Category Archives: Startups

Why I’m Against Succession Planning at Startups

I have to admit I’m not a fan of succession planning in general, at startups in particular, and especially when the successee is involved in the process. Why? Because the process quickly ends up presumptuous and political.

In my experience, the successee is more concerned with being a “good guy” on the way out than with what’s best for the business. Consider the retiring CFO of a $500M company. Eighteen months before he wants to retire, he starts succession planning, picks his favorite division-level finance chief, anoints her the chosen one, and starts the grooming process (“one day all this will be yours”). The chosen one starts showing at meetings to which she’s not usually invited, and demonstrates some new swagger with peers.

The CFO eventually retires and the CEO and board replace him not with the chosen one, but with an experienced CFO coming from a $2B company. Feelings are hurt, strong performers are demotivated, and hub-bub generated — all for nothing. The chosen one didn’t even make the first cut of requirements in the job spec. The retiring CFO didn’t (and shouldn’t) get a vote.

The thing to remember with startups (and high-growth companies in general) is that you don’t want to hire the person you need now; you want to hire the person you need three years from now. And the odds that the person you need three years from now is working for the current boss today are pretty low. Put differently (and most certainly when going outside for a hire), the job should grow into the person; the person shouldn’t grow into the job.

The default succession plan for almost any startup executive – including the CEO – is therefore to go hire someone from outside who’s overqualified for the current job. If you wonder why someone overqualified would take the job … well, that’s why the Gods created stock options.

Before you think I’m an anti-career-development cretin, this is not to say that companies should always go outside to backfill key roles. Sometimes people are able to grow within fast-growing organizations. I myself did this as I rose from technical support engineer to director of product marketing over 7 years at a company that grew from $30M to $240M along the way. So I’m all in favor of it; it just doesn’t happen very often. And more often than not, managers who consistently only want to promote from within are actually saying they’re afraid to go outside and find strong direct reports who will challenge them. Remember, I’m talking about patterns and rules here; there will always be exceptions.

The reality is in high-growth startups, just “holding on” to your current management or executive job is both hard enough and a big growth opportunity. Running product management, sales, or HR at $10M is quite different from running it at $300M. During my tenure at Business Objects, as we grew from $30M to over $1B in revenues, only one other team member and myself “held on” during that growth. Out of about 15-20 people that made up the broadly defined leadership team, every other person got replaced, sometimes two or three times, along the way.

That’s why I think succession planning – making plans for how to replace Jane when Jane is healthy, happy, and doing a great job for the company – is a waste of time. Let’s keep Jane focused on growing the business, which is hard enough. If she gets hit by the proverbial bus, well, let’s just deal with that when it happens. We pretty much know what we’re going to do anyway (i.e., call a recruiter).

The best argument against my viewpoint is the case we’ll call Marty. Let’s say Marty would be a great candidate for the CFO job. He’s a great controller, has great leadership skills, and strong business sense — but hasn’t spent much time in FP&A. After Jane gets hit by the bus, we might think “darn, Marty would have been great if we’d moved him into FP&A last year to develop him.”

My two-part response to this is:

  • Yes, sometimes it makes sense and if Marty’s got his act together he’ll be pushing for the FP&A job if it opens up along the way — best developing himself and positioning himself for any eventual CFO opportunity. Since there is always risk associated with any outside hire, Marty should pitch that the risks associated with him learning the job are less than those associated with taking a new person into the organization.
  •  The decision whether to give Marty the job will come down to how fast the company’s growing and whether the company is better off with a talented-but-rookie FP&A head, an internally promoted FP&A manager, or a veteran outsider. Yes, we want to help develop Marty, but if the company’s growing super-fast, then just “hanging on” should provide plenty of development and financial benefit (i.e., stock option appreciation) for him along the way.

Some would note that if we turn down Marty for the FP&A job, he may quit because he feels he has no opportunity for career growth. I understand; I quit a job myself once for that very reason. But I did so in an environment where company growth had stalled and I wasn’t going to get either financial reward or career development for sticking around. If the company is growing fast, then Marty will get both. If it’s not, most of the principles I describe here don’t apply because this post is about succession planning at startups and high-growth companies.

In fact, succession planning makes a lot of sense at low-growth companies, where the organization is static and people move through it. If you want to retain your people over time, you better think about those career paths, and rotate your Marty’s through FP&A to keep them having fun and learning. And, in those environments, the best person to take over for the retiring CFO might well be one of his/her direct reports (and dangling that opportunity might well help retain a few of them along the way).

The real problem is when big company types come to a high-growth company and say “let’s do succession planning (because we did it at my last company and it’s just something that one does)” – and nobody asks why.

Most of the time, in a high-growth startup, it won’t make sense. Or, if you make a succession plan, it will simply be 1-800-HEIDRICK, 1-800-DAVERSA, or 1-800-SCHWEICHLER.

Strategic Focus: I’m Just Trying to Get My Space Together

As a long-time Grateful Dead fan, I have to say that I was advantaged in understanding how the Blown to Bits problem would affect digital media businesses.  You see, for years, the Dead had changed the business model of the music industry, choosing to use “albums” as a loss leader and choosing to make money on live concerts, playing some 2,300 concerts together, not to mention those done individually be band members. (Think:  Jerry Garcia at the Keystone Berkeley.)

steal your face

The Dead even had a “tapers” section at most concerts and sometimes could be heard literally stopping the show to allow someone to move back their microphones.  The Dead have a valid claim to “we did Freemium 30 years before Freemium was cool.”

