I’ve been working within the software as a service (SaaS) industry for more than five years now. During this period I’ve learnt more than I ever thought possible about the SaaS business and my personal growth has accelerated with each passing year.
Working with fast-growing technology companies HubSpot and Indeed.com has taught me how two very different companies can come to dominate their respective industries. Importantly, these experiences have shown me what is required for a SaaS business to launch, grow and ultimately, succeed in new markets. I’ve also become well-acquainted with a number of “rules” or truisms that SaaS businesses are run by - some of which are well known within the industry, but others which have been largely kept under wraps, until now.
Before we dig into the rules, I just want to say that in my mind rules are made to be broken, and should be thought of more as a guide, template or guardrail. My advice is to use them as a starting point of discussion at your business, rather than follow them blindly.
Rules to Run Your SaaS Business By
Let’s get down to it. Here are the key rules I’ve learnt to run a successful SaaS business by:
1. Rule of 40 - finding the right blend of growth and profitability
Perhaps the most famed SaaS rule of all, is the rule of 40. It’s a simple calculation to help you quickly and easily understand the health of a SaaS business. The rule states that a businesses annual revenue growth rate, plus its profit should equal 40%.
For example, if a company’s growth rate is 20%, then profit should be 20% or if the growth rate is 40%, then breaking even is absolutely fine, or indeed any other permutation, so long as the growth rate and profit equals 40%. The chart below shows a number of industry leading SaaS companies that have achieved the rule of 40.
Source: For Entrepreneurs
What I like about this rule is that it takes into consideration the twin challenges of growth and profitability, and can be applied regardless of growth stage. Why does growth stage matter? Well, sometimes investing heavily in the pursuit of growth is the right move for a company, especially in a winner-takes-all market, but at other times, particularly in more mature markets, monetization and profit will likely be the right call. The rule of 40 accounts for both scenarios and everything in between.
2. Rule of 3 and 10 - everything breaks when you grow
It’s important to recognise (and plan for) that how you operate will fundamentally change as your business grows. What works with 50 employees will creak heavily at 500 and come crashing down with 5,000. As you grow you’re going to need new processes, people, playbooks and additional layers of management.
Put simply, the rule of 3 and 10 means that when a company trebles in size everything breaks. The number of employees when things get particularly troublesome are three, 10, 30, 100, 300 and 1,000 - before company headcount hits these milestones you’ll need to rethink how you operate. Just think, the skills and attributes which are required of a marketing leader at a 10 person company are much different, and indeed could be a potential weakness at a 1,000 person company.
3. LTV:CAC needs to be 3:1 (or greater)
Throughout the SaaS world, there’s two metrics that business leaders keep a close eye on at all times - they are lifetime value (LTV) and customer acquisition cost (CAC). These metrics immediately give insight into the health and likely success of a SaaS business.
LTV:CAC is the lifetime value of a customer divided by the customer acquisition cost. LTV as its name suggests is the total lifetime value to the business of a customer and the CAC is the costs associated with maintaining the product, as well as marketing and sales costs.
Looking at these numbers as a ratio helps you understand how effective a business is at making money. You can clearly see what the return will be from every dollar, euro or pound invested. An LTV:CAC of 3:1 is desirable within the SaaS industry (an even greater LTV is better).
4. Keep annual churn <7%
In my mind, churn is the most important of all SaaS metrics. There’s no point acquiring new clients if churn is out of control. Think of it like a leaky bucket - you need to fix the hole, rather than continually filling the bucket with more water. Churn matters and understanding how it’s calculated and the causes behind it is really important.
It may not be immediately apparent, but there’s some important differences between monthly and annual churn. Allow me to explain. A 5% annual churn rate means that monthly churn is 0.42%, whereas a 5% monthly churn equates into a hugely troubling 46% annual churn rate. Or put another way, a 5% monthly churn rate means that if you started January with 100 customers you’d only have 54 customers left at the end of December. In order to record any kind of growth you’d have to acquire another 47 new customers.
While each industry and company is different, a 5% monthly churn rate isn’t a solid foundation for a SaaS business, and in all honesty a business in that situation should seek to ramp up retention and dial down acquisition. Otherwise, it’s literally burning through money. To avoid this situation you obviously want churn to be as low as possible, but SaaS businesses which require a 12 month, upfront commitment should aim to keep annual churn under 7%.
Remember that churn is the silent SaaS killer - often sales and marketing receive all the attention and glory, but services is where the predictable recurring revenue is made and kept. Retention trumps acquisition.
5. Track your NPS closely
One of the best ways to understand the success of your customer base is net promoter score (NPS). It’s an index ranging from -100 to 100 that measures the willingness of customers to recommend a company's products or services.
While NPS may lack detail and qualitative data, it does provide an effective indicator of the health of a client, and was widely used at both HubSpot and Indeed.com. For those unfamiliar with NPS, its scoring system means that you’re penalised heavily for a poor rating (0-6 are classified as detractors), receive nothing for mediocre ratings (7-8 are classified as passives) and are only rewarded for high ratings (9-10 are classified as promoters).
What represents a “good” NPS changes between industry and product, however, you should track your own NPS, as well as conduct research to track and benchmark key competitors. To build upon my previous point - churn is really important and NPS is a metric SaaS businesses can and should use to identify customers that are at risk of quitting.
6. Create a discounting process
Discounting tends to be a big challenge within the SaaS industry - it’s literally one of the quickest and easiest ways to maximise or damage revenue potential. To manage discounting effectively you need some guiding principles and a process in place.
