Back in February 2015, Social+Capital VC Mamoon Hamid unveiled SaaS Quick Ratio at the SaaStr Convention. Since then it’s been a hot topic, emerging as part of investors’ standard fundraising asks. So, we’ve put together everything you need to know about the metric, how (and when!) it’s helpful to a SaaS business, and other things to consider when using SaaS Quick Ratio.
Right off the bat, we need to clarify the term and its meaning. You might have heard of Quick Ratio before. Traditionally, “Quick Ratio” is a finance metric that gauges a company’s liquidity, or a company’s ability to pay off all current liabilities ASAP (aka the “Acid Test Ratio“). SaaS Quick Ratio is different. What the metrics have in common: they both give investors a snapshot of how promising — or risky — an investment may be. Let’s see how this new metric works for SaaS, specifically.
What does SaaS Quick Ratio measure?
The metric pits your gains against your losses, new business and upsells versus cancellations and downgrades. Quite simply: what is the ratio of the money coming in to the money going out? The higher the ratio, the more efficient the growth.
There are a couple simplified or modified versions out there, too. But we’ll stick with the original formula to avoid any confusion.
What does it tell us?
The SaaS Quick Ratio looks at the bright and shiny side of your business and the underbelly at the same time (probably why investors like it so much).
As Tomasz Tunguz (Redpoint) put it, “the quick ratio measures a SaaS company’s growth efficiency.” It’s less about how much you’re growing. It’s more about how good you are at it, and if you can scale that revenue growth rate over time. Can you bring in new business and keep the old? One is silver and the other gold…
It’s no secret that maintaining low churn is key to the success of a SaaS business. It’s key to a strong SaaS Quick Ratio as well. On their own, forward-looking metrics like MRR and customer acquisition all suggest promising growth. But upon deeper investigation, those metrics aren’t able to mask a revenue-draining high MRR churn rate. As a result, a low SaaS Quick Ratio exposes the unhealthy side of even the most impressive MRR growth.
A low Quick Ratio (low revenue expansion in relation to revenue loss) suggests the company’s new revenue is not driving the business forward. Rather, it’s merely replenishing the revenue lost through cancellation and contraction. Over time, more and more effort must be poured into New + Expansion MRR just to compensate for churn. Something, be it the product or customer success efforts, needs tuning before investors will commit.
A high Quick Ratio (low revenue loss, high revenue expansion) confirms the company’s growth rate is both high and stable. The product is successful, the customers are happy, and there is a good framework in place for the business to scale efficiently. Revenue will continue growing at an attractive, predictable rate. Ding, ding, ding!
Well, what’s a good SaaS Quick Ratio?
Isn’t that the question? There’s an emerging debate around the metric’s benchmark.
Hamid says that a SaaS Quick Ratio of 4 indicates a healthy-enough growth rate for him to invest. This would mean you’re adding revenue 4x faster than you’re losing it. Sounds great, right?
But Tomasz Tunguz raises a very valid flag when it comes to the 4 score. He found that, at this benchmark, companies can still sustain monthly churn rates of 5.0% or higher. And, to quote ourselves, “anything over 3-5% should be sending warning signals.” For some businesses, perhaps a ratio of 4 isn’t high enough to overcome issues with churn.
So, the benchmark is relative, and it continues to evolve throughout a company’s lifetime. InsightSquared, in their study around benchmarking the metric, points out that “Achieving a SaaS Quick Ratio of 4 is a good benchmark for young, high-growth companies but the equation changes as those companies reach scale.” The growth characteristics of an established, fully-scaled company will be different than an early-stage startup. Therefore the SaaS Quick Ratio target, and the strategy toward it, will differ as well.
In reality you’ll need to find the right target for your company. What’s certain is that no matter your score — you should always keep an eye on churn.
How can you use it?
Here are some ways you can use the metric:
Tracking. Because VCs will ask for it. You can make sure you’re in the best possible position by the time they come knocking.
- Take note of accounts that are on contract, as they may skew the calculation!
- For companies in the first year of business, SaaS Quick Ratio isn’t so helpful. With young customers and customers still in a commitment period, the ratio isn’t a reliable indicator of anything. Focus your attention on individual metrics instead.
Insights. Tweak your analysis to discover new ways to improve.
- Segment the metric into different business elements (such as payment plan or business vertical) to identify any weaknesses in specific parts of your business. Tightening up there will boost your score.
- Examine the metric for specific time periods. Though the formula is defined across a monthly period, analyzing quarterly or yearly periods could yield different results and prompt further investigation.
Investors are looking at SaaS Quick Ratio to spot a profitable next move in the SaaS world. The currently accepted benchmark is 4, but you need to evaluate what makes sense for your business. If you don’t feel confident with your SaaS Quick Ratio performance, identify what’s bringing it down. Let Expansion MRR actually drive your growth forward, not just replenish losses. Put that hard-earned new revenue to effective use by lowering churn, which will amplify your Quick Ratio score and deliver an impressive number to VCs.
If you’d like to read more about SaaS Quick Ratio, the surrounding discussion, and the concepts involved, check out these other resources:
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— ChartMogul (@ChartMogul) March 10, 2016