In today’s financial climate, it’s becoming increasingly challenging for SaaS founders to raise money at favorable terms. Valuations are depressed across the board, with some businesses forced into raising down rounds in order to survive.
In an environment with such formidable headwinds, only the best companies are able to continue raising capital on terms that are attractive to founders. But what sets the best companies apart from everyone else?
In our decades of advising SaaS startups, we’ve developed all kinds of theories. One that we’ve validated time and time again is the SaaS Triangle.
The SaaS triangle is composed of three key metrics. When a business hits our performance thresholds all three, they rarely have difficulty raising money to continue funding future growth.
Of course, satisfying these three metrics is a high bar. Not every business will make it: in fact, most won’t. That doesn’t mean your business can’t raise money––it just means you may be seen as a less attractive investment opportunity compared to others.
So, what makes up the SaaS triangle, and what actions can founders and other SaaS leaders take to improve their business’s performance on all three metrics?
Introducing the SaaS Triangle
The SaaS Triangle is composed of three metrics, each with a particular performance threshold a SaaS business must clear in order to ‘pass’ our test.
You can think of the triangle as a three-legged stool. For the stool to work, all three legs have to be there; that is, all three metrics have to be hit. Fail to hit just one of these metrics, and the whole thing collapses.
So, what are the three metrics that make up this triangle? They are:
- Gross Margin - 75% +
- Customer Acquisition Cost (CAC) Payback Period: 12 - 15 Months
- Customer Net Dollar Retention: 94% +
If a business satisfies all three of these metrics, it’s likely to be extremely successful, both in the near term as an investment opportunity and in the long term as a successful business.
It’s worth noting that succeeding on all three of these metrics will likely lead to your SaaS businesses satisfying other SaaS models, such as the SaaS Rule of 40. This rule states that when added together, a SaaS business’s growth rate and free cash flow rate should be equal to 40% or higher.
The metrics in the SaaS triangle can and should be influenced by management. Each of these metrics are trackable from month-to-month and leaders are able to tweak elements of their strategy to enable their business to improve its KPIs. However, as we’ll see, these metrics are often in tension with each other, making satisfying all elements of the SaaS triangle a delicate balancing act that requires a strategic approach and best-in-class execution.
Dive deeper on your SaaS business's financial performance with our Ultimate Guide to SaaS Business Accounting.
Rule One: Gross Margins Must Be Over 75%
The first rule of the SaaS triangle is that the business’s gross margins should exceed 75%. Gross margins are calculated by subtracting the Cost of Goods Sold (COGS) from the business’s top-line revenue to calculate gross profit. Then, the gross profit is divided by the top-line revenue and multiplied by 100 to arrive at the gross margin.
SaaS businesses often exceed 75% in gross margins since they do not produce physical products, and therefore their production costs tend to be minimal.
Rule Two: Customer Acquisition Cost Payback Period Should be 12 - 15 Months
When a SaaS business acquires a new customer, it almost always incurs some costs in doing so. These costs are collectively known as the Customer Acquisition Cost, or CAC, and include all sales and marketing expenses.
Many SaaS companies invest heavily in acquiring new customers in order to scale quickly, building out large sales organizations and investing heavily in marketing and advertising.
SaaS companies shouldn’t only track CAC, they should also track the time it takes for their investment in acquiring a customer to pay off. In a high-performing SaaS company, that tends to be 12 to 15 months.
If this time period is any longer than 15 months, investors typically consider it an indication that your business’s product is not particularly efficient to sell. Conversely, if the CAC payback period is less than 12 months, it’s a sign that your business isn’t investing enough in growth.
Of the three elements of the SaaS triangle, this is probably the most difficult area for most SaaS businesses to succeed in. It can be tempting to overspend on CAC, particularly when the business is in the process of scaling rapidly, but it’s important to strike the right balance to ensure you build a sustainable long-term customer acquisition model.
Rule Three: Customer Net Dollar Retention Should Be Over 94%
The final rule of the SaaS triangle focuses on a business’s customer net dollar retention rate: a measure of how effectively a business retains and grows its existing customer base. Businesses that have a net dollar retention rate above 94% satisfy this element of the triangle.
Net dollar retention rate is a measure of the value customers derive from your business’s products and services. Are customers expanding their relationship by adding more seats and upgrading to a more premium tier, or are they churning, forcing your business to continuously acquire new customers to drive growth?
Net dollar retention rates can be tracked using cohort analyses. Let’s say that in January, your SaaS business signs up ten new customers to annual contracts, each worth $10,000, for $100,000 in revenue in total.
After a year, you raise prices to $12,000. Eight customers renew, but two leave. Your business is left with $96,000, giving you a net dollar retention rate of 96%. Net dollar retention rates above 100 are a sign that the business is growing with its existing customer base: an indication that your product is valuable to your customers.
G-Squared Partners: Experienced Advisors to SaaS Businesses
Satisfying each of these metrics in isolation is challenging, and only the very best SaaS businesses are able to satisfy all three at once. The reason for that is that these metrics often exist in tension with each other.
For example, to hit the gross margin target, businesses might be tempted to cut back on Customer Success Managers. However, doing so would create a worse customer experience, negatively impacting net dollar retention.
The bottom line is this: if a business can find efficient ways to attract and retain profitable customers, it’s an extremely investable, scalable business. Getting to that point requires considered financial planning, a keen focus on metrics, and relentless execution.
At G-Squared Partners, we’ve been a proud partner to dozens of SaaS businesses that have raised hundreds of millions of dollars in funding. We don’t just know what excellence looks like, we know how to build the financial foundation that propels your business toward it.
To discover how we can support your SaaS business, contact us today.