A CFO’s Guide to Calculating SaaS Metrics with Usage-based Revenue

Examples of non-traditional ARR

For example, I’m working with a SaaS company that provides managed service on a usage basis. An individual customer’s usage is sporadic throughout the year, but it’s consistent year over year with an annual retention rate of 95%.  This is clearly ARR.

We also had a borrower at SaaS Capital who provided technology to running races like 5k’s and marathons. They were paid on a per-registrant basis at the time of the race. The size and timing of races varied each year, so retention was difficult to calculate, and revenue was lumpy. Nonetheless, there was little customer attrition, so over the entire year, revenue from the installed base recurred at close to 100%. Their revenue was very different from subscription revenue, but clearly ARR.

What about the “A” in ARR? How do you annualize consumption revenue?

This is a critical topic when raising money or selling a business. Annualizing revenue in a subscription business is easy. Take the most recent MRR and multiply by 12. But what if your consumption pricing business has significant variability month to month or has seasonal revenue?

Normal variability

Standard month-to-month variability can typically be handled using a three or six-month average. Try out different periods and see what smooths the revenue line the best without sacrificing recent growth trends. For slower-growing or no-growth SaaS businesses, consider using a trailing twelve-month number instead of estimating a current run rate. It will be less scrutinized and won’t differ much from your run rate.

Seasonal variability

 Seasonality is a bit more complicated. What is the run rate of a SaaS eCommerce platform that gets paid a percentage of revenues and recognizes much of its revenue in the last two months of the year? (See example MRR graph.) You could not pick three or six months that would accurately reflect its run-rate revenue. And using the trailing twelve months of revenue would understate growth.

ARR is attempting to capture what a full year of revenue would look like from the current base of customers.

Contracted minimums and overages

Some SaaS companies will work to get their contracted minimums to be as close to expected usage as possible and minimize overages. In other companies, contracted minimums are established at lower levels, where customers don’t risk paying for usage they do not use, and the SaaS business can generate higher revenue through higher overage rates.

So one company's overage is another's contracted minimum, yet all this revenue behaves essentially the same.

With enough historical data and when working across a base of at least fifty customers, overages are relatively easy to establish as ARR. My experience has been that overages happen year after year at predictable levels, which can typically be demonstrated with historical data. Ultimately, the contracted minimum revenue may be seen as slightly more predictable and valuable, but it's not an order of magnitude difference in most businesses.

What’s the best way to report revenue growth in a UBP business?

Revenue growth is the biggest driver of a SaaS company’s valuation multiple, and it is mathematically the same for a usage-based business as a subscription business. That said, the revenue growth drivers for the two types of companies are different.

New bookings minus churn determine a subscription company's growth. There might be a few new modules sold into the installed base, or there might be a price increase, but expansion revenue is generally limited and typically offset by churn. This typically equates to an NRR (Net Revenue Retention Rate) of 100% or less for these companies.

For UBP companies, however, growth is more balanced between new bookings and expansion revenue. Expansion revenue can include selling new products to existing customers or price increases but is typically driven by:

1. more consumption,
2. higher minimums, or
3. overages.

A vital distinction UBP companies need to make is: what should be considered new revenue? Is it only “new” in the period a customer was added, or does new revenue continue through the ramp-up phase?

By way of example, Snowflake customers start at a low level of revenue and take at least a year to migrate into something resembling their fully deployed revenue. If “new” revenue was only the first month or quarter, 90% of a new customer's total revenue would be captured as expansion. This would be misleading as new bookings are the primary contributor to growth. More on Snowflake later, as this issue significantly impacts net revenue retention.

The best way to address the ramp-up problem is to treat new customer revenue as “new” for a standard period approximating when most new customers are fully deployed. For many companies, this would be a quarter or two from the first month of revenue recognition, but for others, it would be much longer.

Calculating Gross Revenue Retention (GRR) for UBP

GRR is typically the “go-to” metric when trying to understand the underlying stability of a subscription business's customer base and revenue stream because it does not contain the “noise” you find in NRR from outlier customers or price changes. The GRR calculation includes losses from churn and contraction but does not include any expansion revenue.

For UBP companies, however, GRR can be heavily depressed by even modest variability in month-to-month revenue as GRR captures the downside of the normal variability but not the upside. It might be good for internal trending but not for external benchmarking or fundraising.

