Episode 602 | Explaining SaaS Metrics to a Child

Rob: You’re in the right place if you’re looking for another episode of Startups For the Rest of Us. This is episode 602, where I sit down with my 11-year old and I explain to him not only what SaaS is, but we start all the way at the beginning with what is money, what are dollars, and then we talk about businesses and their purpose. Then we talk about software and then about SaaS. Then we dive into SaaS metrics, the KPIs that you should be tracking, things like MRR, ACV, and LTV. We go through all the TLAs, the three letter acronyms.

I was inspired to do this episode by a quote that’s attributed to a bunch of different people. I think most often if you search for this quote, you find it attributed to Einstein. I don’t know if he actually said it, but it basically says, “If you can’t explain a concept to a child, then you don’t understand it deeply enough.” When I heard that, I thought SaaS metrics are so boring, convoluted, and complex.

What’s cool in this episode is actually certain metrics, I say monthly recurring revenue, what does that mean? Then he’s able to define it because the definition is in the three words, but then there are a couple of terms where it’s not obvious what they actually mean. You can hear him thinking about it, because he doesn’t speak the jargon like a lot of us do. You can hear him struggling to define it. I’m going to actually say, yeah, that’s a bad name for this thing but it’s just what is generally acceptable at this point. It’s what most of us use.

Anyway, I hope you enjoy this episode. It’s very different from a lot of the stuff that I do on the show. But I would say that if you are maybe unfamiliar or not super versed in SaaS metrics, this is a good episode for you, because we really do dig in from first principles, starting with dollars, then making it all the way to lifetime value and a few others.

I was also going to do expansion revenue, but it was running long so I decided not to do that. Even if you already know SaaS metrics, I still think you’ll learn something from this because I’ll be honest, I learned a few things from this conversation as well. 

Before we dive into that, tickets to MicroConf Local in London are on sale. Actually, they are going fast. I think we’re going to sell out, if we haven’t already, because I’m recording this a week or two in advance. But if you go to microconf.com, you can go to our events menu and snag a ticket assuming they’re still available. 

Local:London is a one-day event, May 18. We’re going to be hosting three or four amazing speakers. Asia Orangio will be there, and Brennan Dunn. I’m going to be there doing a talk. It’s just a fun get together. It’s a fun gathering to be able to hang out with other Microsoft bootstrapped and mostly bootstrapped founders. And we keep the ticket price really low. It’s around £200, depending on a few factors.

Hopefully, that’s something that you can make it too because I would love to see you and do a fist bump. I never fist bump before COVID, but now, unfortunately, that’s just a better way to do things than shaking people’s hands. Anyway, I would love to meet you face-to-face, if you’re listening to this, and you’re able to make it. With that, let’s dive in to me explaining SaaS metrics to my 11-year old.

Rob: So you know why we’re here today, right?

Fisher: Yes.

Rob: I want to start at the beginning with the basics. Do you know what a dollar is?

Fisher: Yes.

Rob: Of course Do you know that dollars can buy […]?

Fisher: Yes, they can also buy other things. 

Rob: So dollars are our currency. Do you know that there are other currencies in other countries? 

Fisher: Yes.

Rob: Can you name one?

Fisher: British Pounds.

Rob: There you go. You like the Brits, don’t you?

Fisher: Sure, why not?

Rob: So dollars are what make our economy go around and it’s what you would get paid if you get a job. Do you get paid dollars on any recurring basis?

Fisher: Yeah, I have an allowance for doing chores and such.

Rob: Cool. You get that money from us. Where do your mother and I get our dollars? How do we make our dollars?

Fisher: From your jobs being an entrepreneur.

Rob: Right. So we have jobs that are maybe a little different. I know you know different than most people. You and I know some folks who work as teachers, or who work as doctors. They are paid by a school or by a hospital. But your mother and I run our own companies. 

You know what a business is, right? Can you summarize what a business or a company is? Why you might want to start one?

