Originally posted on Quora.
Subscription businesses require a different framework in order to measure and understand their performance.
Such a framework was proposed by VC investor David Skok (see below for a link to the original blog post) and has now been widely adopted by the industry.
In a traditional business model, profit is realized at the point of sale — if you buy a pair of shoes for $20 and the shop paid $10 to buy, transport, and sell that said pair to you, they immediately put the difference in their pocket.
The subscription model allows you to sell complex products and recoup their cost (while also making a profit) over a long period of time. However, you still incur all the costs related to creating and marketing the product and you need to make sure you’re recovering them if you want to stay in business.
In essence, this means two things:
- Attracting enough customers
- Keeping them as long as possible in order to maximize the revenue they generate
The essential SaaS metrics allow you to understand how well you’re performing towards these two goals. Here are some of the most popular metrics and how they relate to that:
- Monthly recurring revenue (MRR): This is the sum of subscription charges that your customers are paying each month. For example, if you have 5 customers and each is paying $5 per month, your MRR is $25. In the case where customers are paying for longer periods of time (say annually), this is just the total subscription charge divided by the time periods it applies to (12 in the case of an annual subscription).
- Annual Run Rate (ARR): This is a projection of how much revenue you’re going to generate in the next 12 months based on your current MRR (or more simply MRR x 12). As such, this is a forward-looking metric that shows the overall trend of your business.
- Retention Rate: This measures how many customers renew their contracts at the end of each subscription period. For example, if you have 5 customers and only 4 of them renew at the end of the month, your retention rate is 80%.
- Churn Rate: Churn is the opposite of the Retention rate, i.e. it measures how many customers cancel their contracts at the end of each billing cycle. So, in the example above, your churn rate would be 20%. Churn can be measured as customer churn and MRR churn.
- Cost of Customer Acquisition (CAC): A measure of how much it costs your company to add another customer. A widely accepted formula to measure it is by dividing the total sales and marketing spend in a given period of time by the total number of customers added in that period.
- Customer Lifetime Value (LTV): The total revenue a customer will generate before they churn.
- LTV:CAC Ratio: In a typical SaaS company, all the costs around creating, marketing, and supporting the product for a customer are frontloaded, so it is important to keep tabs on whether customers stay long enough to repay those costs. The LTV:CAC ratio allows you to do that. The widely accepted rule of thumb is that LTV should be equal to at least 3xCAC.
To learn more about SaaS metrics, check out the following resources: