By Eric Mersch
In the many years I’ve worked with SaaS companies, I continue to observe a surprising lack of standardization of SaaS metrics and performance reporting. My experience reinforces the fact that SaaS business model variants and approaches to measuring performance via metrics are still very much undefined. This is true even though selling software on a subscription basis has been around for well over 20 years.
The Value of Benchmarking
The last two decades of SaaS evolution has generated an enormous amount of information about financial and operational metrics and their reporting. By tapping into this horde of data, a skilled SaaS CFO can create comparable company benchmarks to validate their reporting methodology, then use these to drive their annual planning process and evaluate business performance on several levels.
Validate Reporting Methodology
As an example, let’s take gross margin. In my experience working with enterprise SaaS companies over the past five years, I’ve seen a large variance in benchmarks for gross margin across subscription software businesses. Using current benchmarks, you’ll typically see that the mean gross margin for SaaS companies seems to coalesce around 77%. However, I’ve seen actual gross margins for SaaS companies ranging from a low of 60% to as high as 95%. Digging into these variances, you discover that the large variance in gross margins between SaaS companies is actually due to different interpretations of direct expenses and costs.
An experienced CFO knows how to use the correct benchmarks (those associated with true comparables with common definitions of expenses) to assess their company’s performance. Comparing your metrics with accurate benchmarking data, you can then validate your reporting methodology and templatize your reporting for stakeholders.
Drive the Annual Planning Process
The annual planning process at many SaaS companies often kicks off in August. By then a CFO should have already distributed planning templates to department heads. The planning process consists of two separate exercises: a “top down” approach and a “bottom up” one.
For the Top Down approach to benchmarking, you establish next year’s targets for revenue, gross margin and cash flow. Working with your management team, you then develop a bottom up forecast for expenses. The sum of the cash flow from the top down exercise and the total expenses from the bottom up exercise is often negative. In other words, the targeted revenue won’t support the level of expense requested by the management team. It is your role as CFO to manage the inevitable negotiations around this cash flow gap to land on a final annual plan for the company.
Top-Down Planning: Using Benchmarks
Benchmarking data can provide excellent guidance for establishing next year’s targets, answering questions such as:
- How fast does a company like mine grow?
- How much gross profit should we expect?
- What is the operating expense we can support under these assumptions?
The answers to these questions for SaaS companies are well documented by widely accepted existing benchmarks. Using data from a wide variety of sources such as the Key Banc SaaS Survey, the OPEXEngine SaaS benchmarking and metrics database and public comparables, CFOs can guide their CEOs and boards to appropriate revenue, gross margin and cashflow targets.
Bottom-Up Expense Forecasting
Benchmarking also provides useful data on spending levels across the major expense categories, i.e., COR, R&D, S&M, and G&A, and well as specific data on headcount for each team within these categories. For example, you can access Sales headcount data for Account Executives, Sales Development Reps/Business Development Reps and Renewal Reps along with compensation data. This knowledge gives you the credibility to push back in negotiation around department level expenses, easing the way towards consensus around a final negotiated solution.
Evaluate Business Performance: Operating Margins
What should your operating margin target be? This is such a basic question but answering it for SaaS companies can sometimes be tricky. SaaS companies have higher gross margins than perpetual license software companies so these dollars can support a greater operating spend. But what is the right amount to spend? An additional complexity here is that SaaS companies, like many high growth venture-backed companies, generate consistently negative cash flows, i.e., cash burn.
Benchmarking data gives you the credibility to drive decision making by helping to optimize the appropriate operating spend for your company’s particular circumstances. At the highest level, the operating expense ratio is measured as a percentage of recognized revenue. By evaluating OPEX benchmarks, CFOs can provide the management team with the right parameters for spending.
As a specific example from my experience, I started working with a SaaS company in the middle of a significant restructuring. It was clear that we needed to terminate some percentage of the workforce but the management team could not agree on the post-restructuring headcount. It wasn’t until I developed an employee count range based upon the Human Capital Efficiency ratio benchmarks for my peer group comparables that I was able to gain consensus among company stakeholders.
Evaluate Business Performance: Your Go-to-Market Strategy
A company’s go-to-market strategy is well established at a high level. Enterprise SaaS companies employ field sales, small/mid-market companies use a mix of outbound and inbound sales, and B2C companies use free trial and freemium products. All three categories of companies use SaaS metrics, but the type of spending for each category’s go-to-market activities vary greatly. Enterprise GTM strategies are particularly difficult to measure due to their long sales cycle, which makes matching sales and marketing costs to bookings difficult. Further, there are multiple ways in which customers ultimately connect with the company, resulting in difficulty in assigning spend to leads (a problem known as attribution uncertainty).
Regardless of a company’s go-to-market strategy, benchmarking data provides guidelines for the sales and marketing spend. For example, an enterprise SaaS company with ARR in the $20M to $40M range and a year-over-year growth rate in the mid double-digits typically spends about 60% – 80% of recognized revenue on sales and marketing, with the mix of sales to marketing spend about 75% to 25%. Any company in this size range whose spending lies outside of these benchmarks should evaluate their go-to-market strategy.
Naturally, every company must consider their unique circumstances when using GTM benchmarks. For example, I’ve worked with several enterprise SaaS companies with above average sales and marketing spends. I recall three specific cases in which spending exceeded recognized revenue. All three companies were involved in category creation, i.e., developing and selling software to customers where the customer base did not yet see the need for the product. In these types of category creation plays, companies typically rely on customer evangelism and education to raise awareness of the value proposition, thus increasing the sales and marketing spend beyond comparable benchmarks. The sales cycle is also especially long in such cases and this can also lead to higher sales and marketing spending. Fortunately, the ratio of sales and marketing spending to recognized revenue typically normalizes once companies cross $25m in ARR.
When running a SaaS business, operators need to strategically use benchmarks to assess operating performance to correctly drive their annual planning process and validate their reporting methodology. The results of faster decisionmaking, negotiated positions and internal consensus around everything from headcount to gross margin targets will improve operating efficiency while allowing you to gain respect from all stakeholders and enhance your credibility as a SaaS CFO.