TOBI

After five years as a director at Vend, yesterday was my final meeting.

I’ve written here about a number of milestones in the Vend journey to date: from the bike ride where I first got the pitch, the announcement of our first investment round, Vaughan describing the early history in his own words, notes from our recent visits to San Francisco, watching the team expand, and more recently the search for a “real” board.

So, I thought one final post would be appropriate.

It’s been a privilege to be part of the team from the beginning. It doesn’t feel like that long ago we were putting together cheeky advertisements and videos and hoping that people would notice.

A billboard concept. Probably better this never saw the light of day…

POS Advert

Steve, the potty mouthed, bigoted and small minded, crappy old 1980s cash register, finally meets his fate…

An early recruitment video…

Thankfully, people did notice. Suddenly we had retailers from all around the world using our software to run their business. And more and more of them over time!

As the team expanded, it was great to be able to spend some time in Auckland, Melbourne, San Francisco and Toronto with the local people who are working hard to make Vend a success.

We have also been joined along the way by some of the very best SaaS investors – from here in New Zealand and from Germany, Australia and the United States.

When you look back on this sort of thing it always seems like time is short. So, it’s easy, generally, to be motivated by negative FOMO – the fear of missing out. But, in this case, my overwhelming memory will be TOBI – the thrill of being involved. Thanks to Vaughan and the team for having me along for the ride so far. And, especially to Miki, Barry and (too briefly) Claudia and Sarah for your support as part of the board over the last couple of years.

Vend is in an exciting period as the team works to put the business on the right track for the next phase of growth. To everybody involved now, I remain an enthusiastic investor and will watch with interest to see where you can take it from here. You have a huge opportunity to be part of something special, and I know you’ll make the most of it!

Xero visits Dr SaaS

A few weeks ago Xero released their latest interim report for the six months ended 30-Sept.

I thought it would be interesting to plug these results into Dr SaaS, to see what the diagnosis shows us about how they are tracking.

Most of the details we need are in the report which is available on the investor centre section of the Xero website.

Revenue

There were 371,000 subscribers at 30-Sept, and total operating revenue of $54.295m. They report average monthly customer churn of 1.3%.

Starting with 284,000 subscribers at 31-Mar (from the previous annual report) they added 87,000 new subscribers net. So, if we assume a churn rate of 1.3% that works out to be ~109,200 new acquisitions offset by churn of ~22,200 subscribers.

xero-revenue

Based on these values Dr SaaS calculates growth of 3.91% per month, and and ARPU of just over $27 per subscriber per month (which is slightly less than the $29 value they include in the report).

Dr SaaS also estimates the average tenure of a new subscriber to be approximately 53 months, or nearly 4.5 years, which is pretty sticky! If you’re interested there is more information available about how Dr SaaS estimates tenure.

Profit

Next, we split out the acquisition and service costs. This is all done for us in the report – the total “cost of revenue” was $18.016m and “sales and marketing” was $38.329m.

xero-profit

Based on these values Dr SaaS breaks that down as $165 per new subscriber and just over $19 per month to service each subscriber. The profit margin is calculated to be 17.86%, which is to be expected given the focus on investing in growth.

Runway

To calculate the runway we need to also include the other revenue and expenses that don’t relate directly to subscribers.

Again the report includes all of the details we need – “other income” was $1.48m (this is a combination of government grants and rent received), “interest” was $4.128m and “other expenses” were $27.35m (mostly the cost of software development etc). The cash balance at 30-Sept was $170.8m.

xero-runway

Based on these values Dr SaaS calculates the break-even point (based on the current burn rate) to be around 944,000 subscribers. The runway is just over 43 months (again, based on the current burn rate).

Diagnosis

Based on all of this Dr SaaS gives Xero a pretty good diagnosis:  “you’re bleeding a little, but you’ll survive”.

