Creating your first financial model and defining the right set of SaaS metrics can be daunting, especially for early stage SaaS companies with limited data. It’s tempting for founders/CEOs to take shortcuts that simplify their metrics, but this can result in misleading conclusions for themselves and their investors. In this post, I’ll share three common mistakes to avoid when calculating your SaaS metrics.
1. Oversimplifying your lifetime value (LTV) calculations
The most common shortcut I see is founders calculating LTV by dividing average revenue per account by churn rate. This oversimplification can lead to overstating how valuable your customers are for three reasons:
Firstly, a mathematical formula doesn’t consider how fast things change in tech and startups. When your company is at an early stage, you may see very low churn rates. While a customer may theoretically last forever, even a startup with low churn should adjust their LTV formulas to plan around a maximum customer lifetime of 3–4 years.
Secondly, forecasted revenue is more risky and less valuable to your company than the revenue you get today. To account for that, you should incorporate a discount rate of 20–30% into your LTV calculations.
Finally, the value of a customer depends not just on how much they pay, but also how profitable they are. Understanding your customer profitability is essential in building a solid financial model; things like high support and hosting costs can significantly erode the lifetime value of a customer. It’s critical to factor these costs into your LTV calculation by including gross margin in your formula. Taking these factors into account will give you a much more accurate view of your LTV and help you make better strategic decisions. I recommend taking a conservative approach in your LTV calculation assumptions, especially in the early days when you have limited data. It’s always much better to realize later that you can afford to spend more than you planned on sales and marketing than to find out your LTV is too low to support your sales and marketing budget!
2. Ignoring employee costs in customer acquisition cost calculations
Many founders I work with acquire customers primarily via inbound strategies such as SEO and content marketing. They often assume (incorrectly) that their CAC is low—or even free! Their CAC is calculated based on direct program spend alone, like online advertising, lead generation costs, PR, etc. This approach ignores the underlying costs of the people involved in planning and executing those sales and marketing efforts, and it badly distorts your most important cost metrics. If you plan your future customer acquisition budgets without headcount costs in mind, you’re almost certainly going to miss your targets. In the early days, these efforts are often led by founders, so in addition to including costs of dedicated sales and marketing personnel in CAC, I also recommend including a portion of the costs of other resources who help out with sales and marketing. Again, it’s better to err on the side of overestimating costs; it gives you much-needed breathing room further down the line.
3. Blending metrics across product lines incorrectly
A lot of entrepreneurs I work with have multiple subscription pricing tiers, and they start off using average prices, churn rates and other factors when calculating metrics. While it’s tempting, this shortcut is a very slippery slope. Using averages often generates misleading metrics that don’t reflect the reality of your business. For example, let’s say you have low, medium, and high subscription tiers with average metrics that look above industry benchmarks. Great, right? However, the reality may be that your low and high tiers are highly profitable, while your medium tier is losing money. Without calculating the metrics independently, you may not realize that investing primarily in your low and high tiers is the way to have the most positive impact on your business.
When you have multiple product lines and pricing tiers, the best approach is to calculate metrics independently to gain a better understanding of each revenue source. Once you’ve done that, you can blend them together using an accurate weighted average to provide reporting and benchmarking for the whole business. Building your model this way is not only more accurate, it also gives you the power and flexibility to easily consider a wide range of scenarios when evaluating different investment options.
Want More SaaS Metrics?
This guide explains the core metrics used to measure SaaS company success. Using simple examples, we’ll show you how to calculate each metric, and describe why specific indicators are important to investors.