Here is a short summary of Bessemer’s excellent document (first released in 2010, revised in 2012) for any cloud-based SaaS company. (Read/download the full article here.)
1. Drink Your Own Champagne
Drink it, live it, love the cloud. Use your own product, and that of your customers, partners, and peers. You need to understand the issues, challenges, and opportunities with cloud deployments – starting with your own. If you have a product that touches end users, then end users within your company should be power users of the product. You should all become experts in the strengths and weaknesses of your product, and be able to discuss customer issues and roadmap priorities in some detail. Most of our cloud portfolio companies are power users of their own products and even those of their competitors. Similarly, you should leverage the cloud for your internal systems. This will not only give you a direct understand- ing of the customer experience and best-of-breed strategies of cloud businesses, but it will free up your technical resources and balance sheet to focus on your core product and customers.
2. Build for the Doer, Build Employee Software
Employees are now powerful customers themselves, and not just through their managers. Customers use rich internet applications including Facebook and Skype to communicate with their friends; LinkedIn to manage their business networks, Google or Wikipedia to find accurate online content, Yelp to find restaurants, and Travelocity to book flights. Your customers are now looking for similar “cheap and cheerful” products in an open revolt against the years of oppression by the likes of SAP and Oracle. You should therefore beg, borrow, and follow: take inspiration from the best online products you can find and leverage the fact that you’re naturally smaller and more nimble than the incumbents to provide the best user experience imaginable. Individual employees and mid-level managers can now take out their corporate credit card and expense products, and are becoming direct consumers in the process. The best possible way to land a large enterprise customer is to call up the CIO and say “we’re excited by how much you like our product and we’re happy to note that we now have several hundred users of our product within your corporation. We wondered if you were interested in rolling these into an enterprise license with the administrative dashboard, integration to your other systems, coordinated billing, provisioning and security?”
3. Death of the suite; long live best-of-breed/best-of-feature
Since the internet is the common underlying infrastructure, deployments can now be done in days or weeks, and service ratios are a small fraction of the software subscription costs. This means that with Cloud Computing, the pendulum is swinging back to best-of-breed, and away from integrated suites. Better APIs are now allowing users and developers to literally leverage only the best product services, including the ultimate consumerization of software down to the “best-of-feature” level. This fragmentation means more choices and more pricing transparency for end users and application developers alike. For the foreseeable future, companies won’t claim to address all (or even most) of the application needs of an enterprise, but will instead carve out multiple vertical slices for an enterprise and then highlight preferred ecosystem partners to fill the gaps. The entire software landscape is now open. It’s the great land rush. Now’s your chance to plant your flag and claim a valuable plot of land in the software landscape, while the incumbents are giving it away.
4. Grow or Die
In technology, very few things remain constant. As a result, you either grow up to become a dominant company in your category, or get passed by and killed off by someone who does accomplish this goal. Not surprisingly, growth rate is often the biggest driver of valuation multiples in both private and public markets. Investors, employees, and partners aren’t buying into your current company as much as they are investing into some future version of your business, and growth rate determines the size of the business, at that future period. The power of compounding numbers is straightforward but still surprising, when you consider that a $1M business that grows 100% each year will be a $1B revenue business within 10 years, whereas the same business growing at 10% per year will reach less than $2.6M in revenue a decade later. As a senior executive of a cloud business, you will likely want investors to pay you a huge valuation based on current financial metrics, and you will need to convince prospective employees to walk away from rich cash compensation packages from others in exchange for the potential upside of options for your stock. How do you do this? Present a credible plan for capital efficient hyper-growth.
5. The 5 Cs of Cloud Finance
1. CMRR, ARR, & ARRR – Committed Monthly Recurring Revenue, Annual Recurring Revenue, and Annual Run Rate Revenue. Many 1st generation cloud businesses turned to TCV (Total Contract Value) or ACV (Annual Contract Value) as their top level metric as a carry-over from the legacy software world of tracking “bookings.” In the Cloud Computing world, these metrics can be easily manipulated and are often misleading, and therefore we recommend much more focused metrics around the recurring revenue in a normalized time period. TCV and ACV are flawed for many reasons, most notably with regard to duration and services. If your renewal rates are strong, then contract duration isn’t a major variable, whereas cash collection and the size of the monthly subscription will massively impact your business (see points on Cash Flow and Churn below). Therefore, a focus on TCV has a tendency to encourage sales professionals to focus on longer term (often multi-year) deals to push up TCV, instead of pushing on the more important elements of monthly subscription value and cash pre-payments. ACV does help to reduce this over-emphasis on duration by just focusing on the first year of the deal, but shares the second major flaw that TCV is also burdened with, which is an over-emphasis on services revenue as part of the “contract value.”