Fisher: I guess an organization of multiple people with what’s the defining factor of a business, like a pyramid of authority, hierarchy with someone at the top.

Rob: Oh, that’s interesting. You think about that. That’s the internal structure. Sometimes the business is just one person like your mom, really until the last six or eight months. It was just her in ZenFounder, so there wasn’t any need for that authority or internal structure. I think of a business as an organization that seeks to produce a profit by creating something that people value enough to pay for.

Fisher: Organization of people.

Rob: Yeah, one or more people. Here in the US, they’re called LLC, you can have a sole proprietorship, you can have a C-Corp. Then in Britain, they have a Limited Corp, I think, Private Limited. You’ll have to forgive me, I’m still just learning that stuff. But that business, because there are nonprofit organizations that are set up to do certain things, there are benefit corporations, but really what we’re talking about is a for profit company. What does a for profit company do, do you think?

Fisher: I don’t know. They give people stuff and people give them money.

Rob: Right. Examples of that, can you think of any companies that you buy things from with your dollars?

Fisher: I don’t know, Lego?

Rob: That’s a good example. Target.

Fisher: I sometimes buy stuff from Target.

Rob: Buy Lego from Target.

Fisher: Lego usually, as well. I don’t know. Amazon has better prices, but they’re a massive mega corporation. So is Target […].

Rob: So Amazon’s another business that you give your money to. Ultimately, there’s a lot of (I think) nuance around profit being the main motive of companies, or just one of several because there are these multiple bottom line-companies now that want to make a profit and also help people, which I think is good and noble; I’m actually invested in a couple of those. 

Let’s say that you pay your money to a business like Target or Lego. For every dollar you give them, it costs them $1.20 to produce, market, ship, and provide you with that product.

Fisher: Then they’re losing money, though.

Rob: Okay, so does that work or not?

Fisher: No, they’ll bankrupt themselves.

Rob: Okay, good. So you’re already bringing in a term of bankruptcy. That’s great. When you give them money, do you know the term for that, what they call that inside their company?

Fisher: Revenue?

Rob: That’s right. Revenue is the dollar you give them. But what if it costs them 70 cents to manufacture and provide all the service or the product to you? Do you know what that’s called? That 70 cents.

Fisher: I don’t know. 70 cents relative to a hundred would be profit, but I don’t know it. Manufacturing costs, maybe?

Rob: Yeah. There are two things. You’re getting at it well, actually. The global term or high-level term is an expense. There’s revenue and expense. But you’re even going within expenses. There’s something called cost of goods sold. It’s also often summarized as COGS, that is manufacturing cost, shipping, and some basics. 

We have revenue, which is the dollar. You want to say $100, that makes more sense to you because you never give Lego $1. Let’s give them $100 for a set. And all of their expenses, including their COGS and shipping and Target takes when they sell it to them is 70 cents. That’s their expense. Then the 30 cents that’s leftover for Lego.

Fisher: $30.

Rob: $30 that’s right. I’m still in the dollar. Yup. The $30 leftover is?

Fisher: The profit.

Rob: Yeah, there you go. Okay, so now we have business fundamentals. We have money, revenue, expenses, and profit. Okay. Now I want to switch up the business type and switch from Lego to (let’s say) that I started a software company or you started a software company. That’s now the product you’re selling. To get started, can you name a few pieces of software that you use on a daily or weekly basis?

Fisher: What software, like programs?

Rob: Yeah, just name a few. There are a bunch of them, right?

Fisher: Like apps, I suppose.

Rob: Include games.

Fisher: I play Rec Room and Minecraft sometimes. 

Rob: I think we paid for Minecraft on the iPad. I think Rec Room is free, but there’s currency inside of it. That’s going to be their revenue stream. What else?

Fisher: What else? What other programs? I don’t know the Amazon App if I want to.