While I won’t go as far to say that Everything I Learned about Business, I Learned from the Grateful Dead (a good book, by the way, that takes a top ten set of lessons from “the long, strange trip”), I do believe the Dead were both musical and business model innovators.

Improvisation as strategy was profiled in Competing On The Edge:  Strategy as Structured Chaos, published by Harvard Business School press.  Excerpt:

The Grateful Dead met this challenge through improvisation [...] as distinguished by two key properties:  first, performers intensely communicate with each other in real time [...] second, they rely on a few very specific rules, such as who plays first, what are the permitted chords, and who follows whom.

While I’m riffing on the Dead, I should probably also mention Marketing Lessons from the Grateful Dead, a great booking on topics like community, branding, customer centricity, teamwork, category creation, technological innovation, disruptive business models, disintermediation, and giving back.  The Dead, indeed, were innovators in all these areas and the book is well worth reading.

My favorite Dead-related quote, however, comes not from that book but  from The Grateful Dead Movie, in a famous scene where a completely zonked head is ambling around outside the concert and tells a security guard the inimitable:

“I’m just trying to get my space together, so that I can go into the show.”

..

I always think of this guy whenever I talk to a startup about strategy.  Why?  Because startups are very much about trying to get your space together.

  • What space do you want to be in?
  • Against whom do you want to compete?
  • Where do you draw the boundaries on your space?
  • What adjacent spaces, if any, do you want to incorporate into your space?
  • In what adjacent spaces do you want to partner?
  • How do you see the boundaries on your space evolving over time?

My meta-answer to these questions is “the world is a very large place.”  How does that relate?  In two ways.  It means first that you better define your space in such a way that you are truly world-class within it — and not using world-class as a nice sounding compound adjective, but really grokking its meaning:  what can truly be best in the world at doing?  Second, it means that because the world is a big place that you can turn what might appear to be a small niche into a  very big business if you are truly the best at it in the world.  So don’t be afraid to focus.

Most startups forget focus too early and delude themselves into thinking they can be world-class in across a number of areas.  Take enterprise performance management (EPM) — the space in which Host Analytics competes –for example.  EPM is a $4B market for financial analytic applications that is adjacent to the broader $13B business intelligence (BI) market.  Some of our competitors consider themselves addressing the (incorrectly calculated) “$33B BI market” and are either building or acquiring products in the broader BI space?  It sounds good from a total available market (TAM) perspective.  Wow!  You’ve tripled your TAM.

But think for a minute — what are the odds that  your cheaply-acquired or hastily built BI tools are world-class?  None.  So all you’ve really done is dilute your focus on EPM by complementing it with some third-tier BI.  A far better solution (and the one we follow at Host Analytics) is to partner with someone else who is spending all their energy focused on being world-class in the adjacent space.  In our case, that partner is Birst who is focused on being world-class at cloud BI.

So if you’re thinking of starting a company, ask yourself:  what can we really be world-class at doing?

Answering that question is the only way to get your space together, before you go into the show.

Burn Baby Burn: A Look at the Box S-1

I’m pretty busy this week so I was hoping not to dive into the Box S-1, but David Cummings’ excellent summary served only to whet, as opposed to satiate, my appetite.

Perhaps it was the $168M FY14 operating loss.  Maybe it was the $380M in financing raised during the last three years.  Or the average quarterly burn rate of $23M.  But somehow, I got sucked in.

I just had to know their CAC ratio.  Of course, it’s not going to be easy to calculate.  While they give us quarterly S&M expense, that’s only half the equation; we’re going to have a figure out –as best we can — quarterly new annual recurring revenue (ARR).

Billings as a Sales Metric

While many SaaS companies don’t disclose “billings,” Box does — but on an annual basis only — in their S-1.

[Click on the images to see full size.]

box billings

..

Billings is an attempt to triangulate on new sales (or bookings) in a SaaS company.  The standard way to calculate billings is to add revenue plus change in deferred revenue.

The idea is that if you want to know how “sales” went during a given period, then revenue is not a great indicator because, in a SaaS company, revenue is an indicator of how much you sold in prior periods, not the current one.  So you look at deferred revenue trying to pick up the volume of new orders.  The problem is that things quickly get very complicated because (1) deferred revenue is moving both down (as past deals convert into revenue) and up (as new deals are signed) and (2) deferred revenue itself is limited only to deals that are prepaid — if a company does a constant business volume but suddenly starts doing a lot of two-year prepaids, then deferred revenue will skyrocket and if, for example, hard economic times drive loyal customers to ask for bi-annual billing, then deferred revenue will plummet, all without any “real” change in underlying subscription business.  In addition, multi-year non-prepaid deals are invisible from a deferred revenue perspective (because there’s nothing, i.e., no cash prepayment, to defer).

In short, any metric built upon deferred revenue is only as a good as deferred revenue at reflecting the business.

To demonstrate the relationship between billings and new ARR, I built a model which assumes a SaaS company that starts from scratch, increases new ARR added each quarter by $500K (i.e., $500K in its first quarter, $1M in its second, $1.5M in its third), does only one-year prepaid deals, and has a 90% renewal rate.  Here’s what happens.

(You can download the spreadsheet with Box financial summary and the full version of the model here.  Be sure to download as an Excel file, not a PDF.)

generic model

..

While in year one, billings is equivalent to new ARR, as you build up the renewals base, it contributes more to revenue and muddies thing up.  For a company of the above size, growth, and renewal rate, the ratio of new ARR to billings ends up 0.4.

When you take this same model and (manually) force fit the new ARR numbers to try approximate Box’s revenue and billings from 2012-2014, you get:

box like model

..

