Professional services for many SaaS companies have become an important way to on-board customers, keep customers satisfied with the product and using more features of an application or service, making it stickier. As one CFO recently said, professional services are definitely a churn-reducer. SaaS companies, particularly high growth, venture-backed firms, are pricing professional services as a loss leader, at cost, or even below cost. We have been seeing negative gross margins on professional services from some companies.
Total company gross margin is thus impacted when professional services are included. This is a choice many companies make and are willing to live with in order to grow rapidly and retain customers.
Customer Lifetime Value (LTV) Calculation
Professional services impact gross margin, which in turn is a component of the customer lifetime value (LTV) calculation. LTV is one of the hot performance metrics for assessing SaaS companies and whether their model is scaleable. It is also used to value companies, particularly when viewed in the context of the cost of customer acquisition (CAC)
Many companies use recurring revenue gross margin (not total company gross margin) in their LTV calculation. The logic behind this may come from an earlier time when the consulting group was run effectively as a separate business and was not integral to building the subscription business.
LTV is calculated by taking the average customer Monthly Recurring Revenue (MRR) and multiplying it by gross margin, and dividing it by the average churn rate (1/churn gives you the estimated customer lifetime, or how long they will continue subscribing to your service). For more detail on calculating LTV, David Skok’s SaaS Metrics 2.0 does a great job explaining it.
SaaS Gross Margin – Recurring Revenues Only or Including Professional Services?
For companies selling professional services as a loss leader, using total gross margin would reduce their LTV calculation, so using the recurring revenue gross margin alone, which typically is in the 80+% range, gives a better LTV. Including professional services in the gross margin calculation can affect a key performance and value metric. Let’s take the example of company XYZ. Their raw data looks like this:
- average customer MRR is $23,000
- churn rate is 10%,
- total gross margin is 54%
- recurring revenue gross margin alone is 78%
The first calculation with total company gross margin: (23,000 X 0.54)/.1 = $124,200 LTV
The second calculation using recurring revenue gross margin is: (23,000 X 0.78)/.1 = $179,400 LTV
The LTV/Cost of Customer Acquisition (CAC) ratio is another hot SaaS metric, a quick way to see if your spending on acquiring new customers is worth it in comparison to the lifetime of the customer. For more on why the LTV/CAC ratio is important, see Dave Kellogg’s post on the Ultimate SaaS metric: LTV/CAC ratio.
Let’s look at how the calculation is affected by using total company gross margin, versus only using the recurring revenue gross margin:
Total Gross Margin:
With a CAC of $25,000, the LTV/CAC ratio calculated with total gross margin is 4.97.
Recurring Revenue Gross Margin only:
With the same CAC of $25,000, the LTV/CAC ratio calculated with just the recurring gross margin is 7.1, a ratio which is 43% higher.
Common wisdom says any LTV/CAC ratio higher than 3 is a good result, so both these results are fine to demonstrate a minimum threshold of a successful SaaS business. However, the calculation resulting in an LTV/CAC ratio of 7.1 would be valued more highly. Performance results like that might also cause the board to recommend additional spending, without having a full understanding of what each customer is costing the company.
Going forward, OPEXEngine will start breaking out LTV as two calculations, one using only the recurring revenue gross margin, and the second using total company gross margin, so that companies can see the difference and track their progress.
Wouldn’t a more true look at LTV for these companies with professional services also include the impact of the gross margin on the Professional Services. In your example above if the professional services is done as part of implementation, simply use the recurring revenue margin on the MRR and then adjust the LTV for the impact of implementation. IE in the MRR gross margin case where LTV is $179k, if it the ProServ revenue is $20k and and the costs of that is $25k for a negative margin, simply subtract the $5k on the lifetime value. Obviously the scale of my example is likely not accurate, the loss of ProServ could be significantly larger but my example isolates the impact of two discreet business models on the LTV of a customer. This would better isolate the impact that ProServ and your Subscription Business model is having on your LTV. Simply using the margin, ignores the potential scale of your ProServ business on your MRR LTV.