SaaS Renewals and the Multiplier Effect

In case you've forgotten the concept of the multiplier effect from Economics 101, it's commonly used to project the impact of a change in government spending or money supply on the growth of GDP.

If, for example, we know that the government spending multiplier is 5, and the government increases spending by $10 billion, we'd project that GDP would grow by $50 billion.

In a similar fashion, renewals have a multiplier impact on SaaS companies' revenues.

The higher the renewal multiplier - that is the more times a company can renew a customer and extend its revenue-generating life - the greater the revenue accruing to the company.

Lifetime Customer Revenue

To be more precise, what we're actually referring to here is "lifetime customer revenue."

Lifetime customer revenue = recurring revenue per period * term of customer lifetime

As an example, I'll calculate the average lifetime customer revenue for salesforce.com, estimating a 3-year customer life multiplier:

$985 million in FY 2009 annual subscription revenue/55,400 customers = $17,780 average annual revenue per customer

$17,780 average annual revenue per customer * 3 year customer lifetime = $53,340 lifetime customer revenue.

Changing the renewal multiplier to a 5-year customer life, yields a more favorable result:

$17,780 average annual revenue per customer * 5 year customer lifetime = $88,900 lifetime customer revenue.

To illustrate the dramatic impact of longer customer life on lifetime revenue, I've calculated the lifetime customer revenue at several publicly-held SaaS companies, using 5-year, 3-year and 1-year renewal multipliers. As expected, a higher renewal multiplier yields substantially higher revenue.

The relationship between the renewal multiplier, lifetime customer revenue and customer acquisition cost

This calculation becomes truly useful when comparing the lifetime customer revenue to the cost of acquiring a customer, i.e. sales & marketing expenses.

Average lifetime customer revenue/average customer acquisition cost

This formula reveals how much lifetime customer revenue is generated by $1 in customer acquisition costs. (I discussed this concept at greater length in the May 2009 newsletter and in an earlier post entitled "Marketing Spend: How Much is Enough?")

According to this illustration, when salesforce.com can extend the average customer lifetime to 5 years, the company generates $2.40 in lifetime customer revenue for every $1 spent on customer acquisition. At a 3-year lifetime, $1.44 of lifetime revenue is generated. And at a 1-year customer lifetime, only 48 cents of revenue is generated for every $1 spent on sales & marketing.

Don't lose customers you've already paid for

As you can surmise, spending more than $1 to acquire a customer that yields less than $1 in lifetime revenue is not a sustainable business model.

Extending the life of the customer's subscription is critical to success. It's bad business to lose customers you've already paid for.

Measuring Renewals

Early in my career, I taught bank credit analysts-in-training how to read financial statements. During my course, they heard from me one constant refrain: "Read the notes, read the notes, read the notes." The notes to a company's financial statements often reveal critical insights behind the numbers.

The advice on how to read financial statements certainly applies to software-as-a-service (SaaS) companies, and especially to their reported customer renewal rates. SaaS companies may claim that they have renewal rates of 90% or 95%, but it's critical to look behind these numbers and understand how they're calculated.

Is a 90% renewal rate a good thing?

First, it's important to know what the company is really counting when it refers to "renewals."

• Are they referring to the number of customers, or to revenues?
• Are they counting only the customers whose contracts are up for renewal, or all customers?
  

Then, carefully examine how the renewal rate or attrition rate is calculated.

• Some companies compare the number of customers at the beginning of the period to the number of customers lost during the period. For example, if they start the year with 100 customers and lose 15 customers over the course of the year, they'd show a 15 % attrition rate or an 85% renewal rate: 15/100
• Other companies compare the number of customers at the beginning of the period plus the customers gained over that period to the number of customers lost during the period. By this alternative method of calculation, if they start the year with 100 customers, lose 15 of them over the year, but acquire 50 new customers over the year, they'd show 10 % attrition or a 90% renewal rate: 15/(100+50). Voila! An 85% renewal rate becomes 90%.
  

Finally, look carefully at the length of the subscription term.

• If the subscription term is one year, a 90% renewal rate means that the company loses 10% of its customers each year.
• If the subscription term is one month, a 90% renewal rate means that the company loses 10% of its customers each month. At that rate, it will lose its entire customer base in less than one year.

So to answer the question, "Is a 90% renewal rate a good thing," by reading the notes you may have equipped yourself to provide a definitive answer: Maybe.


Thanks to Tod Loofbourrow for his insights on this topic.

