David Skok of Matrix Partners: Driving SaaS Success Using Key Metrics

Thank you.

Hey everyone. I'm Alex Conrad, a staff writer at Forbes and head reporter of the Midas List. With me is five time entrepreneur and author of the four Entrepreneurs blog, general partner at Matrix Partners, David Scott, and he's here to tell us about building a unicorn.

Thank you, Alex, and good afternoon everybody. It's a real pleasure to be here. It's amazing to see the growth of the SaaS industry. It's certainly been one of my great passions over the years here. So this has been a day where you've been probably listening to multiple people talking about different metrics that you should care about. And the whole talk that I have for you guys is to try to bring all of that together and help you figure out which of these really matters and how they all interlock together. So I call the talk here the key drivers for SaaS success. So one of the ways that I'd like you to think about a SaaS business as a piece of machinery like we show on the slide here, which has a bunch of outputs and a series of dials that you can adjust to fix that machine. And the thing that I think is specifically important about SaaS that has attracted me to it is that unlike any other business model, any small change to some of these dials has an enormous impact on the outputs. And so it's really important to understand which of those specific outputs matter and which of the dials we need to care about here. So that's the goal of my presentation today, is to help bring all of these metrics together that you've heard about so much during this event and show you the ones that really matter. So let's start by tackling the key issue here, which is what are the outputs that we want from this machine? What do we care about the most? And the good news is that it's actually only three things. Kind of amazing, isn't it? We really care about only three things. So let me go into what they are. The first one I believe is growth. Growth is really fundamental to how we grow the value of our business, but it has a second value, which is if we're in a competitive marketplace, we need growth to beat our competitor and avoid them from winning our space. And the second two are kind of obvious. Profitability and cash. Profitability is how you get great evaluation for the business and cash also, but cash is fundamental to how you survive. So I think it's kind of useful to just remember at the highest level what we're doing when we try to run our SaaS business in my view is trying to optimize around those three variables. And now I want to try to expose the innards of this machine, this box, and help with using models to show you which of the dials really matter in terms of moving those outputs effectively. So the first question that I think is interesting is to understand why SaaS is so different. And I think many of you already know this, but nevertheless, let me quickly go over it, because it's material to some of the future points. This slide shows the cash flow for a single customer, and it represents the problem and the conundrum that SaaS creates, which is we start off in month zero, having spent a ton of money to acquire this customer, and we only get that money back after quite a long period of time in a small series of cash flows that come in over the lifetime of that customer there. And the thing that's worth looking at here is the cash impact of that. So if this was your cash balance, you're going to have this quite significant period of time where you've got cash flow negative because of the investment that you made. And it takes, in this particular example of my model here, it shows about 13 months required to break even on that investment that you made in that customer. So that's fine for one customer, but remember, we're talking about growth here. So what happens if the cash flow is bad for one customer and you now decide to go out and get multiple customers, which is what everybody wants, what happens when that takes place? So here's the model effect of that. In the orange, you can see how your cost of customer acquisition is building because we're adding more and more customers every month. We're slightly growing, growing, growing our bookings. And the green shows us what's happened to revenue. And those are the point in time. Look at the profit and loss items here. But to really understand this, we have to look at the cumulative cash flow, which is this diagram. So the bad news about this diagram is that it shows that we have quite a serious cash flow trough. And this is the thing that is so important to understand, because when you're in your boardrooms trying to explain to your investors why everything's going really well, we're growing like crazy, and they're saying, but your losses are getting worse and you're burning all this cash, how can you tell me things are going well? You need to have