A CAC of ~1.6

In this case (and given my assumption set) you end up with a new-ARR/billings ratio of 0.6.  To make life easier, I also calculated a new-ARR/revenue ratio (see the full sheet), which ends up around 0.8.  I’ll use to this number to calculate my CAC, which comes out to between 1.5 and 1.8.  While not quite an idyllic 1.o to 1.2, it’s well below 2.0 and helps explain why Box has been able to raise so much money:  their growth has been deemed scalable.

Billings = Ending ARR

In reviewing my models, it’s hard not to notice that billings for a period equals ending ARR for that period.  This turns out to be true under my assumption set of subscription-only (no services), one-year deals only, and everything pre-paid.  Why?  Because for any deal taken at any point during the year, we will recognize some percent of it (X) and the rest (Y) will go to deferred revenue.  The difference between X and Y changes across the year but X+Y= the deal size at all times.

This is not true when you have consulting or do multi-year prepaid deals (which can make billings > ending ARR).  It’s also not true when you do semi-annual billing (which can make billings < ending ARR).

If you assume for any given company that these factors are roughly constant, then even though uniformly inaccurate, it does provide a simple way to approximate new ARR:  take the difference in ending ARR two periods, add a churn assumption, and bang you have new ARR during the period.

Key Metrics, Cashflow, and the P&L

Here are some summarized key metrics (using yellow to highlight points of interest).

box key metrics

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Of note:

  • Year over year growth, while high at 97% is slowly decelerating.
  • Gross margins are nice at nearly 80%
  • Operating expenses are massive:  278% of sales in 1Q12 down to “only” 182% in 4Q14.
  • S&M expense are a seemingly very high 121% of revenues.  This looks bad, but to really know what’s going on we need to examine the CAC, which looks pretty good.
  • Return on sales is -112%
  • That burn rate sure grabs you:  $22M per quarter

In many ways you see a typical “go big or go home” cloud computing firm, burning boatloads of cash but acquiring customers in a reasonably efficient manner and doing a nice job with retention/cross-sell/up-sell as judged by their retention numbers. When you look big picture, I believe they see themselves in a winner-take-all battle vs. DropBox and in this case, the strategy — while amazingly cash consumptive — does make sense.

Here is  a look at cashflow and billings:

box cashflow and billings

..

And last, but certainly not least, here is the P&L:

box p+l

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Of note:

  • I’m always amazed  by the R&D spend of seemingly simple consumer services.  They spent $46M in R&D last year … on what?
  • The $171M in S&M expense sure grabs your attention
  • As does the $168M net loss!

Burn baby burn!

[Revised and expanded 3/27/14 9:18 AM]

# # #

I am not a financial analyst.  I do not make buy, sell, or hold recommendations on stocks.  See my FAQ for affiliations and disclaimers.

To Pre-Meet Or Not To Pre-Meet: That Is The Question

I once asked one of my board members which CEO ran the best board meetings across his portfolio companies.  His answer was, let’s call him, Jack.  Here’s what he said about him:

  • Jack got the board deck out 3-4 days in advance of the board meeting
  • Jack would call him — and every other board member — 2-3 days before each board meeting and walk through the entire deck and answer questions, taking maybe 2 hours to do so.
  • Board meetings with Jack would go very quickly and smoothly because all the questions had been asked in advance.

When I heard this, I thought, well, I have a few issues with Jack:

  • He spends a lot of time managing his board instead of running his business.  (I guess he got his CEO job by managing-up.)
  • He completely violates my “do it in the meeting” principle by having a series of pre-meetings before the actual meeting.

While I may have my doubts about Jack, others don’t seem to.  Consider entrepreneur and VC Mark Suster’s recent post, Why You Shouldn’t Decide Anything Important at Your Board Meetings.  Suster straight out recommends a 30 minute pre-meeting per board member.  Why?

  • Agenda input so you can adhere to the Golden Rule of Board Meetings:  “no surprises.”
  • So you can “count votes” in advance as know where people stand on important and/or controversial issues.
  • So you can use board members to convince each other of desired decisions.
  • Ultimately, because in his opinion, a board meeting is where you ratify decisions that are already pre-debated.

OK, I need to chew on this because, while practical, it violates every principle of how I think companies should conduct meetings — operational ones, at least.  When it comes to operational meetings, nothing makes me grumpier than:

  • Pre-meeting lobbying
  • Post-meeting “pocket vetoes”

My whole philosophy is that meetings should be the place where we debate things and make decisions.  Doing everything in advance defeats the purpose of meeting and risks encouraging political behavior (e.g., “if you vote for my bridge in Alaska, I’ll vote for your dam in Kentucky”), with managers horse-trading instead of voting for ideas based on their merits.

The only thing worse that teeing up everything in advance is what one old boss called the “pocket veto,” where a manager sits in a meeting, watches a decision get made, says nothing, and then goes to the CEO after the meeting and says something akin to “well, I didn’t feel comfortable saying this in the meeting, but based on point-I-was-uncomfortable-raising, I disagree strongly with the decision we reached.”

I remember this happened at Business Objects once and I thought:  “wait a minute, we’ve flown 15 people from around the world (in business class) to meet at this splendid hotel for 3 days — costing maybe literally $100,000 — and the group talked for two hours about a controversial decision, came to resolution, and made a decision only to have that decision overruled the next day.”  It made me wonder why we bothered to meet at all.

But I learned an important lesson.  Ever since then, I flat refuse to overrule decisions made in a meeting based on a pocket veto.  Whenever someone comes to me and says, “well, I didn’t feel comfortable bringing it up in the meeting (for some typically very good sounding reason about embarrassing someone or such), but based upon Thing-X, I think we need to reverse that decision,” I say one thing and only one thing in response:  “well, I guess you should have brought that up in the meeting.”