There is No Marketing Magic Bullet

Assuming that my entire readership is more than 8 years old, I'll share this adults-only secret: There is no Santa Claus, no Tooth Fairy, and definitely no Marketing Magic Bullet.

The Marketing Magic Bullet? I'm talking about that single masterful trick, the brilliant stroke of genius, the one perfect key that unlocks the door to a roomful of success... if only we marketing folks could find it.

Stop looking. You're not going to find it because there's nothing to find.

How can I say that? I can say that on the basis of 25 years in marketing. And believe me, I've been looking. In every company, someone, somewhere is absolutely convinced that a magic bullet does exist.

"But what about Apple? One brilliant Super Bowl ad put the company on the map!"

If all it took to make a successful company was a single memorable Super Bowl ad, we'd all be buying our puppy chow and flea collars at Pets.com. Instead, their cute sock puppet is the poster child for the dot.com bust.

"If we could just get a front-page press story."

Hearing that prescription for instant success, I was tempted to suggest to that person my 100% guaranteed strategy for national press coverage: "Light your hair on fire and jump off the roof... just wait until the photographers are in place." It's probably better that I had the diplomatic good sense to restrain myself.

It's a Thousand Little Things

I once worked with Penske Racing as one of their Indy Car sponsors. (For the non-motorheads among you, Penske Racing is one of the most successful organizations in motor car racing, having just won their 15th Indianapolis 500.)


In interviewing one of the senior members of the team, I once naively asked, "Is the key to winning the car or the driver?"

He patiently explained, "It's not just the car or just the driver. It's actually a thousand little things." It's the driver, the designer, the crew, each part manufacturer, and every other element involved in putting a car on the track that can go 225 miles per hour down the straightaway and turn left at the end... for 200 laps. If all of those elements perform as required, he said, we've got a chance to win.

He didn't say anything about a "magic bullet."

SaaS and the Automatic Feedback Loop

One of the more useful management development courses I've taken during my career is "Practical Product Management" from Pragmatic Marketing. True to its title, it offers a practical prescription for product managers to better understand the needs of the market: Talk with one prospect, one customer, and one evaluator every month.

Product managers are instructed to use the information gathered in these discussions to become the authority within their company on what the market needs. They equip themselves to be "prospect" experts, not just "product" experts, and use their expertise to guide product development and marketing strategy.

Product managers with on-premise solutions need to consciously establish this routine of systematically gathering market input. And the best of them do it well, diligently carving out time on their calendars to meet with customers and prospects on-site, at trade shows, and user groups.

The sales and marketing for on-premise applications is essentially a straight-line process - running from "attract & cultivate qualified prospects," to "closing deals," to "deploying and supporting the application." Gathering useful input from customers and prospects requires that product managers establish an effective feedback loop themselves.

On-premise solutions follow a straight-line process, and product managers must establish a feedback mechanism themselves

SaaS Provides an Automatic Feedback Loop

In the SaaS world, this feedback process is built right into the model. Product managers automatically get input from every single customer every single day. They can see precisely how customers are using the product, when they're using the product, and where they're running into difficulty. They have access to hundreds of useful data points from hundreds or thousands of customers.

Unlike the straight-line process of the on-premise model, under which product managers must establish the feedback mechanism themselves, the feedback loop is built right into the SaaS model. All current customers are prospects too and enhancing the solution to meet their requirements is essential to securing renewals. And SaaS companies require high renewals to succeed.



SaaS solutions provide a built-in feedback mechanism

Companies that have made the transition from on-premise to SaaS models will tell you that one of the primary advantages they've gained is their ability to better understand their customers. They use this knowledge to set smarter product development priorities and develop more effective sales and marketing strategies. (See "Taking Advantage of Customer Satisfaction Information.")

The automatic feedback loop, built into the SaaS model, gives product managers a window directly into customer and prospect behavior. They should take advantage of that window and watch what customers are doing. As Yogi Berra would explain: "You can observe a lot just by watching."

Taking Advantage of Customer Satisfaction Information

The Massachusetts Technology Leadership Council hosted a program on software-as-a-service (SaaS) sales and marketing issues last week that provided useful advice on how to use the unique qualities of a SaaS solution to enhance customer satisfaction. The program included a panel of executives who have had experience selling their solutions both under an on-premise model and via SaaS.

In the SaaS model, the provider and the customer are more closely connected. For one, the provider is responsible for delivering the solution over the life of the subscription, in contrast to the on-premise model in which the customer licenses the solution and deploys and manages it on their own.

In the SaaS model, providers and customers are also tightly coupled through the renewal mechanism, by which customers periodically renew their subscriptions. Happy customers are essential for renewals, and high renewals are essential for the provider's success.

