Howard Marks talks a lot about never knowing what the future holds but he is a big believer in working out where the hell we are currently. This is a simple concept that we should apply to all forms of investing.
The starting point for analysis is to work out where we are. From there we can build out scenarios and come up with a matrix of possible possibles.
So with this in mind I want to build a picture of a company called BigTinCan (BTH) and examine the unit economics of the business currently.
Business models work when the revenue you extract from a client over the time you have them is greater than the cost to service and acquire them. Pretty simple really. The best businesses not only extract more value from their clients but they do this in orders of magnitude greater than the costs, and at the same time, make the client still believe they are getting a great deal. i.e you are creating Win-Win outcomes.
BTH’s core product value is defined as assisting Salespeople keep track of where they are in relation to the sales workflow pipeline as well as assisting with organisation and presentation of sales material. The BTH application can link inside an existing CRM. BTH claim that as data history builds over time it can be analysed to improve the sales process and hopefully close more deals and reduce the cost to acquire clients for the user of their platform.
If you get the core product value correct and it creates a Magic or a-ha moment then it keeps the user engaged and retains the user on the service. This is the formula that Chamath Palihapitiya made famous at Facebook and leads to sustained organic growth. Increasing churn is an indication that you may be failing on the magic moment metric.
So where is BTH now? Let’s try and lay the foundation and understanding of their basic unit economics.
Initially it has been hard to establish the key metrics of the business. BTH talks a lot about Monthly recurring revenue (MRR). As at June 2017 the MRR was $907,000 which increased 53% from FY2016. The target by December 2017 is $1.07m in MRR.
The other key metric BTH releases is its retention rate which worrying fell to 88% in FY2017 from 92% in FY2016. One of the keys to success for any SaaS business is to keep the clients you have as you have already spent money to acquire them. To replace lost clients you have to spend the money again to acquire new clients. The bucket is no good if it is leaking in the bottom and you are constantly topping up the water at the top to keep your water level constant.
Things that are not clear in the latest company announcements:
- Users on BTH platform as at end of FY2017. In their latest presentation they say it is over 100,000. The Prospectus had a forecast level for FY2017 as 111,300 users so we will use this level in our calculations.
- Gross User adds for the year.
- The company does not state what its cost is to acquire clients (CAC) . So we need to do some work and reverse engineer this number.
So these are some initial calculations for BTH in the table below:
From this we can see BTH has an estimated 111,300 users at end of FY2017 (from the prospectus) an increase of 11,700 from FY2016. This is a net add in users, to calculate a proper Cost to Acquire (CAC) we need to estimate Gross user additions. To estimate this I have taken the churn rate and multiplied this against the number of users at year end. So for FY2017 I have estimated Gross users added as 23,652, for FY2016 it was 19,632.
Sales & Marketing expenses are stripped out in the financials so I have calculated the CAC for FY2017 of $287 per user ($6.808m / 23,652). This is an increase from the FY2016 level of $239 which is a concern. BTH has spent more on sales & marketing in FY2017 for a lower return on user additions. However it is worth noting that S&M incurred in previous financial years is building the pipeline for next years growth so the CAC may fall if BTH manages to convert and increase users this year.
Average Revenue per user for FY2017 is $87.53 and is heading in the right direction, up.
So now we have built a simple picture of the unit economics of this business consider the following table:
Churn or retention for FY2017 was 88%, so in theory you have the client for roughly 8 years (1/(1-.88)).
Administration and Development costs have been fairly stable around $7-7.5m for the last 3 years. So on 111,300 users the cost to administer per user is $66. Let’s say this falls to $30 per user as they grow the client base.
At an ARPU of $87.50, a Gross Margin of 80% and an Admin charge of $30 then each user will generate $40 in pre-tax cashflow per year. At a churn of 88% then the Customer Lifetime value is $333 ex CAC undiscounted.
Taking off the CAC then we are left with a lifetime value of $46 per user undiscounted. You as a reader can play around with Churn, CAC and ARPU to build out what you think BTH may achieve over the coming years.
If you use the common benchmark of LTV/CAC > 3 then BTH comes in at <1. To improve this BTH needs to step up its organic growth which naturally lowers CAC, reduce its churn and increase its ARPU. Easier said than done. If it was that easy they probably would have done it by now.
The median CAC for SaaS companies is around 11 months of revenue. In the case of BTH at a CAC of $287 and ARPU of $87.50 then this figure is around 39 months.
At current EV close to $40m I will let you calculate how many users BTH needs to acquire to reach this total capitalised value. And remember if you add another 100,000 users at a CAC of $287 then this is another $28.7m in negative cashflow out the door.
I may be wrong on all my numbers but these are questions I would ask the company:
- Number of seats at FY2017
- Gross additions of users (not net users) for FY2017.
- CAC (we have kind of estimated this but interesting to hear the companies version).
- Cohort retention. ie I would like an estimate of the retention based on the months clients signed on. Retention rates are typically done as an average over a period. What is more useful is getting an idea of the monthly churn. For example for the clients that signed up in the last 3 month how many of them are still using? What is the retention for clients who have been signed up for 18 months etc. This will give us a feel for the quality of clients signed up recently vs longer term clients.
As a final though I am reminded of the term Steve Blank coined called “Premature scaling”. i.e a company will start spending money on growth before it confirms that it has a product market fit.
“As an entrepreneur there’s always the temptation to grow the sales team at the first sign of revenue traction, but there is always the danger that this early traction is coming from the subset of the market that are early adopters and not the actual market itself. Additionally, too often I’ve seen startups ramp up sales before they’ve figured out the most efficient way to achieve profitability”.
In summary the only way I feel SaaS businesses with a low ARPU can make it work is creating a network effect so the CAC is virtually zero. Network effects are extremely rare and even harder to build, so good luck.