minimum of 1.7x the original amount back to the loan provider with a max of 2.5x (since the interest rate is a percentage of revenue, if the business grows faster than expected, the interest rate could be much higher and up to 2.5x would be paid back)

Wow, it is complicated! Net net, it’s roughly a 25% interest rate loan with variability based on how fast revenue grows. SaaS, with its amazing margins and cash flow predictability, makes this type of financing uniquely suited to both the investor and the recipient, especially compared to most types of other businesses.

SaaS entrepreneurs looking to grow faster, but reluctant to sell equity, would do well to talk to the newish crop of revenue financing firms out there.

What else? What are some more thoughts on revenue financing loans?

SaaS Enemy #1: Churn

At time we sold Pardot several years ago, our monthly gross churn was 1.4%. On an annualized basis, it was roughly an 80% renewal rate. Back then, we had next to no upselling of customers due to a poor pricing model (it was subsequently changed), resulting in a net renewal rate (upsells less downgrades and cancels) that was essentially the same as the gross renewal rate.

With a growth rate of 100% year over year, we weren’t concerned with plateauing where new customer signings are negated by customer churn resulting in a no-growth business (general ballpark, depending on a number of factors, is that the growth rate goes down 20% per year e.g. 100% year one, 80% year two, 60% year three, etc.). Only, without a much better net renewal rate, ideally over 100%, it was clear that in the next few years the customer base would get so large, and the new customer signings larger, but not large enough, that the business would no longer grow.

Customer churn is the #1 enemy of SaaS startups.

So much shine wears off a startup when it isn’t growing fast, and the fastest way to ensure that it keeps growing, is to not have any churn (nearly impossible save for software to large, enterprise customers), or low churn plus upsell, resulting in growth even if no new customers are signed. Everything from custom professional services to great customer support to heavy qualification of the potential customer before they’ve signed should be employed to ensure the highest probability of customer success, and thus the greatest chance of being a customer for life.

Churn is part of the SaaS experience, but everything possible should be done to minimize it and maximize the chance for net negative churn.

What else? What are some more thoughts on churn as the #1 enemy of SaaS startups?

When Freemium Works as a Business Model

Last week an entrepreneur mentioned they were thinking about introducing a new product with a freemium business model. Freemium, where there’s a free edition of the product along with a premium upgrade, has been a mainstay of cloud software for decades now. Only, it doesn’t work for most products.

Let’s look at when freemium works best. Here are a few characteristics:

  • 2nd or 3rd generation product – Once the market has been educated, and people know how to use that type of product, freemium works as users can jump in and be productive (e.g. Mailchimp was a 2nd generation product when it came out).
  • Fast time-to-value – Products that deliver value quickly work best for freemium such that users can understand and appreciate the product with minimal handholding (e.g. Google Docs where you can start typing immediately). Complex, complicated products don’t work well in the freemium model as there’s too much energy required to get value.
  • Viral distribution – Freemium really shines when the very nature of using the product propagates it to other users. Think about Calendly links for scheduling meetings, Dropbox sharing of files to different people, etc. Distribution is one of the most difficult aspects of B2B software, and the most successful freemium products have a heavy viral component.

Freemium, when it meets these criteria, is one of the best business models around due to elegant product distribution and scalability. The next time freemium comes up, see if it has these three characteristics.

What else? What are some more characteristics of the most successful freemium products?

Characteristics of the Ideal SaaS Startup

Earlier this week I was talking with an entrepreneur about the ideal characteristics for a SaaS startup. Some characteristics can be identified at ideation and many of the characteristics emerge once the product is in market with customers. As more of the characteristics emerge, they drive how fast the startup grows and ability to raise capital (if desired).

Here are characteristics of the ideal SaaS startup:

  • Product Value – It can’t be repeated enough: every successful SaaS startup either helps the customer make more money in a quantifiable way or runs a function of the business that’s mission critical. Most startups fail and most startups have nice-to-have products.
  • Product Distribution – Getting the product into the hands of customers in a financially justifiable manner is one of the biggest challenges post product/market fit. Ideal go to market is either viral (like Calendly), high volume inside sales (like Terminus), or a combination of inside and enterprise sales (like SalesLoft). The more complicated the sales model, the higher the average order needs to be otherwise the business won’t scale efficiently.
  • Total Addressable Market (TAM) – Ideal startups serve small, fast growing markets that are going to be large (billions) in a few years but are too small currently for big incumbents to care. Tomorrow’s TAM should be dramatically larger than today’s.
  • Gross Margins – As the startup scales, margins should be in the 70% range at a minimum with 80%+ as the long term target. If the margins can’t be in the 70% range long term, the business likely isn’t SaaS.
  • Renewal Rates – Two of the most important metrics for SaaS startups are gross renewal rates (how many customers or dollars renewed in a time period divided by how many were up for renewal) and net renewal rates (how many dollars renewed and expanded in a time period divided by how many were up for renewal). Gross renewal rates should be in the 80% range, at a minimum, and net renewal rate should be above 100%.

The ideal SaaS startup has both great market fundamentals and excellent metrics across key categories. Most startups won’t achieve all the desired characteristics, but the ones that do have the opportunity to create large, enduring companies.