Category Archives: upsell

New ARR and CAC in Price-Ramped vs. Auto-Expanding Deals

In this post we’re going to look at the management accounting side of multi-year SaaS deals that grow in value over time.  I’ve been asked about this a few times lately, less because people value my accounting knowledge [1] but rather because people are curious about the CAC impact of such deals and how to compensate sales on them.

Say you sign a three-year deal with a customer that ramps in payment structure:  year 1 costs $1M, year 2 costs $2M, and year 3 costs $3M.  Let’s say in this example the customer is getting the exact same value in all 3 years (e.g., the right for 1,000 people to use a SaaS service) – so the payment structure is purely financial in nature and not related to customer value.

Equal Value:  The Price-Ramped Deal
The question on my mind is how do I look at this from a new ARR bookings, ending ARR, CAC, and sales compensation perspective?

GAAP rules define precisely how to take this from a GAAP revenue perspective – and with the adoption of ASC 606 even those rules are changing.  Let’s take an example from this KPMG data sheet on ASC 606 and SaaS.

(Price-Ramped) Year 1 Year 2 Year 3
Payment structure $1M $2M $3M
GAAP revenue $1M $2M $3M
GAAP unbilled deferred revenue $5M $3M $0M
ASC 606 revenue $2M $2M $2M
ASC 606 unbilled accounts receivable $1M $1M $0M
ASC 606 revenue backlog $4M $2M $0M

When I look at this is I see:

  • GAAP is being conservative and saying “no cash, no revenue.” For an early stage startup with no history of actually making these deals come true, that is not a bad position.  I like the concept of GAAP unbilled deferred revenue, but I don’t actually know anyone who tracks it, let alone discloses it.  Folks might release backlog in some sort of unbilled total contract value (TCV) metric which I suspect is similar [2].
  • ASC 606 is being aggressive and mathematical – “hey, if it’s a 3-year, $6M deal, then that’s $2M/year, let’s just smooth it all out [3]”. While “unbilled A/R” strikes me as (another) oxymoron I see why they need it and I do like the idea of ASC 606 revenue backlog [4].  I think the ASC 606 approach makes a lot of sense for more mature companies, which have a history of making these deals work [5].

Now, from an internal, management accounting perspective, what do you want to do with this deal in terms of new ARR bookings, ending ARR balance, CAC ratio, and sales comp?  We could say:

  • It’s $2M in new ARR today
  • Ergo calculate this quarter’s CAC with it counted as $2M
  • Add $2M in ending ARR
  • Pay the salesrep on a $2M ARR deal – and let our intelligently designed compensation plan protect us in terms of the delayed cash collections [6] [6A]

And I’d be OK with that treatment.  Moreover, it jibes with my definition of ARR which is:

End-of-quarter ARR / 4 = next-quarter subscription revenue, if nothing changes [7]

That’s because ASC 606 also flattens out the uneven cash flows into a flat revenue stream.

Now, personally, I don’t want to be financing my customers when I’m at a high-burn startup, so I’m going to try and avoid deals like this.  But if I have to do one, and we’re a mature enough business to be quite sure that years 2 and 3 are really coming, then I’m OK to treat it this way.  If I’m not sure we’ll get paid in years 2 and 3 – say it’s for a brand-new product that has never been used at this scale – then I might revert to the more GAAP-oriented, 1-2-3 approach, effectively treating the deal not as a price ramp, but as an auto-expander.

Increasing Value:  The Auto-Expanding Deal
Let’s say we have a different use-case.  We sell a SaaS platform and year 1 will be exclusively focused on developing a custom SaaS app, we will roll it to 500 users day 1 of year 2, and we will roll it to 500 more users on day 1 of year 3.  Further assume that the customer gets the same value from each of these phases and each phase continues until the end of the contract [8].  Also assume the customer expects that going forward, they will be paying $3M/year plus annual inflation adjustments.

Oy veh.  Now it’s much harder.  The ramped shape of the curve is not about financing at all.  It’s about the value received by the customer and the ramped shape of the payments perfectly reflects the ramped shape of the value received.  Moreover, not all application development projects succeed and if they fall behind on building the customized application they will likely delay the planned roll-outs and try to delay the payments along with them.  Moreover, since we’re an early-stage startup we don’t have enough history to know if they’ll succeed at all.

This needs to be seen as an auto-expanding deal:  $1M of new-business ARR in year 1, $1M of pre-sold upsell ARR in year 2, and another $1M of pre-sold upsell ARR in year 3.

