Key SaaS Metrics Every Investor Should Monitor: ARR, CLTV, and Churn Rate Explained

In SaaS investing, it’s easy to be swayed by impressive user numbers or big rounds of funding. However, experienced investors will know that a company’s true strength can be gauged by three essential metrics: Annual Recurring Revenue (ARR), Customer Lifetime Value (CLTV), and Churn Rate. These numbers are far more than just figures on a spreadsheet; they offer critical insights into the financial health and sustainability of a SaaS business.

Understanding these key metrics can help investors make informed decisions, identifying companies that are not only expanding but also retaining their customer base. In this guide, we’ll break down why ARR, CLTV, and Churn Rate are fundamental indicators of success in the SaaS industry — and why mastering them is crucial for investors. 

What Is ARR, and How Is It Calculated?

Annual Recurring Revenue (ARR) is a key metric that measures the predictable and recurring revenue generated by a SaaS (Software as a Service) company on a yearly basis. It’s a crucial indicator of a company’s financial health and growth potential, especially for subscription-based businesses.

ARR is calculated by summing up all recurring revenue from subscriptions over a 12-month period. Here’s how it typically breaks down:

1. Start with Monthly Recurring Revenue (MRR): This is the predictable revenue generated each month from all active subscriptions.
2. Multiply MRR by 12: This gives you the basic ARR figure.
3. Adjustments: Add or subtract any changes that affect annual revenue, such as:
   • Upgrades: When customers move to higher-tier plans
   • Downgrades: When customers switch to lower-tier plans
   • Churn: Lost revenue from customers who cancel
   • New customers: Added revenue from new subscriptions

The formula can be expressed as: 

ARR = (MRR at the start of the year + New MRR – Churned MRR ± Changes in MRR) × 12

For example, if a company starts the year with $100,000 MRR, gains $20,000 in new MRR, loses $5,000 to churn, and sees $10,000 in upgrades, the calculation would be: 

ARR = ($100,000 + $20,000 – $5,000 + $10,000) × 12 = $1,500,000

Why Is ARR Important?

For SaaS investors, Annual Recurring Revenue (ARR) serves as a critical lens through which to evaluate a company’s financial health and growth trajectory. Unlike one-time sales or project-based income, ARR represents a predictable, stable revenue stream that forms the backbone of a SaaS business model. This predictability allows investors to gauge the company’s ability to sustain operations, fund growth initiatives, and weather market fluctuations with greater confidence.

ARR’s importance lies in its ability to showcase a company’s momentum and market traction. A consistently growing ARR indicates that the business is not only acquiring new customers but also retaining and expanding its existing base. This growth trend can signal product-market fit and effective sales and marketing strategies, key indicators of long-term viability.

ARR also provides a clearer picture of a company’s true size and scale, especially when compared to traditional revenue metrics that might include one-time fees or professional services. For investors, this clarity is crucial in assessing valuation and potential return on investment.

What Is LTV, and How Is It Calculated?

Customer Lifetime Value (CLV or LTV) is a metric that estimates the total revenue a business can expect from a single customer account throughout their relationship. It provides insight into the long-term value of customer acquisition and retention efforts.

Calculating CLTV involves several components:

1. Average Revenue Per Account (ARPA): The average amount of revenue generated by each customer account over a specific period, typically monthly or annually.
2. Gross Margin: The percentage of revenue retained after accounting for the direct costs of delivering the service.
3. Customer Lifespan: The average duration a customer continues to use the service before churning.

The basic formula for CLTV is: 

CLTV = ARPA × Gross Margin × Customer Lifespan

For example, if a SaaS company has:

• ARPA of $100 per month
• Gross Margin of 80%
• Average Customer Lifespan of 3 years

The CLTV would be: $100 × 12 months × 3 years × 80% = $2,880

However, this basic calculation doesn’t account for factors like expansion revenue (when customers upgrade or purchase additional services) or the time value of money. More sophisticated CLTV models might incorporate:

• Expansion Revenue: Additional revenue from upsells or cross-sells
• Discount Rate: Adjusting future revenue to present value
• Churn Rate: The rate at which customers stop using the service

A more complex formula might look like this: 

CLTV = (ARPA × Gross Margin) × (1 / Monthly Churn Rate)

This version factors in churn rate to estimate customer lifespan more accurately.

Why Is It Important for Investors to Know LTV?

CLTV is a critical metric for investors as it provides deep insights into a SaaS company’s growth potential and operational efficiency. Here’s why it’s important and how investors can approach it:

1. Profitability indicator: CLTV helps assess whether the company can generate long-term profits from its customers.
2. Efficiency gauge: It reflects the effectiveness of customer acquisition and retention strategies.
3. Growth potential: A high CLTV suggests room for scaling and market expansion.
4. Competitive advantage: It can indicate a strong product-market fit and customer experience.
5. Sustainability: CLTV helps predict the company’s ability to maintain growth over time.

