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We all think that we are incredibly rational in our decision-making, open to new information, always searching for the best answer regardless of where it takes us, but the reality is that we tend to have blinders on based on how we’ve always done things and past experience. This has often been the case in software management. Recently, though, there’s been a shift in management away from basing decisions on “gut instinct” and what one Microsoft researcher called: “HiPPOs” or Highest Paid Person’s Opinions. Prof. Erik Brynjolfsson at MIT/Sloan has been doing work with very large firms showing that a one standard-deviation increase toward data and analytics correlates with a 5-6 percent improvement in productivity and a slightly larger increase in profitability in those same firms. After benchmarking hundreds of fast growth software firms over the past 5 years, I would venture to suggest that with smaller companies, an even stronger result can be seen in management efficiency, productivity and minimizing risk, as well as making faster course corrections along the path to growth.

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Research shows that the most successful companies use metrics and benchmarking as a key management process and information tool. The popularity of benchmarking in this country originally grew out of the manufacturing world, especially in looking at Japanese manufacturing and comparing best practices. Benchmarking didn’t really take off in the software industry, or at least for budgeting and management processes, but was applied to some extent in the software development area to benchmark the coding and testing process. After the disruptions of the 2001 and 2008 economic downturns, with the rise of the SaaS business model, plus extensive use and experience with affordable financial applications, CRM and other analytics tools, software companies are embracing benchmarking and metrics today. Especially SaaS vendors. And the investment community and external shareholders require good data and good peer comparisons – they are looking at it themselves – to support investments in software ventures. Evidence of data-driven decision making, and a good grasp of key metrics in a company helps drive the value of that company, especially any private company. We find in our own work that our clients that are the most driven to examine the data, metrics and comparisons, are the ones that tend to perform the best and have the highest revenue growth. Because we see their data, I know this is a fact; we see that every day. Benchmarking has its limits, but is a useful tool to drive decisions based on data rather than by intuition or how things were done at somebody’s last company. I always tell companies that deviating from the benchmarks isn’t good or bad, it is just important to understand how and why you are deviating from a benchmark so that you are choosing to be higher or lower to fit your particular business, rather than not even knowing what the benchmark is.

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SaaS is all about the numbers. As the SaaS business has evolved, management has had to dig deeply into the numbers to track how resource investments are paying off, and how customer numbers are growing, while examining in detail the cost of acquiring and maintaining a customer. SaaS, as you all know, is a trickier investment upfront because the vendor has to build a great product which is turn key for the user, take care of all infrastructure investments, and get paid on a subscription basis, not all up front. Gone are the good old days when it was all about building a really cool product and selling the heck out of it by whatever means possible and moving on to the next customer. And gone are the days when your customers were your beta testers and the testers for a variety of environments. But, with SaaS, gone are the days when you had to start each quarter at zero and run til you dropped at midnight on the last day of the quarter. So, once you get past the initial hurdles and get to a scaleable model, a profitable recurring revenue stream in a SaaS company is very profitable and highly valuable. The question is: how do you navigate the hurdles to get from start up to a profitable recurring revenue stream and solid, growing business.

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In early stage companies which are still building products, the key metrics for those companies are around the overall cash burn, cost per employee, and relative costs by function. For early revenue and early stage companies that are still defining their target customer profile, and business model, these metrics are important to track closely to ensure the company has the runway to get to the next stage where it can scale the business. As the business scales, companies tend to focus mostly on operating expense by department – what’s the right expenditure on sales, on marketing, on G&A, on support, on R&D at a particular stage of the company. And companies need to get into greater detail than just the macro expense per department. One area that doesn’t get talked about enough where we see companies having to focus on even as they scale is hosting expense and the cost to maintain a customer. Hosting expense has come down with the availability of services in the cloud, - for example, this past year, we found small, private SaaS companies (about $8.5M revenues) spending 3.6% of revenue on hosting expense, while even in 2009, companies roughly the same size were spending 8-9% of revenue on hosting expense. Hosting expense doesn’t seem to have a nice economy of scale trend line down evenly as the company grows, typically, it goes up as revenue and the number of customer grows, and then at a point which varies for different types of applications and models, starts to achieve some economy of scale, but hits bumps as additional data centers are built out, or availability, security issues, etc. are expanded.

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In the early stages of a SaaS company, cash flow is THE critical metric to track. We’ve watched as SaaS companies have learned to conserve cash flow over the years, from 2007 and 2008 when the SaaS model was taking off and companies, especially venture-backed firms, had around 8% negative cash flow as a percent of revenue, which went up in 2009 as the recession took hold, but by 2010, we saw early stage companies getting on top of cash management and becoming almost cash flow positive (and since this is an average, many were cash flow positive) by the end of 2010.

