Kellblog

The Perils of Measuring a SaaS Business on Total Contract Value (TCV)

Posted on November 15, 2015 | 17 comments

It’s a frothy time and during such times people can develop a tendency to get sloppy about their numbers. The first sign of froth is when people routinely discuss company size using market capitalization instead of revenue. This happened constantly during Bubble 1.0 and started again several years ago – e.g., all the talk of unicorns, private companies with $1B+ valuations.

Oneupsmanship becomes the name of the game in frothy times. If your competitor’s site had 1M pageviews to your own site’s 750K, marketing quickly came up with a new metric on which you could win: “we had 1.5M eyeballs.” This kind of gaming, pardon the pun, is seen through rather easily.

The more disturbing distortions are those intended to impress industry influencers to validate strategy. Analysts – whose job is supposedly to analyze – have a troubling tendency to not judge strategies on their logical merits but on their results. So if vendor has a silly, unfocused, or simply bad strategy, the vendor doesn’t need to argue that it actually makes sense, they just need find a way to show that it is producing results – and the ensuing Halo Effects will serve as validation.

Public companies try to demonstrate results through revenue allocation games, robbing from non-strategic SKUs to pump up strategic ones (e.g., “cloudwashing” as the megavendors are now often accused). Private companies have free reign and can either point to unverifiable lofty financing valuations as supposed proof that their strategy is working, or to unverifiable sales growth figures where sales is typically defined as the metric that looked best last quarter.

Most people would quickly agree that at a SaaS business, the best metric for measuring sales is growth in new annual recurring revenue (ARR). They’d also agree that the best metric for valuing the business is ending ARR and its growth. (LTV/CAC would come in right behind.) Using my leaky bucket analogy, the best way to measure sales is by how fast they pour water in the bucket. The best way to measure the value of the business is the water level of the bucket and how fast it is going up.

But it’s a frothy time, and sometimes the numbers produced using the correct SaaS measures don’t produces numbers that, well, sufficiently impress. So what’s a poor CEO to do? Embellish. The Wall Street Journal recently ran a piece that compared company claims about size/growth made while the company was still private to those later revealed in the S-1. The results were disappointing, if not perhaps surprising.

Put differently, what’s the SaaS equivalent of “eyeballs”?

The answer is simple: bookings or, more precisely, total contract value (TCV) bookings. To show this, we’ll need to define some terms.

ARR = annual recurring revenue, the annual subscription fee
NSB = new subscription bookings, the prepaid (and – no gaming — quickly collectible) portion of the contract. Since enterprise SaaS contracts are often multi-year and can be fully, partially, or only first-year prepaid, we need a metric to understand the cash implications of the deal.
TCV = total contract value, including both prepaid and non-prepaid subscription as well as services. TCV is the largest metric because it includes everything. Some people exclude services but, to me, total means total.

Now, let’s look at several ways to transform a simple $100K ARR deal in the following spreadsheet:

Note that in each case, the ARR is $100K. But by varying deal terms the TCV can vary from $150K to $750K. Now in the real world if someone was going to pay you $100K for one-year deal, they are unlikely to pay $300K for a three-year prepay or contractual commitment. They will want something in return; typically a discount.

Let’s combine these ideas in one more example. Say you run a SaaS company and want to impress everyone that you’re doing really well. The trouble is you’re not. You sold $10M in new ARR in 2014 (all one-year, prepaid) and think you can sell $10M again in 2015 on those same terms. If you measure yourself on new ARR growth, that’s 0% and no one is going to think you are cool or write you up on the tech blogs. But if you switch to TCV and increase your contract duration, you get a lot more flexibility:

If you switch to TCV, the good news is you can grow literally as fast as you want just by playing with contract terms. Want to grow at 60%? Switch to 2-year prepaids and give a 20% discount. That’s not fast enough and you want to grow at 101%? Move to 3-year prepaids by effectively doing a year-long “buy 2 get 1 free” promotion. That’s not good enough? Move to 5-year non-prepaids and you can grow at a dazzling 235% and get nice TechCrunch articles about your strategic vision, your hypergrowth, and your unique culture (that is, most probably, just like everyone else’s unique culture).