this story up your sleeve to be able to explain to them what's going on there. Now, the great news about this slide is that once you come out, the far end, you can see that there's some terrific momentum and you do come out into a very positive cash flow situation. So it is a good business model, but it requires a lot of cash to get it through that, that trough there. I love this quote from one of the co board members. I'm on the HubSpot board and Ron Gill, who's the CFO of NetSuite, is our audit chair and he said the thing that surprises many investors and boards of directors, and he's referring to the NetSuite board of directors here, about the SaaS model, is that even with perfect execution, an acceleration of growth will often be accompanied by a squeeze on profitability and cash flow. And so he is finding himself constantly re explaining why every time they get close to break even, they decide to go for another bout of investment, maybe they do some international investment and the damn thing goes back into a nosedive again. And he's got to try to get them calm down and have them understand that it's going to come right. So the impact here of increasing growth is worth understanding in the model. Not surprisingly, the trough deepens if you increase the number and it's pretty linear. So if you go from five customers per month to 10 customers a month, you double the depth of the trough. What's not so obvious is that the actual time for it to come back into profitable mode doesn't change. And the other thing that's pretty obvious is that the slope at which it comes bouncing out of that trough is obviously twice as fast. So that's a useful thing to be aware of. Now we've got an interesting conundrum here because there are good SaaS businesses and there are bad SaaS businesses. And if you've got a business that's growing losses and kind of diving into the floor, how are you able to tell whether you've got one that's actually good and will finally come out of this nosedive? So we need a new kind of metric gap accounting doesn't deal with this at all because it doesn't look at the future revenue values that you have. So we're going to introduce this concept that I think is now very well known of using unit economics. And I think many of you are familiar with customer based unit economics. I'm also going to introduce you to salesperson based unit economics later on in this presentation. But customer unit economics, let's start with that, is an incredibly simple concept. The concept simply is one of the most important aspects of the business model. Can I make more profit from this customer over their lifetime than it costs me to acquire them. Pretty straightforward. So that means that we need to look at two variables, CAC and ltv. By now I'm sure I don't need to explain these to anybody in this audience here at all. And our goal, again to state the obvious, is we need the lifetime value to be much bigger than the cac. And one of the things that always continues to surprise me here is, particularly with first time entrepreneurs, is how much they under appreciate the importance of CAC and how big it actually is. I think there's a ton of optimism that if they build this great product, everybody's just going to beat a path to their door. So a long time ago I came up with a guideline that you should have your CAC as being a third or your LTV should be three times greater than your cac. And I kind of guessed at that number after visiting many, many SaaS companies. This was probably about, I think, seven years ago or so when I first wrote this. And the good news is that I think this is really still held up today as a minimum threshold for a viable business. So this is one way to judge if you're going into losses, that you are going to come out and have a decent business at the end. And so given that we care about these two variables, CAC and ltv, I thought it might be helpful to take a deeper look at the right hand side, the LTV side. And the basic formula for how you get to lifetime value of a customer is pretty simple. You look at how much profit per month do they generate, multiply that by the number of months of expected lifetime. And so let's look at the customer lifetime formula. It's again, something I'm sure all of you know. It's one divided by churn. So that tells us something. We really need to care a lot about churn. And everybody in this audience knows that. But let me focus in on it a little bit deeper here and go into some thoughts on how you can deal with churn. So the first thing to note is that there are two kinds of churn. And I'm still constantly amazed by how rarely I see both of these being tracked and tracked separately because they each teach you something different. And the best way I can illustrate these two forms of churn is to give you a very simple example. Imagine we have a cohort that we sign up in January of 2016 that has two