Rob: Yeah, that’s software, but realistically, so Amazon, you don’t pay for their software. That’s just a catalog to buy through them. How about, wasn’t there one called Kahoot!?

Fisher: That’s like a quizzing app.

Rob: Right. But didn’t we pay? You downloaded it for free then you could pay for a premium plan. 

Fisher: That was Lookit for school. It’s like Kahoot!

Rob: They’re learning apps and we paid a subscription. You get some special stuff, right? Some upgrade. How about other software? Those software all download to your iPad, and it runs locally. You could turn off WiFi and it would work. What about software like Google Drive, Google Docs, and Google Sheets? Those run on the Internet, don’t they?

I know there’s an offline mode, but let’s just assume that there was no offline mode, because there was actually many, many years before they had that. Realistically, you need WiFi to access that, don’t you?

Fisher: To access a document?

Rob: Yeah, in Google Docs.

Fisher: Yeah. I guess.

Rob: Like to edit a document without offline mode.

Fisher: Assuming there’s no offline mode, yeah, you would need WiFi.

Rob: Do you use any online web-based video or photo editors or is it all app-based?

Fisher: I use Adobe Express Photoshop sometimes.

Rob: Is that downloaded onto your iPad? Is it an app or is it in a browser?

Fisher: It’s both.

Rob: Got it. It’s both. Okay. So that’s the thing. If it’s local, it’s downloaded to your iPad, then it’s just software or apps programs, as you said. If it’s any browser, there’s this term, and it’s Software as a Service. The term is terrible. So it’s SaaS, right?

Fisher: Wouldn’t it be a service, if it was an app?

Rob: There can be a money line where Google Drive or Google Docs, you can access it in the browser, and it goes out onto the Internet into their servers to retrieve your documents is what it is. But they also make an app. It’s the confusing part. They also make an app but that also goes out to the server, they call it in the cloud, right? You’ve heard this. It goes out to the Google servers to pull your docs back when you want to edit them.

Fisher: Docs also just redirects you to the app. 

Rob: Got it. So the app versus browser thing maybe is not the best distinction. But I think the big thing is Software as a Service is where your data is usually not hosted locally. It’s hosted not locally on your machine, but it’s hosted on Google’s servers, or it’s hosted on Dropbox’s servers. 

Think of Spotify, which is more of an entertainment app. I create playlists and those playlists live on the Spotify servers. I can access them from any device. Software as a service, terrible name, agree?

Fisher: Sure. It’s not like you build your company around it or anything.

Rob: What company are you referring to?

Fisher: I don’t know. You use that term a lot. It’s not like you build your life around that term.

Rob: Well, because Drip was Software as a Service.

Fisher: Not that not that much exaggeration, to be honest, but yeah.

Rob: Right, my life is built around it. Well, that’s the thing. It’s this very left brain nerdy term that I think is overly technical. I wish there was a better term for what we do. So you remember Drip, it was software that people could use to build their email list so they could communicate with their audience. Remember that?

Fisher: Yeah.

Rob: Okay. People paid monthly for Drip. That’s Software as a Service. That’s usually monthly or annual. It’s not a one time fee. Some of the apps that we buy that you pay for like Angry Birds, Plants vs. Zombies, where you pay $5 or $10. Then you don’t subscribe. You just get to play the game.

Fisher: Yeah, you did it yourself by using those two examples.

Rob: Yeah, you get it?

Fisher: Yeah. They’re good games, though. Yeah, that is the case. You buy the game and then you play it.

Rob: Right. Well, Software as a Service is different. You get what’s called recurring revenue. What do you think that means?

Fisher: Recurring revenue is revenue that reoccurs. So multiple payments in a month or a week.

Rob: Right. It’s standardized. It could be anything, but it’s kind of standardized in general on monthly payments or yearly payments. Those are usually the two options, I’d say in 80% of the cases. What if I were to give you this phrase, average revenue per account per month, average revenue per account? What do you think that means?

Fisher: Account?