Overall the lifetime value per subscriber is positive – total revenue per subscriber of $1428 offset by acquisition costs of $165 and service costs of $1008, leaving a gross profit of $255 per subscriber.

xero-diagnosis

See the full summary

This is obviously a pretty rough and inaccurate analysis. To do this properly you’d want to understand a lot more detail about growth and performance in each of the different markets where Xero operates, as well as the trends in terms of ARPU, churn, and acquisition costs for different channels etc. However, as a quick exercise it’s useful to give a high level overview.

You can try Dr SaaS for yourself, using either your own numbers, or (if you just want to have a play) using the public details from one of many listed SaaS companies. Hopefully going through the process will teach you a little about the SaaS business model.

http://drsaas.md

We’d love to hear what you think.

Estimating Tenure

The key number that Dr SaaS needs to calculate in order to diagnose your SaaS business model is average tenure, or, if you prefer, the life expectancy of a new customer when they subscribe to your service.

To calculate the lifetime value of a customer (LTV) you just need to know how much you earn on average from them each month (ARPU), how much it costs you on average to acquire a new customer (CAC), how much it costs you on average to service a new customer (CTS) and how long you can expect them to remain a customer (Tenure). ARPU, CAC and CTS are all easily derived from your financial statements. But, tenure is not so straight forward.

The way this is typically calculated is using the current churn level, which is the rate at which existing customers currently cancel:

Churn = Cancelled Subscriptions / Total Subscribers

For example, if you have 500 subscribers and 12 cancel during the month, then your churn rate is 2.4% per month.

Then:

Tenure = 1 / Churn

For example, if your churn rate is 2.4% then your average tenure using this formula is just under 42 months (or 3.5 years).

This sort of makes sense: if you have 12 cancellations every month then after 42 months all 500 subscribers will have cancelled.

However, in practice this approach often ends up over estimating the actual tenure, as Jason Cohen (aka A Smart Bear) explains in his great blog post on this topic:

“It’s impossible to see ahead to timeframes beyond a few years for a young company and perhaps 4-6 years for a mature one. In those timescales you expect drastic changes in market conditions — a strong new competitor appears or dies, the economy slumps or soars, a disruptive technology changes the landscape, etc.

That in turn will cause material changes in pricing, retention rates, reorganized customer segmentation, usage levels, service levels, and so forth.

Computing expected months with the ad infinitum approach leads you to over-estimate the total revenue you can depend on.”

This skew is especially evident if your churn rate is low as the inverse value increases rapidly at this point:

Alternative Tenure Calculations

So, what to do about this? Jason suggests two alternative approaches – either capping the number of months or using a discount rate.

Tenure = 1 / (Churn + Discount)

This option does product lower estimates of churn when the churn rate is low (and as he points out who cares about what it does if the churn rate is very high, as in that case you likely have much greater problems to deal with than what tenure formula to use!)

Alternative Tenure Calculations

In Dr SaaS we use a third option which gives values somewhere between these two extremes when the churn rate is less than 2%, but lower values when the churn rate is higher.

Tenure = ln(0.5) / ln(1 – Churn)

While this looks complicated, it’s just using the churn rate to work out how many months it takes before half of the new customers in a given cohort have cancelled.

Consider the example above, where tenure is estimated to be 29 months (compared to 42 months for the simple formula):

Month 0: We start with 500 subscribers
Month 1: 500 * 2.4% = 12 cancellations, leaving 488 subscribers
Month 2: 488 * 2.4% = 12 cancellations, leaving 476 subscribers
Month 3: 476 * 2.4% = 11 cancellations, leaving 465 subscribers
Month 4: 465 * 2.4% = 11 cancellations, leaving 454 subscribers

Month 28: 259 * 2.4% = 6 cancellations, leaving 253 subscribers
Month 29: 253 * 2.4% = 6 cancellations, leaving 247 subscribers

At this point, 50% of our original 500 subscribers remain, so we take this as our average tenure.

You can see how this looks on the graph:

Alternative Tenure Calculations

If you want to try this out with your own subscriber numbers, check out Dr SaaS:

http://drsaas.md

What do you think?

How are you currently calculating tenure? How does it change your results if you use this formula instead?