For example, here are two deal options, which would you pick?
Deal A: 6 month prepaid contract; renews monthly; $10k monthly subscription; $10k services. (TCV: $70k,
ACV: $130k, CMRR: $10k)
Deal B: 3 year contract; 3 months prepaid; $5k monthly subscription; $80k services. (TCV: $195k, ACV: $140k, CMRR: $5k)
Despite lower TCV and ACV, Cloudonomics says you should pick Deal A every time. Deal A will gross ~$370k of revenue over 3 years, whereas Deal B will only gross ~$260k. Deal A will also likely be much higher gross margin given the lower services ratio. In fact, there are only two reasons to even consider Deal B and they are related to Churn Risk and Cash Flow, but we also attempt to correct those misconceptions later in this paper. In almost every case, CMRR is the single most effective metric.
CMRR: This single metric gives you the purest forward view of the “steady state” revenue of the business based on all the known information today. The monthly focus also tends to drive many positive behavioral changes within a team in- cluding a monthly sales and development cadence, better sales compensation plan and cash flow alignment, reduced customer price sensitivity, and heightened awareness around small MRR changes. Many leading cloud companies therefore use CMRR as the basis for everything from the financial model to the sales commission plan. This is the single most important metric for a cloud business to monitor, as the change in CMRR provides the clearest vis- ibility into the health of any cloud business.
ARR; ARRR: For external purposes, you will likely want to highlight slightly different versions of these metrics: the Annual Recurring Revenue (ARR) and Annual Run Rate Revenue (ARRR). ARR is simply the currently recognized portion of this, multiplied by twelve. ARRR is the ARR, plus any non-recurring revenue related to items such as professional services, transactions, and implementations. These external “vanity” metrics can help drive home the run rate scale of your business, especially when used to describe the forward business model. Your current CMRR may be $1.75M and projected to grow to $2.17M at year end, so for external audiences you may get maximum impact by summarizing the business plan by saying: “As we exit this year our Annual Run Rate Revenue (ARRR) should cross $30M, which includes $26M of Annual Recurring Revenue (ARR).”
2. Cash Flow – Start with Gross Burn Rate and Net Burn Rate, then hopefully turn to Free Cash Flow over time. CMRR gives you a great sense for the revenue health of the business, but can very often be disconnected from the “cash health” of the business. As any scrappy entrepreneur will tell you, a business will live or die based on its cash management in the early days, and therefore detailed cash metrics are also needed.
Gross and Net Burn Rate: (Cash flow) metrics are critical for cloud businesses because the working capital require- ments are higher and the payment terms are often back end weighted. Gross Burn Rate is all of the expenses paid for in the month including debt and finance charges. Net Burn Rate is simply all cash received during the month minus all the expenses, which nets out to the cash burned in the month. These numbers are obviously lumpy based on the timing of collections and payables, so many companies further refine this by adding a “rolling 3 month average” Burn Rate set of metrics. Cloud businesses typically show significant positive Free Cash Flow (FCF) long before they turn GAAP EBIT positive, so hopefully you will be able to flip your Burn Rate (negative cash flow) metric to a positive one as you grow, and start tracking FCF instead.
CAC – Customer Acquisition Cost Payback Period. The CAC Payback is a statement in months, of the time to fully pay back your sales and marketing investment. This is worthy of much more detail and therefore broken out further in Law #6 later in this paper.