You see, I believe, based on a bevy of research, that functional groups of smart people make better decisions than even the smartest individuals.  So my job as CEO is to then assure three things:

But I’ve got a problem here because while we know that boards like pre-meetings, operationally I am opposed to both pre- and post-meetings.  Would it hypocritical for to say that pre-meetings are OK for me to conduct with the board, but that managers internally should avoid them?

Maybe.  But that’s what I’m going to say.   How can I sleep at night?  Because I think we need to differentiate between meetings with a decision maker  and meetings of a decision-making body.

Most people might think that the pricing committee, product strategy committee, or new product launch committee are democratic bodies, but they aren’t.  In reality, these are meetings with a decision maker present (e.g., the CEO, the SVP of products) and thus the committee is, perhaps subtly, an advisory group as opposed to a decision-making body.  In such meetings, the decision-maker should want to encourage vociferous debate, seek to prevent pre-meetings and horse-trading, and eliminate pocket vetoes because he/she wants to hear proposals debated clearly and completely based on the merits in order to arrive at the best decision.

However, board meetings are different.  Boards truly are a decision-making bodies ruled by one-person, one-vote.  Thus, while I reject Suster’s advice when it comes to conducting operational meetings (which I believe are inherently advisory groups), I agree with it when it comes to decision-making bodies.  In such cases, someone needs to know who stands where on what.

And that person needs to be the CEO.

Insight Ventures Periodic Tables of SaaS Sales and Marketing Metrics


I just ran into these two tables of SaaS metrics published by Insight Venture Partners (or, more precisely, the Insight Onsite team) and they are too good not to share.

Along with Bessemer’s awkwardly titled 30 Questions and Answers That Every SaaS Revenue Leader Needs to Know, financial metrics from Opex Engine, and the wonderful Pacific Crest Annual SaaS Survey, SaaS leaders now have a great set of reference documents to benchmark their firms.

(And that’s not to mention David Skok’s great post on SaaS metrics or, for that matter, my own posts on the customer acquisition cost (CAC) ratio and renewals rates / churn.)

Here is Insight’s SaaS sales periodic table:

ivp saas sales

And here is Insight’s B2B digital marketing periodic table:

ivp saals mkting

The Customer Acquisition Cost (CAC) Ratio: Another Subtle SaaS Metric

The software-as-a-service (SaaS) space is full of seemingly simple metrics that can quickly slip through your fingers when you try to grasp them.  For example, see Measuring SaaS Renewals Rates:  Way More Than Meets the Eye for a two-thousand-word post examining the many possible answers to the seemingly simple question, “what’s your renewal rate?”

In this post, I’ll do a similar examination to the slightly simpler question, “what’s your customer acquisition cost (CAC) ratio?”

I write these posts, by the way, not because I revel in the detail of calculating SaaS / cloud metrics, but rather because I cannot stand when groups of otherwise very intelligent people have long discussions based on ill-defined metrics.  The first rule of metrics is to understand what they are and what they mean before entertaining long discussions and/or making important decisions about them.  Otherwise you’re just counting angels on pinheads.

The intent of the CAC ratio is to determine the cost associated with acquiring a customer in a subscription business.  When trying to calculate it, however, there are six key issues to consider:

  • Months vs. years
  • Customers vs. dollars
  • Revenue on top vs. bottom
  • Revenue vs. gross margin
  • The cost of customer success
  • Time periods of S&M

Months vs. Years

The first question — which relates not only to CAC but also to many other SaaS metrics:  is your business inherently monthly or annual?

Since the SaaS movement started out with monthly pricing and monthly payments, many SaaS businesses conceptualized themselves as monthly and thus many of the early SaaS metrics were defined in monthly terms (e.g., monthly recurring revenue, or MRR).

While for some businesses this undoubtedly remains true, for many others – particularly in the enterprise space – the real rhythm of the business is annual.  Salesforce.com, the enterprise SaaS pioneer, figured this out early on as customers actually encouraged the company to move to an annual rhythm, for among other reasons, to avoid the hassle associated with monthly billing.

Hence, many SaaS companies today view themselves as in the business of selling annual subscriptions and talk not about MRR, but ARR (annual recurring revenue).

Customers vs. Dollars

If you ask some cloud companies their CAC ratio, they will respond with a dollar figure – e.g., “it costs us $12,500 to acquire a customer.”  Technically speaking, I’d call this customer acquisition cost, and not a cost ratio.

There is nothing wrong with using customer acquisition cost as a metric and, in fact, the more your business is generally consistent and the more your customers resemble each other, the more logical it is to say things like, “our average customer costs $2,400 to acquire and pays us $400/month, so we recoup our customer acquisition cost in six months.”

However, I believe that in most SaaS businesses:

  • The company is trying to run a “velocity” and an “enterprise” model in parallel.
  • The company may also be trying to run a freemium model (e.g., with a free and/or a low-price individual subscription) as well.

Ergo, your typical SaaS company might be running three business models in parallel, so wherever possible, I’d argue that you want to segment your CAC (and other metric) analysis.

In so doing, I offer a few generic cautions:

  • Remember to avoid the easy mistake of taking “averages of averages,” which is incorrect because it does not reflect weighting the size of the various businesses.
  • Remember that in a bi-modal business that the average of the two real businesses represents a fictional mathematical middle.

avg of avg

For example, the “weighted avg” column above is mathematically correct, but it contains relatively little information.  In the same sense that you’ll never find a family with 1.8 children, you won’t find a customer with $12.7K in revenue/month.  The reality is not that the company’s average months to recoup CAC is a seemingly healthy 10.8 – the reality is the company has one very nice business (SMB) where it takes only 6 months to recoup CAC and one very expensive one where it takes 30.  How you address the 30-month CAC recovery is quite different from how you might try to squeeze a month or two out the 10.8.