We’re interested to hear any suggestions.

Dr SaaS

Make your appointment now

How do you know if your SaaS business is healthy?

You need to start with the unit economics, which are the key to understanding how you will (or won’t!) make money.

At Southgate Labs we’ve had the opportunity to work with a number of growing ventures, and one thing they all have in common is that keeping on top of the maths is hard work – the calculations are confusing, it’s hard to even find a consistent formula, and a lot of what is written about this stuff is pretty dense and academic, plus there is a long list of different metrics to calculate.

All of this makes it hard to know if the business is growing well or not. So, we decided to build a tool to try and make this all easier. It’s called Dr. SaaS, and you can find it here:

http://drsaas.md

It asks you to enter some information about your subscribers, revenues and expenses, and then does all of the maths for you. All of the details are explained in plain English, so you can get started quickly and easily. And, once you’re done, a diagnosis is generated based on the information you enter, highlighting healthy areas, and also areas where there’s room for improvement. It gives you an honest assessment – if things are not healthy this will help you identify the problems early and make the changes that are needed. And, once done, you can also share the details online and invite others to view the diagnosis – it’s a good way to quickly share a snapshot of your progress with your team, your advisors and your investors.

For example, check out this diagnosis of the mythical Dobalina Inc, as an example.

We’ve been using Dr. SaaS ourselves, in various forms, for a while now, so it’s good to finally launch it for you to start to use today.

Please try it out, recommend it to others, and let us know what you think so we can make it better.

How does this work?

To understand your unit economics you need to answer three questions about your venture:

1. How much does each customer pay?
2. What does it cost to get a new customer?
3. What does it cost to provide your product or service?

Then, once you know those values, you can think about what it would take to have a profitable venture:

4. How many customers are needed to cover your fixed costs? (the break-even point)
5. How much cash do you need to get to that point?

In a traditional business model this is all reasonably straight forward – when you make a sale the revenue and the costs of goods sold are normally obvious, so all you are left to do is divide the amount spent on sales and marketing by the number of sales made to get an average cost of acquiring a customer, and you already have a pretty good picture of the health of the business.

However, with a software-as-a-service business model, where customers are paying a monthly or annual subscription, it quickly gets much more complicated. In order to calculate the revenue from a new customer, you need to know not only how much they pay, but also how long they are likely to remain a customer. Likewise, to determine what it costs to provide the service, you need to consider the total cost over the whole time they are a customer.

To complicate this even more, there is a long and confusing list of metrics used:

ARPU = average revenue per user (or customer!), normally per month or per annum
Churn = the rate at which your existing customers cancel their subscription (sometimes also expressed in terms of tenure, or life expectancy of a customer)
CAC = average cost of acquiring a new customer, ideally including all sales and marketing staff costs
CTS = average cost to serve, again ideally including all customer support staff costs (sometimes also called COGS or cost of goods sold), normally per month or per annum
LTV = expected lifetime value of a customer
Burn = the amount of cash you spend each month
Runway = the amount of time you have left before you run out of cash, given your current burn rate

Dr SaaS has been designed to cut through all of this. You only need to enter your subscriber numbers (i.e. how many subscribers you have, how many new subscribers you added in the last month and how many subscribers cancelled?) and some details from your accounts about how much you earned and how much you spent (i.e. how much did you spend acquiring new customers, how much did you spend supporting existing customers and how much did you receive from them in subscription revenue?) We even help with suggestions about where you look to find these numbers.

With those details we can calculate the amount of money you can expect to earn from each new subscriber. The graph will look something like this:

Average Lifetime Value per Subscriber

This shows the total revenue you will earn from the subscriber over their lifetime as a customer (the big green bar on the left), less the amount you spent acquiring them as a customer (your sales and marketing costs, including staff costs) and the amount you will spend supporting them while they are a customer (your operations and support costs, including staff costs). What’s left is your gross profit per customer the (hopefully!) green bar on the right. If you spend more to acquire and service customers than you earn from them then the gross profit will be a red bar.