The panelists noted several effective marketing practices that have had a positive impact on their SaaS business:

• Their companies closely monitor customer satisfaction through their on-going connection to their customers. They do this through quantitative surveys, as well as through focus groups, observing customer behavior, and close review of support calls.

• Nancie Freitas, CMO of Constant Contact, explained how the company uses customer satisfaction data to drive product enhancements. Customer support reps work closely with engineering to address user issues, and each new release, delivered every two months, is explicitly designed to address flaws identified by customers. Success is measured by gains in the "net promoter score," the number of users who are likely to recommend the product to others.

• Some companies gather aggregate data on customer usage and provide it as benchmarks to their customers. This helps customers better assess their activity and understand best practices.

• Brian Zanghi, CEO of Kadient, explained that they monitor customer usage to identify follow-on sales opportunities. Heavy usage may indicate that the customer is a prospect for additional subscriptions.

SaaS enables - in fact requires - that companies stay closer to their customers. Marketers should take advantage and leverage the insights gained from that on-going connection.

The Risks of Spending Too Little on SaaS Marketing

Though most companies worry about spending too much on sales & marketing, there are also risks in spending too little. In the interests of conserving cash in the short term, companies could be jeopardizing long term success.

I'll talk about two specific types of under-spending risks. I've labeled them 1) climbing a mountain wearing flip-flops, and 2) the Ferrari stuck in the garage.

Climbing a Mountain Wearing Flip-flops

Companies expose themselves to one type of risk by denying sales & marketing the resources they need to complete their required tasks. They're asking them to take on a steep challenge without providing them the proper equipment, like asking them to climb a mountain wearing flip-flops. The company may save money on the footwear (I just bought a pair a flip-flops from Old Navy for $2!), but it's hard to imagine them getting very far on the journey.

Think about what companies are asking from sales & marketing. Here's some of the critical tasks they've been assigned:

• Build visibility in the market
• Establish a positive reputation, market leadership, and credibility
• Generate and cultivate qualified leads
• Prepare effective and timely sales support tools
• Pursue qualified opportunities
• Close new business
• Build loyalty among existing customers
• Secure renewals.
  

Some of these challenges are unique to software-as-a-service (SaaS) companies, making the sales & marketing task particularly difficult. For example, SaaS companies generally need to attend much more closely to their existing customers in order to secure renewals. Also, SaaS companies tend to introduce product enhancements more frequently than on-premise application vendors. These enhancements require more frequent updates to marketing and sales material.

The size of the task explains why most SaaS companies provide relatively high funding for their sales & marketing organizations. For those companies for which financial data is publicly available, they spend, on average, 45% on sales & marketing relative to subscription revenue. In some instances, they spend as high as 82%. Sales & marketing expenses typically account for their single largest budget item.



This high level of spending relative to subscription revenues is inherent in the SaaS model because sales & marketing expenses are generally recognized up-front, while revenues are spread over the life of customer subscriptions.

If your company is spending below that 45% average, you may want to look at whether your sales & marketing organization has the resources it needs. You'll recognize this problem, for example, when over-loaded sales reps are unable to follow up on qualified opportunities, existing customers are unaware of product enhancements, your company is consistently overlooked by influential analysts, or marketing collateral is out-of-date or unavailable.

A Ferrari Stuck in the Garage

SaaS companies expose themselves to a second kind of risk when they under-fund a sales & marketing operation that is well-built and runs efficiently. Efficient sales & marketing operations can generate high lifetime revenues with low customer acquisition costs. (See "Marketing Spend: How Much is Enough," for an extended discussion of this "lifetime customer revenue/customer acquisition costs" ratio.) Under-spending on sales & marketing in this instance means a lost opportunity to leverage an efficient machine.

Top performing SaaS companies can generate more than $10 in lifetime customer revenue for every $1 spent on sales & marketing for customer acquisition. They've built a high-performance vehicle. But if they chose not to fill it with fuel, they'd have the equivalent of a Ferrari stuck in the garage. Their investment would be squandered. The consequences are foregone opportunities for growth and market share.

Short-term Cash Conservation or Long-term Capital Destruction?

In general, I advise that companies be careful with their sales & marketing spending. In fact, I've probably spent as much time in my marketing career poring over "opportunities yielded per program dollar," "mid-funnel conversion" ratios, and other metrics as I have pondering ad layouts or direct mail offers. Companies selling via the SaaS model have little room to spend foolishly on sales & marketing. And companies spending too aggressively on sales & marketing - the Wile E. Coyotes - can quickly get into trouble.