Rob: Yeah. There’s a different way to say it, average revenue per customer.

Fisher: Okay, if an account is paying $5 for your service a month, that would be in fact, the average revenue per customer per month.

Rob: That’s exactly right. In this case, account and customer are interchangeable; ARPC or ARPA. What if I had 10 customers or 10 accounts paying me $5 a month, then I had 10 paying me $15 a month because they use the more premium version. What would my average revenue per account be?

Fisher: 10 paying you $5 and 10 paying you $15. $15 times 10 is $150 and $5 times 10 is $50. So you get $200 in revenue a month for your service.

Rob: Awesome. So that’s total revenue per month. That’s called MRR. Monthly recurring revenue. MRR is what you just defined. That is the total monthly revenue that I get from all of my customers. What is the average revenue per customer? Because I have 20 customers.

Fisher: 5 and 15, $10 per customer averaging? 

Rob: That’s correct. Yup, exactly. You could get there one of two ways, the same amount are paying you $5 and $15 that it’s in the middle at $10. Or you could get your MRR, you went to MRR, which is $200. Then you said, I’m going to take my MRR, and I’m going to divide it by my number of customers. That’s the formula for average revenue per customer. So you came across $10. Now $10 would be very low and you’d have high churn, but we’re not going to do that today. 

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So we have MRR, we have average revenue per customer or average revenue per account. What do you think I mean when I say annual contract value or ACV?

Fisher: The word that confuses me is contract. Annual is yearly, and value would be how much is worth relative to something else, but contract?

Rob: Yeah, it’s weird. It’s another clunky phrase that I wish was different. Maybe ACV stood for annual customer value, the value that I received from a customer in a given year.

Fisher: It would make more sense. 

Rob: Yeah. And do you know what that means? Let’s say a customer pays me $10 a month, what do you think is their annual customer or contract value?

Fisher: 10 times 12 is $120.

Rob: Right. So that’s it. That’s ACV.

Fisher: $120 a year?

Rob: Yeah, but if you get a thousand of them, then you get $120,000 a year. With that, I want to cover just a couple of more things. This is all revenue. You notice that this is all money coming in. We haven’t talked in SaaS about anything going out. So we’ve talked about MRR, ARPA or ARFC, annual contract value.

One of the hardest parts about SaaS is that your customers can cancel anytime. What if a customer, if you say they’re going to pay me $10 a month, do they pay you that forever? What if someone decides they don’t need it after three months and they cancel? How much have they paid you?

Fisher: $10 a month that’d be $30. You’re expecting $120.

Rob: Right. So in that case, you expected them to pay you $120 in a year, but they only paid you $30 and they’re gone. Do you know the word for that when someone cancels that we use inside SaaS?

Fisher: Cancel? I don’t know.

Rob: Yeah, that’s called cancellation. But the way we represent it as a metric or as a number is we call it churn. Churn is the percentage of your customers who cancel in a given month. Churn with an N. Churn. You know, like churning butter. It’s that word. The reason it’s called that (I think) is because it’s like you’re churning butter. It’s you’re turning it over. You turn butter over and over to make cream, white milk. You turn cream over and over to make butter.

You can tell I’ve lived on a farm. But you’re turning customers over in this case. What if I had 100 customers at the start of a month, and then 10 customers canceled during that month? What do you think as a percentage? What do you think my churn would be?

Fisher: 10 out of 100 would be 10%. So you have 10% churn.

Rob: That’s correct. That’s called customer churn. There’s also something called revenue churn, which is, let’s say I had $10,000 a month in MRR (monthly recurring revenue) and $1000 worth of MRR canceled. It doesn’t matter if it’s one big customer, or if it’s a thousand $1 customers, but it’s that amount of MRR churn. So $1000 out of $10,000. What would that revenue churn be?

Fisher: $1000 out of $10,000. $1 out of $10 or $10 out of $100 revenue churn.