For starters, you should always sell on the basis of the value that your product will create, rather than features or functionality. And if you do find yourself in a negotiation, it is advisable to take a “give-to-get” approach and request a greater commitment (more product, multi-year contract, payment upfront) in return for a discount. You should also have predefined limits about who can authorise what level of discount - for instance, a sales rep can sanction 5%, a sales manager 10% and sales director 10%+.
While principles are valuable, you also need a process for sales reps to follow when entering a negotiation - a clearly defined process ensures that sales reps avoid discounting at every stage of a deal.
At HubSpot we rolled out the following discount process. Sales reps explain to prospects that the first four steps must be completed before a discount can be discussed:
The prospect agrees that their challenge needs to be solved now.
The prospect agrees that HubSpot solves their challenge and not a competitor.
The prospect shares the desired start date and procurement process.
The key decision-maker is part of the sales process.
Only now can a discount be discussed.
7. Have a framework to evaluate investments
Over the next 12 months should you build a new product line, open your first international office or acquire a competitor? Understanding what, when and where to place your bets is hugely important. You need a system to help guide your investments so you not only succeed today, but in the future.
During my time at HubSpot there’s been two frameworks which have stood out as strategic ways to make important decisions. The first is the idea of S Curves - all products, markets and business models follow a predictable cycle of growth, maturity and decline (the pattern often looks like an “S”, hence its name). After a period of growth, maturation strikes as price competition emerges, the most attractive customers are acquired and businesses see diminishing returns.
To overcome this challenge, the best companies continually innovate and create new products to offset the maturation and decline of existing ones. The lesson here is to view your products in terms of S Curves and ensure you’re investing in your next greatest hit.
The second model is the Horizons Framework developed by McKinsey. It offers a way to focus on short, mid and long-term growth opportunities, and the eagle-eyed among you will notice that (see chart below), visually, it shares some similarities with the S Curve diagram.
The Horizons Framework is an effective way to categorise projects, which in turn helps with assigning budget, headcount and timelines. The framework requires you to categorise work that is either a horizon one, two or three. Horizon one represents core products and services readily identified with the company and those that provide the greatest profits.
Horizon two covers emerging opportunities like new products and acquisitions, moves that are likely to generate substantial profits in the future, but that could require considerable investment. And Horizon three contains ideas for profitable growth further down the road. For instance, this could be research projects, pilot programmes and investments in other businesses.
The key point is, you need to have a framework for categorising and investing in future growth opportunities for your SaaS business.
8. Decrease your CAC with a freemium offering
While most SaaS companies focus on increasing the LTV of clients and simply controlling CAC, they should not be afraid to disrupt their existing go to market strategies in order to reduce CAC.
HubSpot applied its marketing product to the S Curve framework and saw it was reaching maturation. The tool remains the company’s greatest hit and what it’s best known for, however, it is a high touch sale with a high CAC, and has an increasing number of competitors. In order to create another line of business while reducing CAC, HubSpot launched sales, CRM and more recently, customer service tools.
Importantly, free, low touch versions are available for the marketing, sales and CRM tools (see image below) - people can test a light version of the product, see value and then graduate to the paid version.
The beauty of this freemium strategy is that HubSpot can use its free products to acquire large numbers of users, a percentage of which will be converted into paying customers at a later date. This approach means HubSpot has a new source of highly qualified leads at a much lower CAC (in comparison to other acquisition channels).
Adopting a freemium strategy lowers CAC for several reasons. First up, while free products require development time and ongoing maintenance, the potential reach is vast and products are more scalable than other acquisition channels, albeit less predictable. Secondly, free users often want to upgrade “touchlessly” without speaking to a sales rep, and for those that do want to speak with somebody, they often require less sales rep interaction than a regular sale - both of which reduce CAC and time to sell.
9. Hire for stage fit, not experience
Let’s face it, when you boil it down, most problems are people problems. Hiring matters. A lot. One of the biggest mistakes a fast-growing SaaS company can make is hiring for experience over stage fit.
For example, it’s not uncommon for a 100 person company fresh off a funding round to go and hire a VP of Sales from a Fortune 500 company. While this can work, you need to ensure that you’re hiring somebody for their ability to do the job today - as I said, it can work, but in all likelihood it’s unlikely a VP at a Fortune 500 company will succeed at a 100 person company. You need the right people for your company’s growth stage.
Businesses need to make hires based on people’s ability to execute in the short and mid-term, not on the fact that they worked at a publicly listed SaaS company.
10. Avoid overeating - as your business grows do more of less
At HubSpot, CEO Brian Halligan frequently reminded employees that “companies are more likely to die of indigestion than starvation.” What he meant was, as SaaS companies grow there’s always the temptation to do more, but if you’re not strategic you risk becoming slow, bloated and losing focus.
HubSpot communicates its goals in a document called MSPOT, which is published on the company wiki for all to see. It stands for mission, strategy, projects, omissions and tracking:
Mission: Rarely changes.
Strategy: Annually changes.
Projects: 4 or 5 big annual initiatives.
Omissions: Projects we decided not to fund.
Tracking: Numbers we are looking at to see if we are on track.
Halligan adds,“The most important part of the document is probably the “Omissions” part. These are the projects we are not going to fund this year. This is how the organisation limits my appetite so I don’t overstuff us.” The key learning here is that’s important to have a simple document which spells out the strategy for the year ahead, plus the initiatives that very deliberately won’t happen. That’s how you create alignment and focus.
There you have it. These are the rules I’ve learnt from my time within the SaaS industry. Both HubSpot and Indeed.com have not only survived, but thrived during this period and recorded record growth. I’d love to hear what rules, principles and truisms you use to lead your SaaS business. The SaaS industry is still very much in its first act - by sharing this information we will uncover new best practices, dispel myths and define what good looks like. It’s my belief that the best is yet to come from the SaaS industry and I’m excited about the second act and beyond.