Because customers come in so many different sizes, I dislike presenting CAC as an average cost to acquire a customer and prefer to define CAC as an average cost to acquire a dollar of annual recurring revenue.

Revenue on Top vs. Bottom

When I first encountered the CAC ratio is was in a Bessemer white paper, and it looked like this.

cac picture

In English, Bessemer defined the 3Q08 CAC as the annualized amount of incremental gross margin in 3Q08 divided by total S&M expense in 2Q08 (the prior quarter).

Let’s put aside (for a while) the choice to use gross margin as opposed to revenue (e.g., ARR) in the numerator.  Instead let’s focus on whether revenue makes more sense in the numerator or the denominator.  Should we think of the CAC ratio as:

  • The amount of S&M we spend to generate $1 of revenue
  • The amount of revenue we get per $1 of S&M cost

To me, Bessemer defined the ratio upside down.  The customer acquisition cost ratio should be the amount of S&M spent to acquire a dollar of (annual recurring) revenue.

Scale Venture Partners evidently agreed  and published a metric they called the Magic Number:

Take the change in subscription revenue between two quarters, annualize it (multiply by four), and divide the result by the sales and marketing spend for the earlier of the two quarters.

This changes the Bessemer CAC to use subscription revenue, not gross margin, as well as inverts it.  I think this is very close to CAC should be calculated.  See below for more.

Bessemer later (kind of) conceded the inversion — while they side-stepped redefining the CAC, per se, they now emphasize a new metric called “CAC payback period” which puts S&M in the numerator.

Revenue vs. Gross Margin

While Bessemer has written some great papers on Cloud Computing (including their Top Ten Laws of Cloud Computing and Thirty Q&A that Every SaaS Revenue Leader Needs to Know) I think they have a tendency to over-think things and try to extract too much from a single metric in defining their CAC.  For example, I think their choice to use gross margin, as opposed to ARR, is a mistake.

One metric should be focused on measuring one specific item. To measure the overall business, you should create a great set of metrics that work together to show the overall state of affairs.

leaky

I think of a SaaS company as a leaky bucket.  The existing water level is a company’s starting ARR.  During a time period the company adds water to the bucket in form of sales (new ARR), and water leaks out of the bucket in the form of churn.

  • If you want to know how efficient a company is at adding water to the bucket, look at the CAC ratio.
  • If you want to know what happens to water once in the bucket, look at the renewal rates.
  • If you want to know how efficiently a company runs its SaaS service, look at the subscription gross margins.

There is no need to blend the efficiency of operating the SaaS service with the efficiency of customer acquisition into a single metric.  First, they are driven by different levers.  Second, to do so invariably means that being good at one of them can mask being bad at the other.  You are far better off, in my opinion, looking at these three important efficiencies independently.

The Cost of Customer Success

Most SaaS companies have “customer success” departments that are distinct from their customer support departments (which are accounted for in COGS).  The mission of the customer success team is to maximize the renewals rate – i.e., to prevent water from leaking out of the bucket – and towards this end they typically offer a form of proactive support and adoption monitoring to ferret out problems early, fix them, and keep customers happy so they will renew their subscriptions.

In addition, the customer success team often handles basic upsell and cross-sell, selling customers additional seats or complementary products.  Typically, when a sale to an existing customer crosses some size or difficultly threshold, it will be kicked back to sales.  For this reason, I think of customer success as handling incidental upsell and cross-sell.

The question with respect to the CAC is what to do with the customer success team.  They are “sales” to the extent that they are renewing, upselling, and cross-selling customers.  However, they are primarily about ARR preservation as opposed to new ARR.

My preferred solution is to exclude both the results from and the cost of the customer success team in calculating the CAC.  That is, my definition of the CAC is:

dk cac pic

I explicitly exclude the cost customer success in the numerator and exclude the effects of churn in the denominator by looking only at the new ARR added during the quarter.  This formula works on the assumption that the customer success team is selling a relatively immaterial amount of new ARR (and that their primary mission instead is ARR preservation).  If that is not true, then you will need to exclude both the new ARR from customer success as well as its cost.

I like this formula because it keeps you focused on what the ratio is called:  customer acquisition cost.  We use revenue instead of gross margin and we exclude the cost of customer success because we are trying to build a ratio to examine one thing:  how efficiently do I add new ARR to the bucket?  My CAC deliberately says nothing about:

  • What happens to the water once S&M pours it in the bucket.  A company might be tremendous at acquiring customers, but terrible at keeping them (e.g., offer a poor quality service).  If you look at net change in ARR across two periods then you are including both the effects of new sales and churn.  That is why I look only at new ARR.
  • The profitability of operating the service.  A company might be great at acquiring companies but unable to operate its service at a profit.  You can see that easily in subscription gross margins and don’t need to embed that in the CAC.

There is a problem, of course.  For public companies you will not be able to calculate my CAC because in all likelihood customer success has been included in S&M expense but not broken out and because you can typically only determine the net change in subscription revenues and not the amounts of new ARR and churn.  Hence, for public companies, the Magic Number is probably your best metric, but I’d just call it 1/CAC.

My definition is pretty close to that used by Pacific Crest in their annual survey, which uses yet another slightly different definition of the CAC:  how much do you spend in S&M for a dollar of annual contract value (ACV) from a new customer?