Rob: Right, 10%. It’s the same number because these are contrived examples. 10% churn, does that sound high to you or low to you?

Fisher: I don’t know.

Rob: Imagine that every month you turn 10% of your customer base. So you go from 100 down to 90. 

Fisher: That’s quite high.

Rob: Then you churn nine that month, because it’s 10%. So now you’re at 81 then you churn 8.1.

Fisher: And then you bankrupt yourself.

Rob: Well, that’s what happens, right? 10%, churn, I believe you, you churn out 90% of your customers, and I forget what the number is, but it’s eight months or something. It’s the end. It’s expensive to find new customers. It’s the death of SaaS growth, it makes it hard to grow when people are canceling. That’s a more advanced topic to talk about, eliminating churn and why that happens and all this. 

But I want to get to this concept called lifetime value, which is what do you think that means, lifetime value of a customer?

Fisher: The only thing I could guess is, how much money they could give you in their lifetime, I guess? I don’t know. 

Rob: That is another one where lifetime is maybe not the best term for what it is. It’s like the relationship value of the customer.

Fisher: The lifetime is how long they use.

Rob: Yup. How long they use your software, how long they pay you for your software. That makes sense. We call it lifetime value. It should honestly be relationship value or something like that. Let’s say someone signs up, they pay you $10 a month, and they stick around for 20 months, and then they cancel, what was their lifetime value?

Fisher: Okay, they gave you $200.

Rob: That’s right. Usually you don’t look at it as an individual customer. You look at an aggregate because when you have a thousand customers, they’re all paying you different amounts. Some cancel at month 6, at 9, at 12. You have to average it out. To calculate the average lifetime value of your customer, first, you need to calculate the average lifetime of your customer, the average time a customer stays with you.

I want to name the formula for this and have you tell me if you think it’s intuitive or not. If you had 5% churn, for easy math, it would be 1 over 5% which is 1 over 0.05. How many months is that? One divided by 0.05 is the number of months, the average lifetime of your customer.

Fisher: 2?

Rob: Close to estimate, it’s zero.

Fisher: 20?

Rob: Yeah, if it was 0.5, that’d be 50%, and your average lifetime, it would be? So the lifetime average would be 10 months or 20 months with those numbers. The way you get your lifetime value of a customer— remember this is relationship value—is you take that lifetime, 10 months, 20 months, and you multiply it times your average revenue per customer. If we go back to our example earlier, average revenue per customer per month is $10. Remember, we did the average. If your average lifetime is 20 months, we take 20 times $10. Audio math is riveting, isn’t it?

Fisher: Equals $2000?

Rob: $200. That’s an average revenue over the lifetime of your customer. It’s called the lifetime value of a customer on average. And $200 is actually fine for a small business. It’s really, really hard to grow a company with a $200 lifetime value. I feel like that covers the revenue side, the money coming into the business.

I really want to talk about the two largest expenses. There are tons of expenses in any company, even in SaaS. There are the incorporation fees and there are legal fees and you have a payment processor like Stripe and you pay a small amount to them, but really the two biggest expenses, what do you think they are?

Fisher: I can see the document where you’ve listed these things.

Rob: Well done. Hacking the system.

Fisher: I can see it on the dock and I was going to guess salaries anyway, paying your employees.

Rob: That’s right. That is the number one expense.

Fisher: Other expense is how much the time was worth making the product.

Rob: Yes, that’s right. It’s different. Remember we talked about COGS or cost of goods sold with Lego and how they might have a lot of that because they have a huge manufacturing plant. They have people on the floor and they’re paid for the plastic. There are all those things. SaaS really just has time, doesn’t it? And time is money. You’ve heard this expression, right? Let’s say I hire five engineers, two support people, a customer success person, and a salesperson. What do I have to pay all of those people? Back to our first thing, dollars?

Fisher: I don’t know. I can’t estimate all those people.