customers only one is spending $5,000, the other one's spending $1,000 per month, month with You. And now let's look a year later and see what happened if we lost the big customer here. Our customer churn is 50% right, because we lost half of our two customers. But our revenue churn in this particular case is actually 83% because we lost the biggies. So this is a serious problem and quite a worry here. So obviously nicer would be if we lost the smaller customers. But the real powerful thing is when you look at the other option, which is if you could grow the second remaining customer by more than the amount that you lost from losing that very first customer, something truly magical happens here, which is now we've still got that same 50% customer churn, but we've got negative 16% revenue churn. And this is one of the most important concepts. I'm sure many of you already know this, but I cannot stress highly enough to you just how big of a deal this particular dial is in a SaaS model, because I spend a lot of time modeling things to try to figure out which of these dials matter. This is a big one. So just to repeat what we're dealing with here, this is a situation negative churn happens when your expansion revenue is greater than the amount of revenue that you lost from the customers that churned out of the business there. Now, to get expansion revenue, we need another part of our sales funnel. We've got to add on something after we've made the sale to get some expansion revenue through cross sales or upsells or expansion. And that's kind of a problem for many entrepreneurs who are starting their first business because hey, we've only got one product. How the hell do we cross sell? There's nothing to cross sell here. We've got no other things to sell them. So this is one of the big learnings that we had at HubSpot. HubSpot, if you may remember, in the early days, had just a single priced product. The big deal that we had to understand was we needed to introduce variable pricing axes to allow us to get more revenue out of an existing customer. And one way to do that is to have multiple versions of your product like a Pro Edition and an Enterprise Edition. Another way is to charge, for example, for users. But quite a lot of businesses don't happen to increase the number of users like a new relic for example, or a HubSpot actually. And so they have a different way of going which is to measure the depth of usage. So HubSpot charges for the number of leads and that's pretty cool since HubSpot actually generates more leads. They're actually going to automatically, if their product works, increase their LTV over time, which is nice. And you know, the Dropbox mechanism of charging for storage and you know, new relic charges on a per container or server core instance. So those are key things to think about. Again, I would warn you here that a lot of what I'm talking about you should ignore if you're still searching for product market fit. Because this is fairly. This is the stuff that you want to be thinking about as you're coming out of product market fit and you're starting to try to think about expansion. So don't panic about this too early. I've had a lot of entrepreneurs that are just getting their product to market freaking out because they don't yet have variable axis. Wrong thing to focus on. Just worry about getting product market fit at that stage then. So I mentioned that cash is one of those three outputs that we care about. It turns out there's one variable that has a gigantic impact on your cash that you're going to consume and, and that is the months to recover your cost of customer acquisition. Months to recover cac. Simple variable. And one of the ways that I can illustrate to you how powerful this is is to show you this chart where the green line represents six months to recover CAC. The orange line is 12 months to recover CAC and the deep orange bar at the bottom There is 18 months to recover CAC. Well, in the top instance I'm going to have a hard time reading this here, but it's something like $36 million in cash in the bank at the end of 40 months, whereas the bottom line is $0 at the end of 40 months. So this is a gigantically powerful lever. Again, you've probably all heard of it, but you may not have appreciated just how important this variable is. I want to stress one thing to you today, it's this one. This is the number one thing to drive down if you really want to have a Great, a successful SaaS business. This is the difference between Atlassian, who really didn't have to raise any capital to expand their business and some of the other companies out there that have raised 300 million to get to the same kinds of revenue run rates is focusing on this particular thing here. So my guideline that I like to use is try to get your months to recover CAC to 12 months. I will tell you that very few businesses actually do achieve this, so