Every SaaS company is different, and there is not one right answer with this stuff, but it is important that you know your numbers and then think about what you need to do to improve those as you grow.

Good luck!

Track Record

Early-stage investment is a dark art.

Very few investors are forthcoming about their results, and so there is a lot of misunderstanding about what is “normal”.

The common belief seems to be that you just need to invest in ten companies and one of them will be a winner. I actually don’t think those sort of results are typical. My observation is that most investors have a selection bias which skews their returns significantly in one direction or another.

Either way, I thought it might be helpful to others to consider my own experience to date.

My first early-stage investment post Trade Me was Xero, in March 2007. It was a relatively easy decision, as I was also joining the team ahead of the IPO later that year. With the benefit of hindsight, I probably should have stopped after that, and I could now claim a 100% hit rate!

Instead, in the seven years since then I’ve made fifteen further direct investments. I’ve also made follow-on investments in six of these.

In total I have invested just over $4m so far.

This is the list in chronological order 1:

Sonar6 is the only real exit to date, after they were acquired by Cornerstone On Demand in April 2012. As an investor in their later rounds, that represented a ~2x return for me.

Four are sold or confirmed dead (in a couple of those cases there were very small amounts returned to investors, but only cents on the dollar so more of a gesture than something that should be considered a return) and one other is missing presumed dead, so 31% by count or circa 16% by value invested have resulted in a loss of the money I invested. That compares favourably with the 40% figure that Fred Wilson has written about although, as he says, that’s maybe just a signal that I’m not taking enough risks.

Thankfully, I’ve invested larger amounts in the companies which have been successful thus far. This is partly good luck and partly, I think, a function of the approach I take – typically investing a small amount at a reasonable valuation initially and then more later, once the company has proven they can execute and start to scale and as a result have significantly reduced the risk.

Xero is clearly the biggest success on that list at this point. The small portion I’ve sold has repaid my initial investment several times over, and the majority that I retain is worth more than all of the others combined, even after the recent share price correction. I remain very long and patient.

I’m also very optimistic about Vend and Timely, which take a large chunk of my time today. I am chairman at Vend and a director at Timely.

Atomic, Revert and Respondly are three recent investments, so far too soon to tell, but I’m very excited to be working with all of them too.

And, the jury is out on a few of the others – I’m hopeful there may be a couple more winners in that list too.

Overall, the portfolio doesn’t owe me anything at this point.

On top of that I’ve also gained some useful scars from the early failures. This is what I mean when I say get started and be prepared to suck for a bit. I suspect that is actually the only option, if this is something you’d like to be good at.

Some of the biggest lessons, so far:

I’ve learned it’s better to invest in the best companies, not the most companies. As the list gets longer I feel less and less inclined to do more and more.

I’ve learned that investing passively from the sidelines doesn’t provide much personal satisfaction, even if it goes well for the company, so my recent investments have been in ventures where there is an opportunity to get involved in some capacity in addition to investing cash 2. The downside with this approach is that time is finite. At the moment I have my hands full to overflowing with the things I’m already invested in and working on, so I’m focussed on those rather than looking to add anything new into the mix (and, as I have to constantly remind myself, focus means saying no or, aspirationally, having an assistant to say no on your behalf).

I’ve learned that you can achieve a lot more if you’re not worried all the time about who gets the credit, but if you take that approach you have to assume that you won’t get the credit and be comfortable with that.

I’ve learned that as a potential investor aimless networking, coffee meetings and events are a black hole, and you can spend all your time there, but it doesn’t really help you to find the best investments or contribute much of value to the companies you’re already working with.

Time will tell how this goes.

It will be interesting to look back at this list in another seven years and see whether the companies that I think are the possible winners now actually worked out that way, or if there were any surprises. And, who knows if there will be more names to add to the list which at the moment are nothing more than an idea.

I continue to make it up as I go. No doubt there are many more lessons to come.

Perhaps this post will prompt other local early-stage investors to talk more openly about their own results and experiences too. If so, please add a link in the comments below.