Rob: I’m not asking how much but what do you think I pay them in? Do I give them granola bars to show up for work?

Fisher: No, no, you give them money.

Rob: Monies. Monies or salaries are your number one expense. The other one and it’s another SaaS metric, much like we talked about it, MRR and average revenue per customer, annual contract value. These are metrics that we track and pay attention to and try to improve. The last one I want to talk about is CAC.

Fisher: That’s funny. CAC.

Rob: Cost to acquire a customer. What do you think cost to acquire a customer means?

Fisher: I guess it’s an estimation, but you could estimate how much money you spend on the products you acquire. I don’t know.

Rob: You’re getting there. Yeah. It’s how much money you spend on marketing.

Fisher: Oh, it’s marketing. Okay.

Rob: And it’s averaged. So realistically, if you’re buying ads, it’s usually easy to calculate costs to acquire a customer. Because you know that if each click is $1, and 1 out of 10 clicks results in a customer, you’ve paid $10 to acquire each customer. That makes sense.

Fisher: Yeah.

Rob: Okay. It’s harder when you’re doing things like producing content, because really, what is the cost of your founder’s time? Sometimes I’ll see CAC estimated as all of our marketing expenses, divided by the number of new customers we receive in a month, and it’s across all of those things. 

The hard part is, you do want to drill down further because you want to figure out where you’re low. Why would you want to figure out where your low CACs are? If I had three different marketing approaches, let’s say I was running ads, and it was $10 to acquire a customer. 

I was creating content, meaning I have maybe videos on YouTube, and it’s costing me $50 to acquire a customer. Then I’m doing outbound sales, like reaching out to people on LinkedIn, Twitter and email, and it’s costing me $100 to acquire a customer. Well, which one of those is best? And why is that important?

Fisher: Well, LinkedIn and YouTube. The last two approaches I already forgot.

Rob: The first one was ads, it was $10, $50, and $100.

Fisher: Then reaching out for people for $100 bucks for a single customer would obviously be the weakest. You would probably eliminate that one and spend that money on salaries or more marketing.

Rob: Right, the other approaches that are working. You’d rather try to optimize.

Fisher: That’s why you need to know the weakest approach.

Rob: Very good, sir. That’s your SaaS metrics. Do you feel smarter for having had this conversation?

Fisher: I don’t know. I kind of already dealt with all of them.

Rob: You knew most of these things. All right. Well, we won’t tell the people that because the whole point is I was supposed to be explaining it to someone who didn’t already know these.

Fisher: Plot twist. Your editor doesn’t cut this part out.

Rob: I thought we were going to leave it. Do you have a YouTube channel you’d like to plug?

Fisher: Yeah. I know you’re not going to do it but subscribe to my YouTube channel.

Rob: How do they find it? They go to youtube.com and they search for what channel?

Fisher: This is going to cringe, I’m not going to lie. I haven’t played Among Us in 12 months and this is a reference to that.

Fisher: Yes. Because no one even spells it with a Y anymore, or else you’ll cringe.  It’s just the laws of dignity now.

Rob: Laws of dignity thermodynamics. Am I right?

Fisher: Yeah, editor, editor, man, I’m sorry. You had to listen to 35 minutes of unsmart people talking. Thanks for editing stuff.

Rob: Thank you for joining me on the show today.

Fisher: Bye.

Rob: If you enjoyed that episode, let me know. I’m @robwalling on Twitter. Let’s connect there. If you haven’t downloaded our two free guides, these are never released podcast episodes plus PDF guides. First one is Eight Things You Must Know When Launching Your SaaS. The next one is 10 Things You Should Know As You Scale Your SaaS.

These are my learnings from 15–16 years-ish in SaaS as well as mentoring, advising, and starting companies. I put them all into these two episodes and these two guides. If you go to startupsfortherestofus.com, enter your email, and we will send those to you. 

Thanks as always for joining me again this week. I look forward to being back in your ears again next Tuesday morning.