That said, however, companies should also recognize that under-spending exposes them to significant risks as well. Though they may conserve cash in the short term, they may be losing an opportunity to grow even faster. In a market in which 2 or 3 vendors are looking to emerge from a crowd , under-spending could cost visibility and market share. Saving a few thousand dollars in the short term could forfeit a long-term market leadership position and millions in future revenues.

Marketing Spend: How Much is Enough?

Workday, a software-as-a-service (SaaS) provider of HR and financial solutions, raised another $75 million last month to fund growth. This is in addition to $75 million raised in earlier rounds, bringing the total to $150 million in funding.

Workday will probably use some of the new funding to build out its application and its operations and support infrastructure, but I suspect a large portion will be spent on sales & marketing to acquire customers.

Is this amount too much? Too little? Just right?

A formula to assess the level of spending on customer acquisition could be helpful.

Average lifetime value of customer/average cost of customer acquisition

In this formula,

Avg. lifetime value of customer= avg. monthly recurring revenue * avg. length of subscription

and

Avg. cost of customer acquisition = sales & marketing expense/new customers

According to this formula, a calculation yielding "1" would indicate that the cost of acquiring a customer would be equal to the revenues derived from that customer over time. In other words, $1 in customer acquisition expense yields $1 in lifetime revenue.

A number greater than "1" would indicate that customers are contributing more than the costs of acquiring them, and the excess could be applied to fund development, support, operations, and other expenses, or even show a profit. That is, $1 spent on acquiring a customer would generate more than $1 in lifetime revenues from that customer.

A number less than "1" would indicate that the cost of acquiring customers exceeds the revenues they'll contribute over time. SaaS vendors may run at a rate of less than "1" for a period of time, funding the shortfall with debt or outside capital, but it's not sustainable over a long period.

(There are certainly more sophisticated formulas, using gross margin, cash flow analysis and other elements, which would provide indicators for profitability and capital requirements, but in this instance I've opted for simplicity in order to focus on sales & marketing spending. Bessemer Ventures and Joel York are excellent sources for more in-depth financial analysis.)

For illustration, let's run the formula using financial results reported by salesforce.com for the fiscal year ending January 31, 2009.

• Revenues from subscriptions in FY 2009 = $985 million
• Sales & Marketing costs in FY 2009= $534 million
• New customers acquired during FY 2009 = 14,400
• Total customers at Jan. 31, 2009 = 55,400

salesforce.com reports that the average length of a subscription contract is 12-24 months, though I suspect they renew most of these contracts, so the average length of a subscription is much longer. For the sake of this exercise, I'll estimate 5 years.

• Avg. lifetime value of customer= ($985,000,000/55,400 customers) * 5 years =$88,899
• Avg. cost of customer acquisition = $534,000,000/14,400 new customers = $37,083
• Average lifetime value of customer/average cost of customer acquisition = 2.40

Based on these data and my assumptions, for each $1 spent on customer acquisition, salesforce.com generates $2.40 in lifetime customer revenues.



I've calculated the ratio for several publicly-held SaaS companies, using the same estimate of a 5-year customer lifespan.

At the high-end of the scale, athenahealth generates about $10 in lifetime customer revenues for every $1 in sales & marketing costs to acquire a customer.

RightNow, by contrast, generates 40 cents for every $1 spent acquiring a customer.

Use these numbers with caution. For one, they represent only a single year's worth of data and can be skewed by unusual events. Taleo's ratio, for example, is affected by its acquisition of Vurv and its entire customer base in 2008.

More data and deeper analysis would be required to assess the potential profitability, cash requirements or overall financial health of SaaS companies, but the formula does give useful guidance on marketing spending.

• Extending the life of the customer's subscription is critical to success. Be certain to allocate resources to retain your current customers. Losing customers you've already paid for can be disastrous.
• Carefully control spending to maximize effectiveness. To the extent possible, measure the impact of all sales & marketing activity on acquiring or retaining customers. Certainly, this is critical to on-premise vendors as well, but it's especially so for SaaS companies.
• Carefully identify your target prospects and avoid deals that don't offer an adequate potential lifetime value. There's no point in spending $5 to acquire a customer who's maximum potential lifetime value is $3. That's spending money to lose money.
  
• Ensure your pockets are deep enough to carry you while you wait for revenue. Though you're making the sales & marketing investment up front, the returns are spread over the lifetime of the customer. You need to have adequate funding to bridge this mismatch of immediate investment and long-term return.