This is great. Why doesn’t everybody do it? Because you’re mortgaging the future:

The discounts you’re giving to get multi-year deals are crushing ARR; new ARR growth is shrinking in all cases.
You are therefore crushing both revenue and cash collections over the time period(s)
The prepaid deals create a drug addiction problem because you’re not collecting cash in the out years. So you build a dependency either on lots of capital or lots more prepaid deals.
Worse yet, on the non-prepaid deals you may not ever collect the money at all.

Wait, what did he say?

In my opinion, non-prepaid multi-year deals are often not worth the paper they are written on. Why? Just look at it from the customer’s perspective. Say you sign a $100K five-year deal with only the first year paid up-front. And say the software’s not delivering. It took more work to implement than you thought. You’ve fallen short on the requirements. It’s not performing very well. You’ve called for help but the company can’t fix it because they’re too busy doing other 5-year non-prepaid deals with other customers.

What do you do? Simple: you don’t pay the invoice when it comes. Technically, yes, you are very much breaking the contract that you signed — but if the software really isn’t delivering, when the vendor calls you say: “sue me.”

Since software companies generally don’t like suing customers, the vendor – especially if they know the implementation failed – will generally walk away and write it your receivable as bad debt. If they are particularly devious (and incorrect) they might not even take it as churn until the end of the five-year period when the contract is supposed to renew. I wouldn’t be shocked if you could find a company that did it this way.

Most sophisticated SaaS people know that SaaS companies shouldn’t be run on TCV or bookings and are well aware of the problems doing so creates with ARR, revenue, and cash.

However, I have never heard anyone make the simple additional point I’m making here: in a frothy environment dubious companies can create a fictitious bubble around themselves using TCV. However, because non-prepaid multi-year deals only work when the customers are happy, if the company is out over its skis on promises and implementations, then many of the customers will not end up happy, and the company will never collect much of that TCV. Meaning, that it was never really “value” in the first place.

Beware Greeks bearing gifts and SaaS vendors talking TCV.

17 Comments

Posted in Metrics, SaaS, Startups, VC

Six Words That Can Make or Break Your Credibility: “I’ll Get It To You Tomorrow”

Posted on October 11, 2015 | 4 comments

I can’t tell you the number of times people I’ve worked with over the years have said, “I’ll get it to you tomorrow,” and then don’t. Sometimes they take a few extra days. Sometimes, amazingly, they don’t get it to me at all.

Maybe I’m the problem. Maybe I’m one of a rare breed who thinks that tomorrow is a date and not a euphemism for “later” — which itself is all too often a euphemism for “never.”

But I do notice and I think other people do, too. In fact, probably the first and simplest sign that someone is in over their head is failing to hit tomorrow promises. Heck, if you can’t accurately say at 2 PM that you’ll get something done before the end of the day, how I can expect any accuracy on your estimates of a major project?

I’m not so anal that I track every interaction with people. But once I feel like a may have a “tomorrow” problem, I do start tracking. I’ll randomly file promises for tomorrow under my tomorrow tasks and for next week under my next week tasks.

When I see problems, I usually start our snarky: “somebody tell Garth that tomorrow never came.” Or, “hey Scarlet, are you going to get to that again tomorrow, which is another day.” Or, “yo, Annie, did the Sun come out yet because it is indeed tomorrow?” There is just too much great tomorrow-themed material to resist. “Say hi to George Clooney there in Tomorrowland.”

But unfortunately when you’re in this situation, it’s usually not funny. We can apply the same logic to broken promises as Malcolm Gladwell applies to broken windows: one the first one breaks, a bunch quickly follow.

So the moral of the story is simple. If you want to work in a culture of professionalism and proper expectations management, at a company that properly under-promises and over-delivers to its customers, then it all begins with you and the simple tomorrow promise. Don’t make it if you can’t deliver, and once you make it, deliver. If you find that you can’t, then reset expectations accordingly — but never, ever promise “tomorrow” and then go silent.