When you celebrate it at the company kickoff you can say the customer has made a $6M commitment (total contract value, or TCV [9]) to the company and when you tier your customers for customer support/success purposes you might do so by TCV as opposed to ARR [10].  When you talk to investors you can say that $1M of next year’s and $1M of the subsequent year’s upsell is already under contract, ergo increasing your confidence in your three-year plan.  Or you could roll it all together into a statement about backlog or RPO [11].  That part’s relatively easy.

The hard part is figuring out sales compensation and CAC.  While your rep will surely argue this is a $2M ARR deal (if not a $3M ARR deal) and that he/she should be paid accordingly, hopefully you have an ARR-driven (and not a total bookings-driven) compensation plan and we’ve already established that we can’t see this as $2M or $3M ARR deal.  Not yet, at least.

This deal is a layer cake:  it’s a three-year $1M ARR deal [12] that has a one-year-delayed, two-year $1M ARR deal layered atop it, and a two-year-delayed, one-year $1M ARR deal atop that.  And that, in my opinion, is how you should pay it out [13].  Think:  “hey, if you wanted to get paid on a three-year $3M ARR deal, then you should have brought me one of those [14].”

Finally, what to do about the CAC?  One might argue that the full cost of sale for the eventual $3M in ARR was born up-front.  Another might argue that, no, plenty of account management will be required to ensure we actually get the pre-sold upsell.  The easiest and most consistent thing to do is to treat the ARR as we mentioned (1+1+1) and calculate the CAC, as you normally would, using the ARR that we put in the pool.

If you do a lot of these deals, then you would see a high new-business CAC ratio that is easily explained by stellar net-dollar expansion rates (173% if these were all you did).  Think:  “yes, we spend a lot up-front to get a customer, but after we hook them, they triple by year three.”

Personally, I think any investor would quickly understand (and fall in love with) those numbers.  If you disagree, then you could always calculate some supplemental CAC ratio designed to better amortize the cost of sale across the total ARR [14].  Since you can’t have your cake and eat it too, this will make the initial CAC look better but your upsell CAC and net-dollar expansion rates worse.

As always, I think the right answer is to stick with the fundamental metrics and let them tell the story, rather than invent new metrics or worse yet, new definitions for standard metrics, which can sow the seeds of complexity and potential distrust.

# # #

Notes

For more information on ASC 606 adoption, I suggest this podcast and this web page which outlines the five core principles.

[1] I am not an accountant.  I’m a former CEO and strategic marketer who’s pretty good at finance.

[2] And which I like better as “unbilled deferred revenue” is somewhat oxymoronical to me.  (Deferred revenue is revenue that you’ve billed, but you have not yet earned.)

[3] I know in some cases, e.g., prepaid, flat multi-year deals, ASC 606 can actually decide there is a material financing event and kind of separate that from the core deal.  While pure in spirit, it strikes me as complex and the last time I looked closely at it, it actually inflated revenue as opposed to deflating it.

[4] Which I define as all the future revenue over time if every contract played out until its end.

[5] Ergo, you have high empirical confidence that you are going to get all the revenue in the contract over time.

[6] Good comp plans pay only a portion of large commissions on receipt of the order and defer the balance until the collection of cash.  If you call this a $2M ARR deal, you do the comp math as if it’s $2M, but pay out the cash as dictated by the terms in your comp plan.  (That is, make it equivalent to a $2M ARR deal with crazy-delayed payment terms.)  You also retire $2M of quota, in terms of triggering accelerators and qualifying for club.

[6A] This then begs the question of how to comp the $1M in pre-sold upsell in Year 3.  As with any of the cases of pre-sold upsell in this post, my inclination is to pay the rep on it when we get the cash but not on the terms/rates of the Year 1 comp plan, but to “build it in” into their comp plan in year 3, either directly into the structure (which I don’t like because I want reps primarily focused on new ARR) or as a bonus on top of a normal OTE.  You get a reward for pre-sold upsell, but you need to stay here to get it and you don’t year 1 comp plan rates.

[7] That is, if all your contracts are signed on the last day of the quarter, and you don’t sign any new ones, or churn any existing ones until the last day of the quarter, and no one does a mid-quarter expansion, and you don’t have to worry about any effects due to delayed start dates, then the ARR balance on the last day of the quarter / 4 = next quarter’s subscription revenue.

[8] Development is not “over” and that value released – assume they continue to fully exploit all the development environments as they continue to build out their app.

[9] Note that TCV can be seen as an “evil” metric in SaaS and rightfully so when you try to pretend that TCV is ARR (e.g., calling a three-year $100K deal “a $300K deal,” kind of implying the $300K is ARR when it’s not).  In this usage, where you’re trying to express total commitment made to the company to emphasize the importance of the customer, I think it’s fine to talk about TCV – particularly because it also indirectly highlights the built-in upsell yet to come.

