SaaS Waterfall Metrics
What are SaaS Waterfall Metrics?
Revenues generated by a SaaS (Software as a Service) business or company are primarily “Subscription Revenues”, generated as customers pay to access the software or a digital service. These are typically termed “Recurring Revenues” as enterprise customers commit to a subscription (e.g. annually) and pay on a regular basis (e.g. monthly) for the service. Waterfall metrics demonstrate how these subscription contracts flow into monthly (and annual) revenues.
Monthly Recurring Revenue (or MRR) and month-over-month growth of MRR are key metrics that SaaS companies and investors monitor closely. SaaS models are driven by such scalable revenues as companies are not limited by product capacity. Recurring revenues are attractive as the customer is already subscribing to use the service, and therefore sales do not require further incentives. Advertising and promotions can be targeted towards attracting new customers to the company. As a result, recurring revenues typically have higher profit margins.
Key Learning Points
- A SaaS business model targets generating Recurring Revenues based on contracts signed with customers and recognized as revenues on a monthly basis
- Each month a SaaS business can add new customers (New MRR) and subtract lost customers (Churn MRR) to the beginning MRR balance
- Expansion MRR is another component which increases MRR and includes services such as increased users on their contract, product price increases and product upgrades
- Contraction MRR is the opposite of Expansion MRR and decreases MRR as the result of decreased users on their contract or decreased pricing
- Bookings and Recurring Revenues are not the same: Bookings represent the total value of contracts, but they are not yet recognized as revenue until the subscription service is provided
SaaS Metrics Fundamentals
There are three key components in calculating recurring revenues: New Customer Count, Churn and MRR. Collectively, these three comprise the core “SaaS Waterfall Metrics”.
Customer Churn
Churn refers to the volume of customers who exit their subscriptions (either by cancelling or choosing not to renew) during the time period.
Monthly Recurring Revenue (MRR) Formula
A simple waterfall formula for monthly recurring revenues is:
Revenue Churn
SaaS start-up companies carefully monitor, and track recognized recurring revenues. They can forecast recurring revenues or subscription amounts based on their existing customer contracts and the likelihood of attracting more customers. Tracking MRR and understanding the impact of the three components provides valuable insights into the long-term financial stability and customer loyalty of the SaaS business.
MRR Calculation Example
SaaS companies typically use some form of the waterfall as depicted below, access the template from the free download section.
- The MRR formula takes the Starting Monthly Recurring Revenues, adds any New MRR and Expansion MRR, then subtracts the Churn and Contraction MRR to get Ending MRR.
- MRR measures the run rate of recurring revenue from the current base of executed customer contracts with a minimum duration of one year.
- The Annual Recurring Revenue is calculated by multiplying the MRR by 12 to give a rolling annual figure.
- Both the ARR and MRR calculations exclude one-time or non-recurring revenues.
- Companies will be looking to expand their MRR and identify as early as possible any issues which may be driving churn or contraction in revenues.
In any given month a SaaS company will “book” a contract and onboard new customers. Revenues for the month coming from these new customer contracts are called New MRR. In addition, each month, a SaaS company may lose customers and see revenues contract through normal attrition, increased competition, or some other reason. The Churn MRR (or Lost MRR) is the amount of monthly recurring revenues lost in a particular month.
Expansion and Contraction MRR
For large SaaS companies with multiple SaaS products and sales teams, there are additional customer contract situations which are categorized as “Expansion MRR” and “Contraction MRR”.
Expansion MRR is growth that comes from existing customers during the month. For example, increasing user counts in their contract, increased pricing and product upgrades will add Expansion MRR. Contraction MRR would be the opposite, where a customer remains for the length of the contract but at a lower MRR, resulting from reduced number of users, reduced products or price reduction.
Bookings vs. Recurring Revenues
A common mistake when measuring Recurring Revenues is to use Bookings and Revenues interchangeably. Bookings refer to the value of the contract a customer agrees to pay a SaaS company, but they are not yet recorded as revenues. Revenues are recognized only at the time that the product or subscription is provided.
While Recurring Revenue is a key metric for SaaS companies, bookings often provide a better proxy for long term growth and the business viability of a B2B/SaaS company. Bookings present metrics around new customers and new business which gives insight to a SaaS company’s future recurring revenues. A B2B (Business to Business) or SaaS company could show stable recurring revenues for a long time just by working off its bookings backlog, which would make the business seem healthier than it might be. Focusing on both ensures that the SaaS company monitors both existing and future recurring revenue streams.
Achieving an Attractive Customer Lifetime Value
Customer retention is critical to the success and growth of a SaaS company. A high churn can mean that the company must spend extra money replacing lost customers on an ongoing basis. Over a long period of time, a high churn is unsustainable and impacts the profitability and valuation of the SaaS company. A sustained low level of churn rate implies that a company is better at retaining its customers and thus may have a larger customer lifetime value (CLV).
Customer Lifetime Value is a gauge of how much revenue a company can expect to receive from a single customer. This can provide insights by looking at metrics such as the average purchase price and the number of months or occasions that the customer is active. Often with services such as online food delivery, there is an average customer lifespan before they decide to explore other eating options. Customer retention and keeping customers engaged is a critical part of maintaining a good CLV.
SaaS is an attractive business model due to the predictability of the revenue stream coming from customers paying regularly on a monthly (or quarterly or annual) basis. If customers are pleased with their software/service subscription, they will likely continue to renew their annual contract, and the SaaS business will profit from that customer over time. However, if customers are not pleased with their subscription, they will discontinue payment and churn out.
Cost of Acquiring New Customers
The earlier a customer churns out, the more costly it is for the SaaS company. The cost of acquiring new customers can be very high and will typically be greater than the revenues gained in the initial period. Customers usually pay on a monthly basis but the expenses to acquire new customers and deliver the software/service are upfront. By shortening the customer lifetime, the SaaS business does not have the time to recoup their selling costs.
The acquisition and on-boarding of new clients is an important component of a recurring revenue business model. SaaS companies typically spend thousands of dollars to “acquire” new customers but do not see the payback or profit for months. The more new customers that a SaaS business can acquire with the same level of marketing spend, the lower the payback period and the higher the return on investment for each customer acquired.
Customer Retention
Equally important to acquiring new customers is Customer Retention. Keeping the churn low means the customers are on the platform longer and provides the SaaS company with a profitable base of recurring revenue.
Measuring MRR will indicate what the company will book in recurring revenues next month, but more importantly it will illustrate the month over month growth in recurring revenue as the business expands. Although MRR is not recognized by GAAP or IFRS, it is a widely used metric by founders and investors in the VC sector.
How to Calculate MRR
There are two ways to calculate MRR: Tracking customer revenue, and Using an Average revenue per user (ARPU).
Tracking Customer Revenue
The first is the easiest and the most widely used methodology among SaaS companies and is discussed in the table above:
Average Revenue Per User (ARPU)
The second method is straightforward to calculate but because it assumes one average price for a subscription. However, it lacks the detail to provide meaningful insights into a SaaS company’s business operations and customer loyalty. The Average Revenue Per User is derived from dividing the total revenues by the average number of monthly users.
Conclusion
Revenues in a SaaS business or company are primarily subscription revenues, paid monthly, based on an annual contract with an enterprise customer. These are considered recurring revenues and typically have a higher margin and are scalable – all very attractive features for a high-growth company. Companies that can deliver growing recurring revenues, low churn, and can attract new customers with relatively low advertising costs will offer attractive investment opportunities for VC investors.
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