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Here’s data over time for larger SaaS companies, comparing 2010 and 2008, one peer group averaging $57M and another averaging $61M – so roughly similar in size. 2008 was a year of spending and growth for a lot of venture-backed software companies as budgets had been set to expect high growth even though the recession was getting started, as compared to 2010 when companies were clearly more careful about spending, even though the economy, especially markets for successful Saas companies, seems to have improved. Generally, SaaS companies are showing greater efficiency reflecting more conservative cash management. Even Successfactors (SFSF), which as a public company in 2008 at $112M spent 105% of revenue on SG&A, brought that down to 66% of revenue in 2010 (while doubling revenue during that time period). The largest public SaaS companies in 201 showed a large increase in cash growth, averaging 17.5% cash from operations as a % of revenue. This benchmark is for companies averaging $186M in 2010 revenues.

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Lets look at the key metrics for SaaS companies: customer metrics. In an early stage company with early customers, the critical metrics to watch are around the cost of customer acquisition (coca), cost of sale, average deal size, implementation costs, and costs of maintaining the customer. The key focus for this phase of the business is to develop a solid and repeatable sales model that can bring the company to profitability and growth. One of the metrics which is well discussed in SaaS circles is the “Magic Number”described by Josh James, CEO of Omniture at an industry summit to explain how Ominiture tracked their customer profitability and whether or not to add gas in Sales & Marketing, or not. Basically, you take a quarter’s incremental revenue growth, multiple by 4 to annualize, then divide by last quarter’s S&M marketing spend. According to James, anytime the magic number is .75 then you should spend more and put gas on your sales and marketing to bring in more customers. If your magic number is 0.5 or less, then there is something wrong with your model. Again, the key is watching your sales and marketing spend, and revenue growth. One assumption in this model is that you have very low Churn rates, Omniture was shooting for 95% renewals or better. The industry average is about 15% churn or less. We look at both customer renewal rates by number of customers renewing and by amount of dollars renewed. For example, if you had 100 customers up for renewal for contracts totalling $10M, and all 100 customers renew, you have a 100% renewal rate, but they renewed contracts now totalling only $8M, you have an 80% renewal rate by dollar value (or conversely, they renewed for a total value of $12M, yo u have a renewal rate of 120%. You can see these benchmarks in the next two slides

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Here we have customer renewal rates for smaller, private companies and larger public companies in 2010 and for small versus larger companies in 2009. As you can see, the renewal rates by customer is higher for the larger companies, which makes sense as they presumably know their market and target customers better, so are more likely to keep them, and they have better resources to support their customers, also helping them keep them. Also, we tend to find that companies selling subscriptions at a higher average contract size, for example, over $100k/annually per customer, have less churn than companies selling a low average contract size.

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We typically see renewals by dollar value being slightly higher than the number of customers renewing. This means that companies are maintaining the value of contracts and increasing them.

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I spent 20 years building businesses for small and large companies, in the PC software world, in enterprise software and internet infrastructure and applications and I wish that I had had better information as I was making decisions, so I started OPEXEngine. We started by developing our own content through the confidential software benchmarking, and now are starting to develop information products incorporating a variety of data sources, but all focused on the small and mid-sized corporate market and giving executives data reports so that you can spend more time analyzing and making informed decisions, instead of spending a lot of time and personnel resource compiling data.

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I’d like to encourage that all of you that are building your software company participate in our next confidential software benchmarking which annually takes place in the Feb/March timeframe and will cover the previous year’s financial and operating data. We include companies from $1M to $350M in revenues, so this obviously includes private and public companies. Over a hundred software companies participate by inputting their data directly into our secure on-line system. We have a team of accountants and statisticians who help us clean and sort the data, and we have been doing this for 5 years now, so we have an extensive database with over 50,000 data points. Participating companies receive an individual company report, which shows their data against several peer groups. We look at the data not just by similar sized companies, but companies with similar types of business models. For example, companies selling SaaS applications to thousands of customers at a low price point with an inbound internet marketing strategy, versus a peer group of companies with a higher price point selling more into the enterprise space. Participating companies also receive the overall Software Industry Benchmarking Report and we’ve just built out a new interactive custom benchmarking system for participating companies. Last year, benchmarking participation cost $999 for companies under $10M, and $1995 for companies over $10M. Many participants have told me they have easily saved the participation price through looking at peer expense benchmarks. But more importantly, companies use the metrics as part of on-going management, which has a far greater value. Please register at: www.opexengine.com/register if you are interested in being informed about participating in the 2012 benchmarking. We work with CFOs and CEOs, as well as investors to define the most useful software and SaaS metrics to track each year. I invite you to participate, and also to help us define which benchmarks are most important for you to track in growing your business. Please feel free to contact me directly at: lauren@opexengine.com Thank you.