(Note that many vendors include first-year professional services in their definition of ACV which is why I prefer ARR.  Pacific Crest, however, defines ACV so it is equivalent to ARR.)

I think Pacific Crest’s definition has very much the same spirit as my own.  I am, by comparison, deliberately simpler (and sloppier) in assuming that customer success not providing a lot of new ARR (which is not to say that a company is not making significant sales to its customer base – but is to say that those opportunities are handed back to the sales function.)

Let’s see the distribution of CAC ratios reported in Pacific Crest’s recent, wonderful survey:

pac crest cac

Wow.  It seems like a whole lot of math and analysis to come back and say:  “the answer is 1.

But that’s what it is.  A healthy CAC ratio is around 1, which means that a company’s S&M investment in acquiring a new customer is repaid in about a year.  Given COGS associated with running the service and a company’s operating expenses, this implies that the company is not making money until at least year 3.  This is why higher CACs are undesirable and why SaaS businesses care so much about renewals.

Technically speaking, there is no absolute “right” answer to the CAC question in my mind.  Ultimately the amount you spend on anything should be related to what it’s worth, which means we need relate customer acquisition cost to customer lifetime value (LTV).

For example, a company whose typical customer lifetime is 3 years needs to have a CAC well less than 1, whereas a company with a 10 year typical customer lifetime can probably afford a CAC of more than 2.  (The NPV of a 10-year subscription increasing price at 3% with a 90% renewal rate and discount at 8% is nearly $7.)

Time Periods of S&M Expense

Let me end by taking a practical position on what could be a huge rat-hole if examined from first principles.  The one part of the CAC we’ve not yet challenged is the use of the prior quarter’s sales and marketing expense.  That basically assumes a 90-day sales cycle – i.e., that total S&M expense from the prior quarter is what creates ARR in the current quarter.  In most enterprise SaaS companies this isn’t true.  Customers may engage with a vendor over a period of a year before signing up.  Rather than creating some overlapped ramp to try and better model how S&M expense turns into ARR, I generally recommend simply using the prior quarter for two reasons:

  • Some blind faith in offsetting errors theory.  (e.g., if 10% of this quarter’s S&M won’t benefit us for a year than 10% of a year ago’s spend did the same thing, so unless we are growing very quickly this will sort of cancel out).
  • Comparability.  Regardless of its fundamental correctness, you will have nothing to compare to if you create your own “more accurate” ramp.

I hope you’ve enjoyed this journey of CAC discovery.  Please let me know if you have questions or comments.

What To Do If You’re Winning the Product Evaluation But Losing the Deal

Dear Dave:

I think the art of negotiation is dead. Over the past two years we have won over prospects on our product capabilities, but then lost out on price to inferior products. In all recent cases the prospect never once negotiated with us for a lower cost but clearly their staff preferred our product. I am baffled by the lack interest in negotiation among these generally price-sensitive buyers. It has become a guessing game of sorts for us to figure out what someone can afford. What do you think is going on?

Dear Reader:

I believe the customer is not negotiating because they are not interested in your offering, even at a lower price and despite the fact that the recommending team may strongly prefer your product. I agree that the buyers in your segment are price-sensitive so this may be counter-intuitive, but I also believe the buyers in your segment are quite conservative. So I think you are getting your legs cut out from underneath you “up the chain” at a business level on business issues like risk, “safe choice,” and company size.

While my take is pure speculation it would certainly explain how you can win the product evaluation with the buying team and then lose the deal without even having a price negotiation. So the problem isn’t a lack of interest in negotiation, it’s that your deal is getting killed up the chain, probably by a sales manager or regional VP from a mega-vendor who is hitting both the business buyer and probably the CIO with “safe choice” message. (As in, you aren’t one.)

Thus, I don’t think price experimentation is going to help your problem. In fact, and sorry if this irks you, I’d bet $100 that the customer is paying more – maybe 2-3x more – to buy from the mega-vendor. The customer is, in effect, paying a hefty risk premium on the “nobody ever got fired for buying IBM” logic chain.

So here’s what I recommend to improve your odds:

  • Ask your marketing person to call several recent losses, ask for a debrief, and try to validate this hypothesis. Most important words: “I am not trying to sell you anything, I am researching this issue so we can do better next time.”
  • Get you and your sales team working higher in the organization, and building relationships with the business buyer and the CIO/CTO. I can 100% guarantee you that mega-vendor has these relationships.
  • Once working at that level, inoculate the customer against the safe choice message. Remind them of mega-vendor’s 50% operating margins (“Gee, I guess none of the profit is coming from you; it must be their other customers.”) Document and remind them of the total cost of owning mega-vendor’s solution vs. yours over the lifetime of the project. Shares stories of peer organizations who have been successful with your solution. Offer peer-level, senior business references to validate your claims.

Remember what you are trying to do is de-value the risk premium that the mega-vendor is selling.

  • Mega-vendor’s argument: [1] we might cost 2-3x more, but we will eventually get the job done, and [2] even if we mess it up, remember that no one ever got fired for buying from us.
  • Your argument: [1] why pay 2-3x more for worthless insurance policy – our customers are successful and I can prove it, [2] and while no one ever got fired for buying from mega-vendor, nobody ever got promoted either.

We can deliver this project better/cheaper/faster and tee you up for additional success downstream. To paraphrase the classic old Harvard Business Review direct mailer: isn’t your career about more than not getting fired?

Good luck and let me know how it works out.

What Drives SaaS Company Valuation? Growth!