there's an awful lot more that are in the 18, 20 month range, but they will Chew through cash and there are a lot of businesses that have managed to get it lower. So don't freak out if you can't get there, but just be aware you're going to be raising a lot of venture capital and will probably enjoy being there at the time when that happens. So it's not a disaster, but it's definitely something valuable to know. And one of the reasons why this can be so useful is if you're looking at a new channel to go and buy leads with. Ask yourself the question with this lead channel here. If I know how much money I get from a customer in 12 months, that that tells me how much money I can afford to spend to get leads through this new channel and still have a really good outcome from it. So that's another way you can use that formula. So let's take a deeper look at the other side of the equation. Let's have a look at CAC and see what we can do about that. And I found one of the most powerful things to look at with CAC is sales complexity. It stands to reason if you have a really simple product like Dropbox that can be evaluated in about 30 seconds and spreads virally, that's going to have very low sales complexity. But if you have an enterprise product where you've got to use a sales engineer to go out there and help get it sold, that's going to be a more complex sale that's probably going to cost more money, particularly if it's a high price and needs lots of decision makers to agree on it. So I put together this series of businesses. On the left hand side I've got the freemium business which was Dropbox in the very early days, not so much now in the left of that no touch self service was Zendesk, where in the very early days of Zendesk they got to about 12 million in ARR with only one sales guy because they had a no touch self service model there. Then I have constant contact was a data point where they were using a very light touch, not really selling so much as helping coach the customer through the early usage in a trial. And then I had HubSpot as a good example of a high touch inside sales. They were doing a lot of work on their inside sales calls. And then I had a couple of other companies that I worked with, one called Netezza that sold data warehouses that cost a million dollars and they were using field salespeople and ses. And in my mind I had this picture that this correlation of customer CAC would be roughly linear to how complex sales was. So I went out and got the numbers and something kind of shocking happened, which is I discovered that it wasn't at all linear. It's exponential. So I really was shocked by this and spent a lot of time thinking about it. And this graph maybe shows you the key conclusion is this is a logarithmic scale on the left hand side which is as you add complexity to your sale. And you need to add more human touch into the sale. And adding human touch is unbelievably expensive and pushes your CAC upwards dramatically. Now, don't worry if you've got high cac, so long as you've also got high ltv, you're fine. But if you're sitting in the audience trying to think about how do I improve my SaaS business model? This is one of the places where you really can do something fascinating and that is to use your engineering group and your product group to drive CAC down. Most people think of CAC as being in the domain of the sales department, the marketing department. It's not. It is a whole company effort. And the top thing that I think great SaaS CEOs do is they recognize that every department works together to ensure customer success, to ensure low cac, and that you can use engineering to drive these particular things down there. So let's switch gears for two seconds. You remember I talked to you about unit economics at the salesperson level? Well, why does that matter? Well, you, when you're creating your business model for 2016, I'm sure all of you sat down and thought, how am I going to figure out how much revenue we're going to book? And I'll bet you almost everybody here said, well, we can probably look at the quota of a salesperson and if we've got two salespeople, it'll be double that quota. And if we've got 10 at the end, it'll be 10x the quota. There's. So this is the unit by which we model and create growth in our companies, is we hire salespeople. So let's have a look at what kind of economics a salesperson has. This shows you what you'd hope would be the revenue growth. It kind of starts slow as they're ramping and then you get predictable additions to mrr. The problem is that we have to pay that salesperson from day one at pretty much the full rate. And that means we have a lot of losses in the early days of the salesperson. And when you look at those losses, cumulatively you get a shock. The shock tells you that in this pretty simplistic example, just looking at the salesperson alone, it costs you $110,000 of investment