[10] Or perhaps some intelligent mix thereof.  In this case, I’d want to weight towards TCV because if they are not successful in year 1, then I fail to collect 5/6th of the deal.  While I’d never tell an investor this was a $6M ARR deal (because it’s not true), I’d happily tell my Customer Success team that this a $6M TCV customer who we better take care of.  (And yes, you should probably give equal care to a $2M ARR customer who buys on one-year contracts – in reality, either way, they’d both end up “Tier 1” and that should be all that matters.)

[11] Or you could of the ASC 606 revenue backlog and/or Remaining Performance Obligation (RPO) – and frankly, I’d have trouble distinguishing between the two at this point.  I think RPO includes deferred revenue whereas ASC 606 revenue backlog doesn’t.

[12] In the event your compensation plan offers a kicker for multi-year contracts.

[13] And while you should factor in the pre-committed upsell in setting the reps targets in years 2 and 3, you shouldn’t go so far as to give them a normal upsell target with the committed upsell atop it.  There is surely middle ground to be had.  My inclination is to give the rep a “normal” comp plan and build in collecting the $1M as a bonus on top — but, not of course at regular new ARR rates.  The alternative is to build (all or some of) it into the quota which will possibly demotivate the rep by raising targets and reducing rates, especially if you just pile $1M on top of a $1M quota.

[14] This ain’t one – e.g., it has $6M of TCV as opposed to $9M.

The Leaky Bucket, Net New ARR, and the SaaS Growth Efficiency Index

My ears always perk up when I hear someone say “net new ARR” — because I’m trying to figure out which, of typically two, ways they are using the term:

  • To mean ARR from net new customers, in which case, I don’t know why they need the word “net” in there.  I call this new business ARR (sometimes abbreviated to newbiz ARR), and we’ll discuss this more down below.
  • To mean net change in ARR during a period, meaning for example, if you sold $2,000K of new ARR and churned $400K during a given quarter, that net new ARR would be $1,600K.  This is the correct way to use this term.

Let’s do a quick review of what I call leaky bucket analysis.  Think of a SaaS company as a leaky bucket full of ARR.

  • Every quarter, sales dumps new ARR into the bucket.
  • Every quarter, customer success does its best to keep water from leaking out.

Net new ARR is the change in the water level of the bucket.  Is it a useful metric?  Yes and no.  On the yes side:

  • Sometimes it’s all you get.  For public companies that either release (or where analysts impute) ARR, it’s all you get.  You can’t see the full leaky bucket analysis.
  • It’s useful for measuring overall growth efficiency with metrics like cash burn per dollar of net new ARR or S&M expense per dollar of net new ARR.  Recall that customer acquisition cost (CAC) focuses only on sales efficiency and won’t detect the situation where it’s cheap to add new ARR only to have it immediately leak out.

If I were to define an overall SaaS growth efficiency index (GEI), I wouldn’t do it the way Zuora does (which is effectively an extra-loaded CAC), I would define it as:

Growth efficiency index = -1 * (cashflow from operations) / (net new ARR)

In English, how much cash are you burning to generate a dollar of net new ARR.  I like this because it’s very macro.  I don’t care if you’re burning cash as a result of inefficient sales, high churn, big professional services losses, or high R&D investment.  I just want to know how much cash you’re burning to make the water level move up by one dollar.

So we can see already that net new ARR is already a useful metric, if a sometimes confused term.  However, on the no side, here’s what I don’t like about it.

  • Like any compound metric, as they say at French railroad crossings, un train peut en cacher un autre (one train can hide another).  This means that while net new ARR can highlight a problem you won’t immediately know where to go fix it — is weak net new ARR driven by a sales problem (poor new ARR), a product-driven churn problem, a customer-success-driven churn problem, or all three?

Finally, let’s end this post by taking a look and then a deeper look at the SaaS leaky bucket and how I think it’s best presented.

leaky1

For example, above, you can quickly see that a massive 167% year-over-year increase in churn ARR was the cause for weak 1Q17 net new ARR.  While this format is clear and simple, one disadvantage of this simpler format is that it hides the difference between new ARR from new customers (newbiz ARR) and new ARR from existing customers (upsell ARR).  Since that can be an important distinction (as struggling sales teams often over-rely on sales to existing customers), this slightly more complex form breaks that out as well.

leaky2

In addition to breaking out new ARR into its two sub-types, this format adds three rows of percentages, the most important of which is upsell % of new ARR, which shows to what extent your new ARR is coming from existing versus new customers.  While the “correct” value will vary as a function of your market, your business model, and your evolutionary phase, I generally believe that figures below 20% indicate that you may be failing to adequately monetize your installed base and figures above 40% indicate that you are not getting enough new business and the sales force may be too huddled around existing customers.