CLTV – Customer Lifetime Value. CLTV is the net present value of the recurring profit streams of a given customer less the acquisition cost. Part of the attraction of Cloud Computing business models is that once you have repaid the initial Customer Acquisition Costs (CAC), the cash flow and profit streams from customers can be quite attractive. However, whereas the CAC ratio can at least ensure that you recover your incremental sales and marketing costs on each customer, it still doesn’t tell you if these customers are highly profitable over time. To measure this, many customers have modified the consumer internet concept of lifetime value, into a similar cloud CLTV metric. To simplify the calculation, let’s assume that a customer generates $10,000 of annual re- curring revenue for a company with a CAC Payback ratio of 12 months, a 70% Gross Mar- gin and 10% each of R&D and G&A costs. The $10,000 of revenue will generate $7,000 of gross margin and $5,000 of profit each year ($7,000 less $1,000 of R&D and $1,000 of G&A costs). Over 5 years, this customer will generate $25,000 of profit (5 years x $5,000/ year). A CAC Payback ratio of 12 months means a $7,000 upfront acquisition cost, making the CLTV equal to $25,000-$7,000= $18,000 Obviously if the retention period is longer, and/or you benefit from net positive CMRR renewal rates that actually grow your average customer relationship over time, these numbers can be much larger.
Churn & Renewal Rates – Logo Churn, CMRR Churn, and CMRR Renewed.
Cloud executives need to track renewal rates in detail to capture “logos lost” (lost customers) as well as the percentages of CMRR renewed and lost. The standard approach is three key sub-metrics, all related to this concept of renewal rate:
Logo Churn %: This is a percentage calculation of all your customer names (“logos”) that have churned over the measured time period. If you started the year with 500 customers and 460 of them were still paying customers at some level at the end of the year, then you have churn of 40 customers and your annual Logo Churn is 8% (40/500).
CMRR Churn %: This is a percentage calculation of all your customer CMRR that has been lost over the measured time period. If you started the year with $500k of CMRR for your same 500 customers, and the 40 customers that churned represented $30k of CMRR at the start of the year, then your Base CMRR Churn Rate is 6% annually ($30k of starting CMRR churned/$500k of starting CMRR).
CMRR Renewal %: This is a percentage calculation of the total CMRR of your renewed customers at the end of the year, divided by the total CMRR of your existing customers at the beginning of the year. Of your 460 renewed custom- ers, if they have been upsold on new products and grown in their usage of the product during the year to the point where their CMRR equals $550k in total, then your Total CMRR Renewal Rate is 110% ($550k end of year CMRR just from customers who were on board at the start of the year/$500k CMRR of all customers at start of year).
6. Only invest aggresively if you have a short CAC Payback Period
The CAC Payback Period is now a statement in months, of the time to fully pay back your sales and marketing investment. This single number is the key to determining your level of sales and marketing investment. It can be calculated simply by dividing the sales and marketing costs of the previous time period (typically a month or a quarter) excluding any account management costs attributed to your “farmer” organization, divided by the new CMRR gross margin added during the same time period (forget the effect of churn and upsells for now).
As an example, if your company added $100k of CMRR in a quarter with 70% gross margins, the denominator would be $70k. If your fully burdened quarterly sales and marketing costs were $770k then that would be the numerator. The CAC Payback Period would equal an encouraging 11 months.
For SMB customers with higher churn rates and thus shorter monetization windows, CAC Payback Periods of 6-18 months are typically needed, whereas enterprise businesses with high upsells and long retention periods may be able to subsidize payback periods of 24-36 months in some cases. A CAC Payback Period of 36+ months is typically a cause for concern and suggests you may want to slam on the brakes until you can improve sales efficiency, whereas a Pay- back Period of under 6 months means you should invest more money immediately and step on the gas (and please call Bessemer immediately because we want to fund you!) as your customers are likely very profitable within the first year.
The Sales Learning Curve
The Sales Learning Curve (SLC), a concept Mark Leslie helped pioneer at Veritas, is that software organizations often fail because they staff up their sales efforts too quickly, before the sales model has been refined. This concept is even more critical for cloud businesses, given the large upfront investment required to acquire customers. Ramping up too quickly will burn precious cash reserve and may fool the product team into missing some critical elements of the real product/market fit that will be important to go big over time. This typically means you should hire sales reps slowly up front, only focus on your core geography until your business starts to scale considerably, and separate your “hunters” and “farmers” as you start to ramp. For an enterprise-oriented direct sales business, it typically takes at least $300,000 CMRR to climb the Sales Learn- ing Curve. You should tune your model before you scale, which typically means stopping at three field sales reps until you hit at least $300,000 CMRR or at least two of your reps are making their ~$100,000 CMRR quotas.
