The old sell-and-forget technology service model is fading fast. Technologists are going back every few years to do a refresher or sell new hardware, which is not the way the market is procuring its IT services anymore. It increasingly prefers a service model where the customer can turn everything on and off as they desire it. Providers that can’t align with this will have trouble down the line, if they don’t already.
How should technology providers measure that change? This has been the focus of Gregg Lalle, ConnectWise’s senior vice-president of international sales. A key consideration is how key performance indicators (KPIs) need to evolve for a more service-based organisation, where recurring revenue from customers is a key metric. After noting the considerations that private equity firms make regarding such businesses, he set out to compile these views and communicate them to managed service provider (MSP) markets.
KPI describes any performance indicator one wants to map to a dashboard. As such, KPIs can be segmented into various business areas (and be further split across categories such as key management indicators and key strategic indicators). For example, managing staff often involves an array of KPIs, such as closed tickets or effective hourly rate.
But to navigate KPIs into the XaaS (anything as a service) era, the conversation should start at the higher levels, with KPIs such as valuation. If a business can start appreciating the idiosyncrasies of a XaaS business model at the top, it can map KPI considerations further down the ladder.
So in this article, KPI is treated as a generic term. The question is rather: What should you have on your dashboard to measure your service business effectively, particularly if you are transitioning from previous business models?
“What are the business drivers, the levers, of MSPs? Once you understand these and the mechanics that create them, then you know what levers to pull within the business, how to approach growth and profitability,” says Lalle.
If an MSP starts weighing these KPIs effectively, it brings a higher degree of predictability to the business. Such metrics are very straightforward and, once seen in their context, make a lot of sense.
New valuation calculation
There are two types of companies in this conversation. The first is the traditional provider that measures success on product sold, labour, project hours and such, but not much in terms of recurring revenue. An MSP model can, and often does, include those factors, but it has the potent addition of recurring revenues. This, according to Lalle, has a dramatic impact on valuation.
Based on what private equity sources are asking about, recurring revenue is a major factor in the revenue valuation KPI, as this formula shows:
(Product x .12) + (labour x .6) + (recurring revenue x 2.5) = valuation
To demonstrate the difference that recurring revenue generates, a company with R10 million in revenue (R6 million in product, R3 million in labour and R1 million in reoccurring) has a total valuation of R5.02 million. Yet a company with R2 million in products, R2 million in labour and R6 million in recurring revenue will get a valuation of R16.4 million.
“Recurring revenue is stable and produces more predictable income, and in turn, results in higher customer lifetime value,” says Lalle. “It can help an MSP remain resilient by being able to weather economic conditions as well as simplify business operations.”
Churn, the canary in the MSP coal mine
But if recurring revenue is such a massive part of modern valuations, it leads that monitoring service to customers and is incredibly important. Customers in a XaaS market can change their preferences very quickly, which is why Churn Rate is a crucial KPI for lifetime value.
“Churn is basically the customers at the beginning of a period minus the customers at the end of the year, and excluding new sales over that period. If I started the month with 50 customers and I end the month with 48, divide that by the customers at the end of the period, you get a percentage,” says Lalle.
Churn isn’t just about lost customers in terms of sales, but also the marketing costs needed to replace them as well as recouping initial costs. Lalle says the reduction of churn is crucial for any XaaS business: “A lot of folks spend really good money to acquire customers. You have to know where that is, what you paid to acquire that customer and if you didn’t get the money out of that individual.”
The cost of customer acquisition
Knowing what you paid to gain a customer is captured in the customer acquisition cost KPI. This can be illustrated in the following:
(Marketing to new customers + sales) : customers acquired
Marketing involves a number of factors that can be split into inbound and outbound activities, as well as supporting functions. Inbound activities include search engine optimisation, Web analytics, content creation, social media and e-mail campaign costs. Outbound costs include print, TV/radio, banner ads and cold calling costs. Other costs are wages associated with marketing, operational tools/technologies for marketing, outsourced marketing services, referral costs and overhead costs.
Sales has numerous of its own cost factors: wages, commissions, immediate sales bonuses (SPIFFs), operational tools/technologies for the sales teams, outsourced services and overhead costs.
The customers acquired are limited to the period the metrics are being based on. This formula gives a clearer indication of the average acquisition cost over that period. It’s a vital metric as it feeds into the next KPI in determining the value and performance of an MSP business.
Rise and fall by customer lifetime value
That fourth KPI is customer lifetime value:
“Leveraging what we just learned for CAC, you will need to measure LTV/CAC to get an optimum ratio for growth and profitability,” says Lalle. “The customer lifetime value to customer acquisition ratio (LTV:CAC) measures the relationship between the lifetime value of a customer and the cost of acquiring that customer. This is an absolute must for subscription-based companies.”
LTV is, again, a pretty straightforward calculation:
(Gross margin x (1 : churn rate)) x average marginal rate of return
The result is then compared to the CAC result. Understanding the resulting ratio gives a clear sense of where to guide strategy:
* Less than 1:1 ratio You need to get a handle on things quickly.
* 1:1 You’re losing money from every customer acquisition.
* 3:1 The ideal ratio.
* 4:1 to 5:1 You’re potentially too profitable. Instead, invest more in marketing to grow faster.
Lalle advises that acquisition costs should be recouped within the first 12 months. This allows the business to understand what it can influence to drive profitability and continue with sustainable growth.
This article was written by James Francis for ConnectWise