Other metrics Impacted by UBP

Logo retention

Logo retention is simply the percentage of customers you had a year ago that you still have today. It’s not influenced by expansion revenue or even the size of the customer. To the latter point, logo retention is a good indicator of the health of a business with large customers that skew revenue-based metrics. If a company has strong logo retention, all the other retention metrics will also be strong. The inverse is not true. It’s a good metric for usage-based companies because it cuts through some of the noise on NRR without understating retention, like the GRR calculation.

Customer Acquisition Cost (CAC) payback for UBP companies

This has become the most widely used metric to track how efficiently a SaaS business can grow its revenue. CAC Payback is calculated as (customer acquisition cost for the period)/((ARR of the acquired customer's/12) x’s gross margin percentage). Basically, how many months does it take for new customers to repay their cost of acquisition? CAC typically includes all fully loaded sales and marketing costs.

This is a straightforward metric for subscription businesses, with the only real obstacle being matching the right cost with the right revenue using the average sales cycle. Most companies selling larger products lag the acquired revenue by three months from the sales and marketing spend, but it’s company-specific. The metric should be calculated on a rolling basis monthly and include at least one quarter of CAC and one quarter of new bookings.

Usage-based businesses face the added challenge of determining the ARR for newly acquired companies. It’s the same challenge they face when trying to determine a new bookings number, and the solutions are the same. As discussed in the New Bookings section above, your approach will be driven by the nature of the UBP revenue.

1. If there are contracted minimums, use them for this calculation. If there is consistent overage revenue for most customers, you could add an overage estimate, but it’s probably not worth it for internal tracking.
2. Suppose new customer revenue is historically consistent around a median but varies monthly. In that case, this metric should be calculated after three to six months of actual revenue is collected and then averaged and annualized.
3. If new customer revenue is seasonal, use the seasonal approach outlined in the new bookings section to determine the ARR for the new cohort. This approach will normalize the metric for customers acquired across the calendar year. Otherwise, the CAC Payback ratio would rise and fall with seasonal revenue changes.
4. If new customer revenue follows a meaningful and consistent ramp-up period, it’s possible to create a schedule just as you would for seasonality. After two or three months of actual revenue, the customer's total first-year ARR can be estimated.

Options 2-4 are all efforts to estimate the normalized future annual revenue of the cohort of acquired customers so CAC Payback can be calculated quickly. Another approach is to wait and keep track of the actual revenue. Every cohort will generate a contribution margin each month, and as you add those dollars over time, they will eventually exceed the cohort's acquisition costs. The month that happens is the CAC Payback period. 

I call this the wait-and-see or cumulative approach. The downside to the approach is that the metric will often be finalized 9 to 24 months in arrears and might be useless to management in adjusting their go-to-market spending. That said, at a minimum, this calculation should be done to validate the estimated approaches listed above. The metric could lead to fundamentally flawed management decisions if the estimates are wrong.

Cash burn ratio

Like the CAC Payback ratio, the cash burn ratio is an efficiency metric. CAC Payback focuses explicitly on the efficiency of new customer acquisition, while the cash burn ratio is more comprehensive. The metric answers the question: How much money did it take to create a new dollar of ARR? The metric is calculated as (Net New ARR/Cash Burned). 

This metric is a good reality check to see if cash-flow-negative businesses are creating value. If a cash-burning business is not growing ARR, it is destroying value.  

Like all metrics that use ARR, this one is complicated by consumption pricing.  But because this is a higher-level metric, if calculated on a trailing twelve-month basis, the distortions of UBP tend to fade away. I prefer to use EBIT to define the company’s cash burn.

The rule of 40

The Rule of 40 is calculated as (revenue growth rate + operating profit margin) and has equal applicability to subscription and UBP businesses. There are no fundamental distortions to this metric brought about by usage-based pricing.

The metric is called the Rule of 40 because private equity firms developed it as a benchmark for their portfolio companies. Growth plus profitability for their portfolio companies was targeted to exceed 40%. (Not easy.)

The metric is a good but simplistic reminder that profits should be considered when evaluating a SaaS business. It’s less instructive, however, in early-stage companies where the growth rate can dominate the calculation. The metric also suffers from its intrinsic assumption that profits and growth are valued equally. From a valuation perspective, this is not true—growth rate drives valuation multiples more than profit margins. As of Q3 2023, revenue growth had a .4 R-squared correlation to revenue multiples, while the Rule of 40 R-squared was .19.

The same is true in the private markets. PE firms know how to make a high-growth business profitable, but it's much harder to turn a profitable business into a high-growth company.  As a result, they will pay more for a growth business.