 

Notes:

  1. There are a few things excluded from this list, where my investment was a token amount. I have excluded the projects I’ve worked on with the team at Southgate Labs, such as Triage. They are not material to the calculation because my investment there has been predominantly time rather than cash. I’m also a small investor in the latest Movac fund, however it would be generous to count any of their investments as mine in this context so they are also excluded.
  2. In practical terms this means spending a day or so each month working with the founders on whatever they need help with, and being available in between those times via video or email to answer questions or be a sounding board – usually for things like strategy, planning, finance, legal and recruitment (or the opposite!) Ironically, these days, less and less of my time is spent on product or software development, even though being good at that was what earned me the right to be in this position in the first place, although I’ve typically invested in ventures where those skills are well represented in the team already.

Investor Motives

When founders think about raising capital my observation is they nearly always start with the question of ‘how much?’, when they would often be better served to first ask ‘who?’

It’s useful, although rare, to try and understand the various things that might motivate different investors to be tempted by your venture at the stage you’re at, because it makes a big difference to how you might present the opportunity to them.

1. Story

Some investors are attracted by the apparent glamour of early-stage ventures. They like to be able to tell their friends and colleagues that they are investors in something that seems more exciting than their day jobs.

You need to offer these investors a role where they will get some recognition for their involvement.

2. Contribution

Some investors are looking for something to spend their time on, and prefer to be able to leverage that investment with a financial stake.

You need to offer these investors a role where they can feel they are involved and making a difference.

3. ROI

Some investors are simply looking for a return on investment – that is, at some point in the future they want you to give them back more than they gave you, plus some extra for the risk they took and the period of time that you had the benefits of their money – that could be on-going dividends or cash on exit.

You need to understand what sort of return they are expecting (this will likely depend on their personal circumstances and how early they are investing), and you need a spreadsheet which shows them the numbers to give them confidence that if things go well this is possible in your case.

4. Carry

Some investors who invest a fund on behalf of others are compensated based on the size of the fund and the overall capital gain they produce for their funders – e.g. a VC will typically receive 2% + 20%, meaning they are paid 2% of the total value of the fund they manage every year (this is used to cover the fixed costs of running the fund) and 20% of the gains. See: http://avc.com/2008/08/venture-fund-1/

You need to convince these investors that you have a chance of knocking it out of the park – because they are investing in a portfolio of companies alongside yours, there is not much difference for them between a complete failure and a mild success, so they will expect you to be swinging for the fences.

5. Uplift

Some investors who invest a fund on behalf of others are compensated based on the current value of those investments – e.g. a hedge fund will typically pay managers a bonus every year based on the increase over that time. This effectively means they buy the shares again every year.

You need to show these investors that you can steadily increase the value of your business over time and avoid any nasty shocks which could cause the value to drop from one year to the next.

So what?

Think about what sort of investor is appropriate for you, given the stage you’re at and your own ambitions for the future. It’s surprising how often there is a complete mis-match between the motivations of founders and investors as a venture grows.

If you’re just getting started and need a small amount to cover your costs while you explore the opportunity, then you’ll probably struggle to get larger investors excited, given they generally prefer to invest bigger amounts once there is an obvious way that this money can be used to remove constraints. More than this, it can actually be toxic to get a high profile investor on-board in your first round – in your next round other investors will take the lead from them, and if they choose not to continue investing, for any reason, then you’ll likely struggle.

Likewise, once you’ve proven the venture and are ready larger amounts of capital to help you accelerate, then you’re probably wasting your time if you’re still pitching investors who are mostly interested in the story or contributing their time, but who normally don’t write big cheques.

And, if you just want to create a great business that will pay a good salary for you and maybe a few friends, then you’re creating a future headache for yourself if you raise money from more institutional investors.

I’d encourage you to have the conversation explicitly in advance with potential investors. If it’s not clear which type of investor you’re talking to then take some time to understand what is attracting them to your venture.

What are the other types of investors and motivations that you’ve seen?