Seeing Your Strategy in Your Numbers
Because of the long investment cycle for software and recurring revenue models, ROIC may not be measurable until the business approaches to scale. This can take over a decade for most software businesses.
5 Key Metrics to ‘See’ if Your Strategy is Working
What are the key metrics you can look at now to ensure that in the end you achieve ‘superior performance’ and know if you do indeed have a tangible strategy that is visible in your numbers?
There are five key metrics that will help you see if your strategy is paying off:
- Lifetime Development Ratio (LDR)
- ARR Payback
- Net Revenue Retention (NRR)
- Coverage Ratio
- Operating Leverage
Lifetime Development Ratio (LDR)
The Lifetime Development Ratio is calculated by dividing ARR by all the money spent on development costs (including maintenance) over the life of the product.
For a subscription software business model to eventually reach scale economics (i.e., generating a 15-20+% operating profit), the development costs need to settle in at around 20-30% of ARR while growth is high and 10-15% of ARR once close to scale.
In terms of the LDR ratio, this means that you should be looking to achieve 2.00 or higher in your current budget and be scaling toward an LDR of 2.00 to 3.00.
If your LDR is less than 2.00, consider asking yourself the following:
- Is the product aligned with what the market needs (product market fit is off)?
- Are the marketing and sales efforts identifying the right customers and are they effective at conveying value?
- Is the development team efficient at building value in creating products and features?
There are several ways to calculate this ratio, but the generally preferred method is to look at a 12-month rolling new booking vs. a 12-month rolling sales and marketing.
I prefer this method because it takes out timing and seasonality issues and shows if the number is improving over time without the noise. The target ratio for this metric is somewhere between 9-15 months of payback.
Net Revenue Retention (NRR)
This metric can give significant insight if you divide your clients into ‘strategic’ vs ‘non-strategic’. If you truly have a strategy where you have identified a specific customer set and have aligned your operations to create value specific to that customer set then you should see a significant difference between strategic and non-strategic in the NRR ratio.
Strategic clients should clearly feel the value and be willing to pay more and ramp while non-strategic customers will not feel that value, resulting in lower growth and much higher churn.
If non-strategic customers are behaving the same as strategic customers, then you will most likely have not customized and focused on your software.
The coverage ratio is calculated by dividing the ARR run rate by the OpEx run rate (excluding cost of services).
Excluding cost of sales enables companies to benchmark on both an infrastructure level and on a total spend level. Once a company has achieved MVP it should focus on improving the Net Coverage Ratio by rationalizing the business. A business is ‘rationalized’ once revenue can cover operating expenses.
A rationalized business can still grow faster than its internal growth rate (IGR = the rate of growth the business could sustain without external financing) by raising funds via debt or equity. If the ARR payback is healthy (between 9-12 months) then the temporary drop in coverage will be replaced within the funding cycle.
The combination of investment funding with client funding via prepayment on subscriptions enables a software subscription model to continue to grow rapidly without creating a significant gap in funding and can switch toward profitability at any time.
A Gross Coverage Ratio would be the target ratio that would cover not only full spend (including cost of sales) but the target profit margin as well. By using this ratio you can determine how fast infrastructure costs should be growing to maintain a 1.00 ratio and gradually work towards a 1.25-1.70 ratio when you are fully at scale.
Operating Leverage is calculated by dividing the ARR growth rate by the OpEx Run Rate growth rate.
This metric is used to measure leverage and to monitor if the revenue is growing faster than the overall cost structure. There is no ‘right’ ratio, but generally, once MVP has been achieved then revenue should always grow faster than operations until the business reaches scale. This means that the operating leverage ratio should be greater than 1.00 until the business reaches scale.
Once again, if a business has a strategy and an integrated operating plan, then it should be ‘visible’ in the numbers. The best measure of superior performance – which is the objective of having a strategy – is ROIC. The long-term nature of a software business makes it difficult to measure ROIC until the business reaches scale. This long-term nature does not mean a company has to wait and see if it was successful.
Monitoring and testing the strategy by using these five key metrics can enable a management team to ensure that the investment is being managed effectively and that its strategy is working to create value for both customers and investors.