If you’ve ever wondered what drives the valuation of a SaaS vendor, then take a look at this chart that a banker showed me the other day.

saas valuations 2The answer, pretty clearly, is revenue growth.  The correlation is stunning.   Taking some points off the line:

  • 10% growth gets you an on-premises-like valuation of 2x (forward) revenues
  • 20% growth gets you 3x
  • 30% growth gets you 4x
  • 50% growth gets you nearly 6x

Basically (growth rate % / 10) + 1 = forward revenue multiple.

You might think that profitability played some role in the valuation equation, but if you did, you’re wrong.  Let’s demonstrate this by looking at CY13 EBITDA margins as reported by the same banker:

  • Marketo (MKTO) -44% with a ~4x revenue multiple
  • Marin Software (MRIN) -40% with a ~4x revenue multiple
  • Workday (WDAY) -22% with a ~11x revenue multiple
  • Bazaarvoice (BV) -6% with a ~5x revenue multiple
  • Cornerstone on Demand (CSOD) 0% with a ~8x revenue multiple
  • Qlik Technologies (QLIK) 13% with a ~3x revenue multiple
  • Tangoe (TNGO) 17% with a ~3x revenue multiple

As you can see, there’s basically no reward for profitability.  In real estate what matters is location, location, location.  In SaaS, it’s growth, growth, and growth.

The “Dumb VC” Controversy: Financial vs. Operating VCs

Last week a scathing post by Andy Dunn, the founder of Bonobos, entitled Dear Dumb VC,  generated some stiff controversy in the blog- and Twitter-spheres.  Serial entrepreneur turned venture capitalist Mark Suster, author of the superb Both Sides of the Table blog, weighed in with a long, fact-filled response, entitled As Populist as it May Feel, 98% of VCs Aren’t Dumb that among other things, challenges some of Dunn’s industry math assumptions.

As someone who’s run VC-backed startups for more than 8 years, raised more than $45M in VC, knows many VCs pretty well and several both in their pre- and post-VC incarnations, is an LP in a few funds, and who has both sat on boards and done advisory work to VC-backed startups, I thought I’d weigh in with a few opinions of my own.

The first is that the idea of the “dumb VC” is simply dead on arrival.  I have never met a dumb VC nor do I ever expect to.  To the contrary, VCs are always among the smartest, best educated people I have ever met.  Most of the folks I know have attended some combination of Harvard, Stanford, MIT, or Cal and have both undergraduate and MBA degrees.   Those who come from the technical side often have PhDs in engineering or computer science.  You may like them, you may hate them, you may agree with them or disagree, but let’s just kill right here any concept that VCs aren’t smart.   They are.  And usually very.  Thinking of them as dumb is both incorrect and isn’t going to help you work with them in any way.

I believe the big issue Dunn is circling is that of operating vs. financial venture capitalist.  Let’s define what I mean.

An operating VC is one who comes primarily from an operating background, typically someone who has founded or run one or more startups and brought them to successful exits, often scaling them massively in the process.  Operating VCs add value by drawing on their past experiences.  Entrepreneurs often prefer working with operating VCs because they feel they have walked in their footsteps.  The original VCs on Sand Hill Road were almost exclusively from operating backgrounds (and I think I once heard, the majority from a single fraternity at Stanford).  As one great, first-generation operating VC recently told me:  “venture capital was supposed to be a second career.”  Andreessen Horowitz is particularly vocal on this topic, frequently messaging that its partners are exclusively operators.

A financial VC is one who has limited operating experience and typically entered venture capital as an associate immediately after completing (Stanford, Harvard, MIT) business school.  They typically have undergraduate degrees from stellar institutions along with a 3-5 years of experience, perhaps in product management at a company like Google or VMware.  Life is tough for financial VCs at the start — a lot of them die off trying to work their way to partner.  Because they are both young and lack significant operating experience, few CEOs want them on their board.  For this reason, they are often paired with senior partners and on a good day the senior partner attends the board meeting with the associate.  Financial VCs typically work by “pattern matching” — i.e., they draw on their experience sitting across 10+ boards and look for patterns and best practices.

In recent years, I have observed a back-to-the-roots movement driving two key changes in how Silicon Valley works:

  • VCs are much more founder-friendly.  Founders are not seen as disposable CEOs who will inevitably be moved to a CTO role.  This reverses a prior decade leaning the other way, typified by EIRs seen by founders as CEOs in waiting (or lurking).
  • Operating VCs are more in fashion than financial VCs.

While there are many things I like about the back-to-the-roots movement, I think pendulum needs to be in the middle.  Yes, some of Silicon Valley’s most successful CEOs (e.g., Larry Ellison, Steve Jobs) were founders.  But also yes, some brilliant technical founders turn out to be terrible managers.  While the fathers of venture capital may have been heavily operating guys, some of today’s Kings of Sand Hill Road more closely match my description of financial VC than operating VC.

For example, John Doerr of Kleiner Perkins got his Harvard MBA in 1976, had six years of sales experience at Intel, and then joined the Kleiner in 1980.  Doug Leone of Sequoia had sales experience at Prime, Sun, and HP and joined Sequoia in 1988 after getting his MS in management from MIT Sloan.  While I don’t know John Doerr, anyone who wants to argue that Doug Leone is either dumb or can’t add value will last approximately 5 nanoseconds before evaporating into a puff of smoke.

Operating VCs are useful to the extent their operating backgrounds and the situations they faced are relevant to your company’s today.  However, they risk getting stuck in the past, doling out stale advice that worked 20 years ago but is irrelevant today.  Financial VCs are useful to the extent they have humility and offer advice based on the patterns and trends they see today.