When evaluating CLTV, savvy investors need to be on guard against common pitfalls that can skew their perception of a startup’s true potential. Be wary of overly optimistic projections that paint an unrealistic picture of customer lifespans or growth rates. These rosy outlooks can mask underlying issues and lead to poor investment decisions. Similarly, CLTV calculations that downplay or ignore churn rates should raise red flags. A high CLTV means little if customers are rapidly exiting the door.

Keep a keen eye on how costs are factored into the gross margin component of CLTV. Some startups might inadvertently (or deliberately) overlook certain costs of servicing customers, inflating their CLTV figures. As an investor, always dig deeper, ask for detailed breakdowns, and cross-reference CLTV with other key metrics to build a comprehensive view of the startup’s health and growth prospects.

What Is Churn Rate, and How Is It Calculated?

Churn rate measures the rate at which customers stop doing business with a company over a given period. It’s essentially the percentage of customers who cancel or don’t renew their subscriptions. It is typically calculated on a monthly or annual basis. The basic formula is:

Churn Rate = (Number of Customers Lost During Period) / (Number of Customers at Start of Period) × 100

Let’s say your SaaS business has 1000 customers at the beginning of the month, then loses 50 customers by the end of the same month. Its monthly churn rate would be:

(50 / 1000) × 100 = 5%

However, this simple calculation can be refined in several ways:

1. Revenue churn: Instead of counting customers, you can measure the amount of recurring revenue lost.
2. Net churn: This factors in expansion revenue from existing customers, potentially resulting in a negative churn rate if expansion outpaces losses.
3. Cohort analysis: Examining churn rates for different customer groups based on when they signed up or other characteristics.

Acceptable churn rates vary by industry, company size, and target market. B2B SaaS companies typically aim for annual churn rates below 10%, while some B2C models might see higher rates.

What Is the Importance of Churn Rate When Investing in a Business?

Investors should also recognize that churn rate can provide insights into a company’s competitive positioning and the overall health of its target market. A rising churn rate might indicate increasing competition or market saturation, while a decreasing rate could suggest a strengthening market position or improvements in product offerings. By examining churn rates across different customer segments or time periods, investors can gain a nuanced understanding of where a company excels and where it faces challenges, informing their assessment of the management team’s ability to address weaknesses and capitalize on strengths.

Even if a business is gaining new customers quickly, high churn can create a situation where gains are offset by losses, leading to slow growth and inefficient use of resources. Churn rate also influences other metrics like Customer Lifetime Value and Customer Acquisition Cost ratio, which are crucial in assessing a company’s profitability and scalability.

A thorough analysis of churn rate helps investors make informed decisions, assess risk, and estimate potential returns in the unpredictable SaaS industry.

Due Diligence Tips for SaaS Metrics

While ARR, LTV, and Churn Rate provide valuable insights into a SaaS company’s health, savvy investors know that surface-level numbers don’t tell the whole story. Effective due diligence requires a deeper dive into these metrics to uncover the true potential and risks of an investment opportunity.

Before jumping into the specifics, it’s crucial to approach due diligence with a skeptical yet open mind. Remember, your goal is to build a comprehensive understanding of the company’s performance, growth trajectory, and underlying business model. These metrics are tools to help you achieve that understanding, not ends in themselves.

Here are eight key tips to guide your due diligence process:

1. Request detailed breakdowns: Look beyond annual figures. Ask for monthly or quarterly data to spot trends and seasonality in ARR, LTV, and churn.
2. Verify calculation methods: Ensure the company’s formulas align with industry standards. Be wary of unique methods that might inflate numbers.
3. Cross-reference metrics: Compare ARR growth with customer acquisition rates and churn. They should tell a consistent story about the company’s growth.
4. Segment analysis: Ask for metrics broken down by customer segments, product lines, or regions. This can reveal strengths and weaknesses in specific areas.
5. Examine cohort behavior: Analyze how LTV and churn evolve for different customer cohorts over time. This can indicate improvements in product value or customer success efforts.
6. Review underlying data: Don’t just accept final numbers. Examine the raw data used to calculate these metrics, looking for anomalies or inconsistencies.
7. Assess customer concentration: Evaluate the impact of key accounts on ARR and how their potential churn might affect overall metrics.
8. Benchmark against the market: Compare these metrics with similar companies to gauge relative performance and identify areas for improvement.

By applying these tips, you’ll gain a more nuanced understanding of the company’s performance and potential, allowing you to make more informed investment decisions in the dynamic world of SaaS.

Final Thoughts

As you evaluate your next investment, think about how these metrics reflect the company’s engagement with its customers and its potential for sustainable growth. Most importantly, use this knowledge to spark meaningful conversations with founders and fellow investors. By doing so, you’ll make smarter investment decisions and contribute to the growth and success of promising SaaS ventures.

Author bio:

Trevor Hatfield founded Inturact, a company providing B2B SaaS user onboarding and customer onboarding solutions that help SaaS companies identify and solve actual product onboarding problems, reduce risk, and provide a clear path to increased paid conversions and better retention.