before that person starts to turn around and generate money for you. And worse still is it takes 23 months to get back the investment on that single salesperson. That's a pretty shocking piece of information, right? That's a long time to get a payback. And it's pretty scary how many of those sales guys don't actually work out. And you discover you made that investment and you've been investing for quite a while then. So the good news is that there's a terrific return on investment once they do start to come out the far end of this thing. But now you get into this point where if you've got product market fit, you need to expand. We want growth, right? So we're going to look at what happens if we hire two of these salespeople every single month. The scary part of that is you're going to have a gigantic cash flow trough. And this is the reason why HubSpot has raised so much money and chewed through so much cash. And even Zendesk, with a very efficient sales model, has also raised a lot of capital and burnt through a lot of cash here. So modeling this is super important because if you don't have the picture to show your investors and board members of how this finally does turn the corner, they're going to have a hard time dealing with the investment level that you need. But I do believe personally that it's extremely important if you're confident about product market fit and you're confident that your sales model is repeatable and scalable, that you hit the gas. Why? Because most of the time you're in a competitive marketplace and you have to win the battle against a competitor. So I know this is somewhat counter to potentially the new talk after the earthquake in the stock markets, but if you have cash and you can afford to invest it, this is a great place to invest it there. So one quick thing that's useful to know is if you hire one salesperson per month instead of two, you simply change the depth of the trough, but you don't change the date on which the thing comes out there, but you do change the slope at the end there. So let's jump to another guideline for you, and probably many in the audience will actually have some thoughts on this. But my view is that for a salesperson, we need to kind of look at the cost versus the roi. So the Cost is their on target earnings, on the left hand side the ote and on the right hand side is the benefit they bring us the quota. And what I've found is that looking around at a lot of companies here, if you can get the quota to be greater than five times the cost, you're in a good place with your sales organization now. There are quite a lot of people that don't reach that. So this is again a guideline. It's for how you get to a great business and I've seen businesses that are up at the 7 or 8x quoted to OTE for the unit economics there. And one last point here before I summarize Cash. One incredibly powerful thing as a lever for you guys is if you can instead of getting monthly payments, get paid annually in advance. Look at the right hand graph here and you'll see that at the end of 40 months here we have 35 million in the bank versus the other one which is up at about 4 million in the bank. So this is one of the most powerful things you can do. If you can do it without damaging your sales cycle. Not many people can do that. So one of the things you can do is perhaps reward your salespeople for how much cash they bring in up front as like a secondary aspect of their comp them. So quickly summarizing for you the key drivers here. I had hoped to try to boil this down to something really simple. I think is three things I've written two on this slide, months to recover CAC hyper hyper important value to tackle LTV to CAC ratio and then collecting cash up front would be the third one not on the slide. So quick, quick summary here of how do you reduce cac, lower your cost per lead, increase your funnel conversion rates, increase your productivity per rep, simplify your product and reduce human touch. And then if you want to increase ltv, go like crazy for negative churn which is all about increasing your product stickiness, selling to the right customers who aren't going to churn, nailing your onboarding and customer success, using variable pricing axes to allow you to actually have something to upsell and then having a great expansion sales organization. Also worth noting, I didn't have much time to talk about it, but gross margin as a percentage is actually kind of a key factor here and then increasing average deal size. And I apologize because I have raced through a subject here that I normally like to take about an hour to go through slowly. The only good news I can say is that a lot of this material is up on the blog. And the models are up on the blog. You can play with the models, you can fine tune them, you can copy them and build your stuff around it. But that hopefully was of some value to you guys. Thank you.