Just as you’d be shocked at how many don’t answer questions in business meetings, you’d be shocked at the number of times people say tomorrow and mean “later” — once you start paying attention.

4 Comments

Posted in Culture, Management

Curse of the Megaround: Expectations and Power

Posted on September 17, 2015 | 2 comments

I’ve written before about the curse of the megaround which can happen, for example, when a startup raises $100M at a unicorn valuation and I’ve described before what typically happens next:

The company is under great pressure to invest the money to drive strong growth. Late-stage investors don’t give you money to put in the bank at 0.2% interest. They want you to invest it, typically over the next 2-3 years, implying something like an insane $15 to $20M/quarter burn rate.

As a result of this spending pressure the company gets inverted — instead of making a plan and finding money to finance it, the company gets a pile of money and then needs to figure out how to spend it. This is backwards.

The company over-expands and over-invests. You end up in 10 countries not 3. You double your employee base in 9 months. You sign up not just for projects 1-3, but for 4-9 as well. It sounds great until you realize that half your countries are executing the wrong strategy, half the new employees can’t articulate the company message, and that projects 4-9 were down-the-list for a reason: they were dubious ideas that shouldn’t have been funded in the first place.

The soon-to-be-former CEO develops a sudden interest in spending more time with his/her family. A new CEO is hired to “bring focus” to the situation. He/she ceases operations in 5 of the countries, lays off 35% of the employees, and shuts down projects 4-9.

If you were paying attention, you probably just noticed that $50M went up in smoke in the process. Fortunately, in Woodside, no one can hear a venture capitalist scream.

The Math Behind the Problem: Expectations and Power
In this post on the Silicon Valley hype machine, I argued that unicorns were the product of three trends:

The cost and hassle of being a public company. Why go public if you don’t have to?

The ability to raise formerly IPO-sized rounds in the private markets.

A generally frothy environment in late-stage financing .

This got me thinking about what really differentiates a $100M IPO from a $100M late-stage private financing. Benchmark Capital’s Bill Gurley recently did a great post on this precise subject where he points out several major differences:

The private round has far less scrutiny due to lack of an IPO process. The numbers in a financing deck may not be the same numbers that would have been in the S-1.

In the private financing, the money is much more likely to have perverse effects on operating discipline (as I detailed above).

In an IPO the company usually ends up with a single class of (common) stock, putting everyone on an equal footing. The $100M private round will be preferred stock, with strings attached in the form of liquidation preferences. This creates a difference between a common stockholder’s nominal and effective ownership positions and — if the business subsequently gets in any trouble — can literally wipe out the value of the common stock in an M&A exit scenario. This can be devastating for employees who typically are unaware of the terms (e.g., multiple and/or participating preferences) that create the gap between nominal and effective ownership.

While I think Bill’s post his excellent, I think he missed two factors that are particularly important from the CEO’s perspective: expectations and power. Specifically, what are the go-forward expectations for the stock and what is the power of the people who have them?

In the IPO scenario, there is a short-term expectation of an immediate pop in the stock price, which is conveniently handled by the endemic under-pricing of IPOs. So, assuming that takes care of itself through the usual process, what are the general expectations of an IPO stock after that, say during the next three years?

I spent some time researching this, looking at several studies and reviewing the capital asset pricing model. Since I didn’t find any authoritative source (and since many IPOs actually under-perform), I will somewhat arbitrarily suggest that an public-market investor would be happy with a 20 to 25% annual return on an IPO stock purchased a few days after the offering. I would be.

What does our late-stage private investor want? Everybody knows that: the rule of threes. They want a 3x return over 3 years. That’s a 44% annual return. And, in today’s markets, that will often be atop a considerably higher initial valuation.

So the first big difference is about expectations. Our private buyer expects roughly double the return of our public buyers.

The second big difference is about power: who, exactly, wants that return?