In the end, the facts of the case are simple:

  • All VCs are smart — usually very.
  • Operating VCs add value in different ways than financial VCs.
  • All VCs, once they become your investors, are definitionally trying to help your company.

I want to close on the last point because the “dumb VC” post seems to miss it — whether you, as a founder or CEO, perceive the VCs on your board as actually helping, I can guarantee you that they are trying.  Rather than blaming them for their misguided efforts, I would direct you to this other amazing Both Sides of the Table post, entitled 8 Tips on How to Get the Most out of Your Board.

In the end, no one forces you to raise venture capital.   You choose to do so.  As part of that choice, you are taking VCs onto your board.  Like you, those VCs want to maximize the value of your company.  Your job as CEO is to work with them to do so.  If that doesn’t work in the end, it’s your fault — not the board’s — because as CEO your job is to work with your board to drive the company to the desired result.

Lifers, FBI guys, and Acquired CEOs

Since I’ve had the good fortune to work at small, large, and small-that-became-large software companies, people sometimes ask me about the pro’s and con’s of working at companies of different sizes.

Let’s start with the basics.  At a small company:

  • You generally see more of the business and can learn more horizontally.
  • You typically have more opportunities for vertical growth (i.e., moving up the chain within your function), particularly if the company is growing quickly.
  • You can often, but certainly not always, make more money on the stock.  Though be careful about assumptions here, I’ve seen small companies that are very cheap with stock and I’ve seen big ones where a GM can roughly equal a startup CEO in terms of equity upside, and with probably higher expected value (if lower variance).
  • You are more hands-on, doing things yourself as opposed to working through others.

At a big company:

  • You can learn more deeply, as large departments are typically filled with deep experts in their domains
  • You get leverage, both in the sense that you can drive programs through others and that in the sense that things are driven for you.  For example, at Salesforce, the amazing customer briefing center machine made it so I could see 3-5 customers / week without leaving the building.  What a great baseline from which to build.
  • You spend relatively more time selling decisions and relatively less time making them.  This can be frustrating if you are the kind of person that, once convinced, wants to go execute.  It can be fun if you like selling ideas internally.
  • You have more opportunities for lateral growth.  At larger companies, I’ve seen the customer success leaders moved into sales, product managers moved into sales ops,  or product marketers moved into HR.  The basic pattern is that once proven a “great person” then a big company is typically more willing to let you try something new.

The biggest disadvantage of bigger companies relates to power, access, and the ability to get things done.  Based upon my own experiences (and a recent coffee with an old friend), I believe that three — and only three — types of people have any real power at a larger $1B+ software company:

  • Lifers.  The inner circle of top managers who have helped build the company and who possess a vast institutional memory.  The more the CEO is  him/herself a lifer the more powerful this group.    For a newly hired executive, this can be a very difficult group to penetrate because the trust, relationships, and shared experiences have often built up across a decade or more.
  • FBI guys.   Companies hire FBI guys when they are either in trouble or simply distrustful of the ability of the lifers to scale with the business.  I call them FBI guys because they are seen as proven experts, and assumed more qualified than those who built the business due to their previous experience in larger companies.  The most non-nonsensical example of this I ever saw was at BusinessObjects when we hired the head of BI from a mega-vendor to a key position on our product team.  (I protested:  “isn’t this the person we just beat over the past decade, despite their having every structural advantage over us?”)    The more common flavor of FBI guy is the entourage that often travels with a new executive.  The other reason I call these people FBI guys because of this scene from Die Hard which reminds us that things don’t always work out so well when you bring them in.

  • Acquired CEOs.   The only other group I’ve seen that consistently has power is the CEOs of acquired companies.  This group has power for several reasons:  (1) because they are often highly expert in their area, (2) because they are seen to have vision and/or dynamism that their big company peers may lack, (3) because the company wishes to retain them beyond the expiration of any handcuffs, (4) because they may have been acqui-hired in the first place, and (5) because some big companies feel like they can “stay young” by injecting entrepreneurs into their corporate bloodstreams.

So let’s distill all this into a few rules.

  • If you’re a lifer, great.  Don’t take for granted that you’ve been a key part of building a great company.  As I used to tell friends who I thought were leaving BusinessObjects too early:  “good waves are hard to find; if you’re on one, ride it to the beach.”  At some point I’d argue that you probably should leave, try something new, and challenge yourself — but do that only once you’re sure you’ve gotten 90% of the value (both learning and money) that you think you can get.  Meantime, be nice to the new executives (except the FBI guys) as you probably can’t easily understand how hard penetrating the group can be for them.
  • If you’re an FBI guy, be humble.  No one likes people who show up with all the answers.  Ask questions for your first 90 days instead of preaching about what worked at BigCo.  When you start implementing decisions, explain from first principles why you think they are good ideas (and never say “because we did it this way at BigCo.”)  Don’t be exclusive and hang out with the old BigCo gang only or spend hours telling the BigCo stories from the good old days that are meaningless to most of those around the  table.  Don’t compare the past to the present because you weren’t there in the past and definitionally can’t know how things really operated.
  • If you’re an acquired founder/CEO, then go make your impact.  You may have significantly more power than you know.  Go leverage it to make a difference.
  • If you’re weighing career options, don’t forget to map your memories to your past role.  If you loved being a lifer at your last company, remember that in joining a new one you’ll be a new guy.  If you were an FBI guy, brought in by a new CEO, remember that unless you’re traveling together again, that you’ll just be a regular new executive.  If you were an acquired CEO who had a great experience at the big company that acquired you, remember that if you just hire-on that your experience may likely be different.