7. Make online sales and marketing a core competency
You’re a cloud business, so by definition, your sales prospects are all online. Savvy online sales and marketing is a core competency (sometimes the only one) of every successful cloud business. Numerous studies show that your customers are now doing most of their primary research online, and this should not surprise you.You should therefore be aggressive in marketing to them online. This is a clear example where business-to-business (B2B) marketers need to learn from their business-to-consumer (B2C) counterparts. The most innovative B2C companies are lead generation machines, leveraging social media marketing, search engine optimization (SEO), viral marketing, search engine marketing (SEM), email marketing, and other technically-advanced methods. Whether they use an automated product like Eloqua or a team of marketing analysts and spreadsheets, online marketing and demand generation is a “must have” for cloud companies. At the marketing executive’s fingertips should be detailed reports showing pipeline sources, costs per lead, funnel conversion rates by stage, costs per acquisition by source and campaign, effectiveness by channel, and so on. If you are the CEO or a Board member, you should review these reports closely and make them the basis for assessing marketing effectiveness and performance.
A strong head of online marketing will also be able to give you detailed demand generation forecasts based on different budget levels. It’s important to understand the natural limits of organic traffic as well as the slope of the supply curve for each of your various paid lead sources. Your blended cost per lead may be very attractive, but if a large portion is organic/free traffic and your marginal cost of an incremental paid lead is quite high, then you may not be able to scale marketing spend in an efficient manner. If SEM is a lead source, you should study the quantity and pricing of your main keywords and do burst testing to validate the assumptions before dramatically increasing budgets. If these data are good, highlight them to your prospective investors. We love to find businesses with 6 month CAC paybacks and the capacity to absorb 10x more marketing spending.
8. The most important part of Software-as-a-Service isn’t “Software” it’s “Service”
There are also service events that are significant negative events for you and your customers, but can be turned into positives if handled correctly. Outages are the most notable, but bumpy product upgrades, faulty product configurations, and weak integrations can all create similar issues. Amazon Web Services (AWS) is a fantastic IaaS platform, but has ex- perienced several very public outages in its availability zones with very direct impact on customers.
Professional services groups are getting smaller in modern cloud companies – and even non-existent in some – but can still play a vital role in customer onboarding, configurations, and integrations when needed. The goals and objectives of these three func- tions are very different, and the skill sets of the top performers in these functions are typically very different, so it is likely a cloud company will want to split these functions out into 2 or 3 different organizational groups as you scale from 50 to 100+ people and can afford to hire specialists. Each of these functions should work with the technical team to enable proactive monitoring of the product for likely churn or upsell opportunities. You can easily check who logs into your product, how often, what they do inside the product, and what results they achieved. So now you need to track the key usage metrics and measures, and create internal dashboards to know which customers are getting the most value (potential upsell candidates) and which are likely to churn (time to intervene proactively).
9. Culture is key as you build your dream team
In terms of the other elements of talent management, three personality traits that we see our best CEO’s repeatedly screen for are: 1) a clear pattern of success 2) a will to win and 3) self critical and accepting of failure. In terms of success, it often doesn’t matter as much where the candidate is coming from previously as that they have been a part of success. This often includes the obvious (Salesforce.com, VMWare, etc.) but increasingly includes success in other industries or fields such as Google, NASA, Cal, sports, or the military.
10. Cash is (still) king – Cloudonomics requires that you focus on cash flow above operating profits, and plan your fuel stops very carefully
Understanding the cash flows of your business – including Gross and Net Burn Rate – is critical to survival in the early days and critical to your dominance in the long term. There have been many promising cloud startups that stepped on the gas too early and were wiped out as a result. Always model the business with a comfortable cash cushion and recog- nize that most cloud businesses paradoxically consume more short-term cash as growth accelerates. As a business, it is critical to weigh forward investments carefully. Cloud businesses typically require multiple rounds of investment and a good amount of capital. For example, it took $126M for NetSuite to go public, $61M for Salesforce.com, $41M for Eloqua, and $45M for Cornerstone OnDemand.