So David, you know you're a SAS rock star because everyone was holding their phones up while you were presenting. They were trying to take photos of the slides you were putting up. But of course, you know, it is on your blog. One thing I was curious about is, let's say I just saw this presentation and I'm not happy with my months to to recover my cac. In your experience, have you found that it's easier to add more services or improve your profit margin and kind of increase the money coming in versus maybe not hiring as many salespeople, maybe cutting down the cost on the expense side and kind of try to bring that time down on the other side.

If you've got the kind of customer that is like a larger customer, it's definitely easier to do what you've said, which is raise the prices effectively sell them something at a higher price point than it is to reduce cac. CAC is kind of a really tough nut to lower. It takes a lot of hard work and it can take ages to get it under control. And the only issue with that is that some businesses just, you know, like if you're Constant contact and you're selling to very small businesses, it's super hard to get them to pay more than the 36 bucks a month that they were charging. And that's why Constant contact really struggled to grow beyond the 400 mil or so, because they just didn't have a way to create expansion revenue beyond that initial sale there for them.

What about if I see my trough and I see the convergence towards profitability and I'm not happy with the scale that I'm projected to get to. Is it possible to successfully redeepen your course?

Yes, yes. Actually, one of the slides that I removed was something that Ron Gill gave me which showed what had happened at netsuite, which is they had repeated troughs. They went and ran through an experiment where they first expanded, expanded the sales organization. Then they went and realized, okay, this is working really well, let's do more of it. So they added a lot more salespeople and then they went and did international and that was yet another one of these. So provided you've got the cash available to do it, it is the smart thing to do. Because this machine is like a cash machine. If you put a dollar into it, Provided your LTV to CAC ratio is right and your month to recover CAC is right, you will get an amazing RA stream and return of dollars coming out of that machine later on. So it's about the best cash bank you can go to that's going to generate money for you as a return on your investment.

When it comes to hiring salespeople, there are a lot of factors. Obviously the founders are thinking about what's the quality of these salespeople, what's the culture, how many people can I inboard at any given time without overwhelming the system at the same time, if I can afford it, it looks like if I hire more salespeople and the return will eventually be there. Being aggressive could really help scale. So I'm curious, what's kind of the number one thing that you would recommend founders look for as sort of the limit to the pace of growth that they would want with their sales team?

So I think it's two things. The number one limit that I see is that they can't generate leads quickly enough to feed the sales force. So it's no point in hiring more people because they're just going to sit there and not be able to be productive. And solving that is a tough challenge and it requires them to go and experiment with multiple marketing lead sources. And clearly the top long term one I believe in is inbound. But the problem with inbound is it doesn't work very well in the early days. It kind of is a long, slow, linear build. So constantly experimenting with new ones. You know, one of my portfolio companies is namely, and I think many of you guys might have seen that, namely is doing TV ads. And they did a lot of advertising on cabs and in bus stops. And so there's there many of many of the SaaS companies have tried the radio. So being able to look for very scalable lead sources has to be cracked before you can really just hit the gas on hiring the salespeople. And that's one of the pieces of this presentation that I felt I had to cut out to try to fit within the time frame here. But thank you for asking the question.

Yeah, well, you crammed a ton in there. One point that I was also really curious about as you were presenting was the idea of upselling current customers and improving your return from your existing customer base. With we hear a lot in enterprise now about customer success as a term. And I'm curious, with your portfolio, with the companies who ask you for advice, what's the first thing they should do to try to get current customers on that path to maybe $1.50 for every dollar the year before. I mean, that would be ambitious, but that would be great.

Yes. And we did hear some great numbers. So Zendesk is about 123% dollar retention rate. New Relic mentioned 129% yesterday. So there are some great numbers out there to encourage you that this is possible. So I'd say that to me, the top two things that I've seen affecting churn, the first one happens in the first 90 days of the customer's life cycle, and that's the onboarding. Because the customer is super excited about your product after they've just purchased it. And if they have a bad experience with the onboarding, it's really hard to get them to pay any attention to you again. So pouring energy and effort into that first few weeks of experience with an onboarding process, that really does a great job of getting them on. And the second thing we've observed in our portfolio companies is that there's a very high correlation to whether your champion, your executive sponsor, is still with the company. So a trick that might be worth watching here is the health of the customer. The happiness score should include looking to see whether you have executive sponsorship. And if somebody leaves to make sure that you re get executive sponsorship with some other person, there's. And that's just getting the thing just settled in off the ground.

Then how would you rate the employee cost of having the right people to maintain relationships relative to going for new leads with new salespeople?

Yeah, it's a great question. And I sort of skipped over gross margin. But if you know the gross margin calculation, the piece that most people think of is that this is our hosting costs with Amazon. But it's not just that. The second piece that goes into that is exactly this customer success team that is required to actually make the product and the support team. So those costs go in there and they drag down both, in fact, they will drag down on your LTV because they will impact that particular part of the formula if they're very high. So again, it goes back to that concept of how do you make your product simpler and not just thinking of this as being the job of the customer success team. It's the product managers and it's the engineers who can have the greatest impact on that by changing the product and making it so much easier and more natural and obvious to adopt and learn. But many other techniques as well. But that's a key one.

Well, we could talk about this all day, but we're out of time. I would recommend everyone read some of the amazing work David's done. And thank you so much.

Thank you very much. Thank you, guys.