As non-GAAP measures, they might be based on variables other companies don’t share, but they can be made more accurate, says SaaStr head Jason Lemkin.
If your monthly recurring revenue (MRR) numbers don’t add up to your annual recurring revenue (ARR) when you extend them out for a year, you’re misreporting the financial health of your recurring-revenue startup, says Jason Lemkin, head of SaaS resource organization SaaStr.
A mismatched MRR and ARR is one of several ways software-as-a-service (SaaS) companies get their numbers wrong, which can lead to a distorted picture for investors, Lemkin says.
Even startups that have grown enough to hire a CFO can make mistakes in reporting non-GAAP SaaS metrics because of the absence of standardization.
“SaaS metrics can be more confusing than one might think,” Lemkin, who’s founded SaaS startups and today invests in them, says in an analysis.
Poorly thought-through metrics are more than just a distortion of how well a company is doing; they’re a red flag to investors about how soundly the company tracks its performance.
ARR = 12 x MRR
Lemkin says he sees a lot of companies excluding some customers from their MRR and ARR calculations. That’s a mistake — it leads to the two numbers not matching up.
“Everyone will just get confused,” he says. “MRR is just a monthly snapshot of your recurring revenue for this month, and ARR is really just a projection of that across the current and following 12 months,” he says. “So, ARR is just 12x your MRR.”
If you’re having trouble tracking your MRR, he says, work around that by multiplying your GAAP revenue for the month by 12 and calling that ARR. “That’s fine enough for now,” he says.
Gross burn rate is not a thing
Many companies report the month’s total of cash out the door, or in some cases their total operating expenses, as a gross burn rate. Both are wrong, he says.
Burn rate is how much cash goes out the door, or how much your bank account has gone down, during the month: always net of revenue.
To calculate it, subtract total cash out the door from total cash received. Any other calculation is a distortion, he says.
The metric, he says, is “designed to tell you how much time you have left, with the exact cash on hand. No games. No exceptions.”
To make it more informative, you can pair it with a zero cash date in your reporting. That’s a calculation of when you would run out of money based on your spend rate.
“Once I tracked [zero cash date] super carefully, I found it super helpful; it aligned everyone in the company and all the investors … on exactly what our runway was,” he says.
Cash collection should at least equal MRR
Many startups report collecting only 60-70% of their MRR, but they’re likely calculating MRR incorrectly.
“Folks challenge me here all the time,” he says. “And then they come back months later and say I was right.”
If the problem isn’t with their MRR calculation, then they could have a more substantive problem: bad collections, particularly if they haven’t set up a sound accounts receivable function.
The problem tends to grow when they bring on enterprise customers and have to invoice for payment rather than rely on the self-service payment gateway they use for regular customers.
“The invoice is sent out, and the startups just wait,” he says. “The cash that sounded so great from an annual deal just never comes — at least, not enough of it.
Lemkin says SaaS companies should bring in at least 100% of MRR in collections and, ideally, 110%.
The way to generate more cash collections than MRR is to factor in any deals in which a portion of subscription amounts are pre-paid or, in the case of upselling existing customers, some amount of the upsell is pre-paid.
All churn counts
Many companies distort their reporting by not including what they consider one-off instances of churn, such as when a big client leaves because of poor product fit.
Even if the customer isn’t typical for the company, their leaving should be included in churn reporting, otherwise investors won’t get a true performance picture.
“I hear this so often,” he says. “A big customer or two churn, and it ‘doesn’t count’ because the product wasn’t the right fit, or there was champion change, or they were an “early customer,” or whatever. Well … it will happen again. You’ll lose another big customer. So, you don’t get to not count it.”
Inflated net promoter scores
Net promoter score (NPS) is backward-looking but it can be considered a leading indicator because of its relationship to customer acquisition and retention. Companies with high NPS tend to bring customers on board and keep them.
“Like clockwork, if your customers love you, you’re going to sell them more,” he says, “even if you aren’t yet.”
But be careful; the metric can be subject to distortion and for companies that routinely boast of a score higher than 60%, it’s likely their measurement isn’t accurate because of the sample pool.
“A super-high NPS is usually an artifact of who answers,” he says. “As you scale, it rarely stays that high, especially if you really ask everyone.”
In short, he says, your NPS is almost certainly lower than you think.
The lack of SaaS metric standardization makes them open to interpretation, which can make them confusing if investors aren’t clear what goes into them. But there’s one indicator that should be a red flag to anyone looking at a SaaS startup: late reporting. Lemkin uses a rule of thumb: the later the investor update, the worse the month.
“By the last day of the month, you should at least sort of know your approximate MRR, if not all your expenses,” he says. “The best SaaS CEOs are proud of that, and almost always get an investor update out ASAP.”
Even if you don’t have final numbers, provide a flash update within at least 72 hours of the month’s end, and then update it with hard numbers later. If you don’t, it can send a bad message.
“The lack of transparency just worries everyone,” he says.
This blog was originally authored by CFO Dive. Republished with permission.