In the IPO scenario, it’s a series of portfolio managers at institutions like Fidelity who each own positions worth single-digit millions. If they get mad at you, they can sell their shares or their sell-side analysts can downgrade the stock.

In the private scenario, it’s a board member from a VC/PE firm that owns maybe $75M worth of stock. If they get mad at you, they can try to fire the CEO at the next board meeting.

So other than getting an investor with infinitely more power seeking double the return, in an environment with far less scrutiny over the numbers, in a situation more likely to cause a loss of operational discipline, and the use of structure / preferences that create potentially large gaps between nominal and effective ownership, there’s no real difference between doing a $100M private round and an IPO.

Well, at least the CEO can sometimes sell into the late-stage round. He or she may well need to.

2 Comments

Posted in Startups, VC

I Don’t Want to Talk to You Anymore

Posted on September 1, 2015 | 7 comments

One time, back in the day at Business Objects, we were all flying back from Paris to San Francisco, when the plane pulled ten feet back from the gate and then stopped. The pilot announced that we were taking a delay of several hours.

Frustrated, one of our board members, a very polished, powerful, statuesque man immediately asked the flight attendant if he could get off the plane. He wanted to take another flight and felt unfairly trapped. She said no. A polite dispute ensued.

As we, the management team, watched in awe of his calm-yet-firm argumentative style, a strange thing happened.

“I don’t want to talk to you anymore,” he said. “I want to speak to the pilot.”

“But, but, but, what do you mean, you need to talk to me, because uh, uh, uh”

“I don’t want to talk to you anymore,” he repeated.

For years, many of us on the executive team would joke about how one day our terminations might go down.

“But you don’t understand, the seminar attendance was low because there was a blizzard that closed the roads and shut down public transportation.”

“All I know is we failed to achieve our lead generation goal.”

“But it was a freak April snowstorm, …”

“I don’ t want to talk to you anymore.”

“But, but, … uh, uh”

“I don’t want to talk to you anymore.”

The phrase developed a certain legend status to it. I’d forgotten about it for years until one day at MarkLogic, I was supposed to meet with one my direct reports and I didn’t want to. I wasn’t looking forward to it. I didn’t want to talk to the person anymore.

And then a huge gut-check went off. Wait a minute. What does it mean when I don’t want to talk to the person who runs <function> at my company. <Function> is an important part of the company. I run the company. I am hugely committed to the company’s success, which cannot happen without success in <function>. How can this be?

In business we are generally taught to be logical and data-driven, which lines up very well with my natural style. But this was emotional. This was a feeling. I didn’t want to talk with someone. What did it mean? Should I listen to the feeling or ignore it? I didn’t know.

It got me to thinking about why I wouldn’t want to meet with someone. Generically, why would I not want to speak to one of my direct reports? I started to generate classes of people who I wouldn’t want to talk to.

People who don’t listen. There’s no point in talking to someone who doesn’t listen. It gets boring over time.

People who don’t follow through. What good is agreeing to a plan and then have it not get executed?

People who can’t keep up. When someone is over their head in a job, they can’t keep up with the conversation. Who wants to talk to someone when you have to keep backing up and slowing down?

People who grinf–k you. Who wants to talk to people who nod their head in agreement when you know they disagree?

People who can’t or won’t change. How many times do you want to have the same conversation?

People who are negative. A huge amount of business is identifying and solving problems, but it can always be done a positive constructive way. Who wants to talk to Debby Downer every day?

People who are mean. There’s a reason The No Asshole Rule is one of my favorite books, and it’s not just because I think the world of Bob Sutton.

Once I generated this list, I began to realize that the feeling was hugely important. If I didn’t want to meet with one of my direct reports — if I didn’t want to talk to them anymore — it was no small sign. It was a indicator of a potentially huge problem.

So now I listen to the feeling. Because I now know that if I don’t want to talk to you anymore, then it’s sign that someone is in one of the above classes and that’s an issue we need to, well, talk about — whether I want to or not.

7 Comments

Posted in Leadership, Management