It’s fair to say we are living in bananaland right now. The overall US economy seems like it’s plowing ahead, oblivious to interest rates on fleek and a growing pile of tech layoffs. Consumer goods companies like Walmart are reporting strong earnings, and overall unemployment rates stubbornly low. And to round out the tornado of weirdness, we have crypto making a comeback.
Bitcoin
When you’re in the thick of operating, it can be hard to see the forest through the trees and accurately call if you are living in a recession.
It’s very common to deny you are in a downturn - I’d estimate it takes one quarter for a company to admit it internally, and two quarters to verbally confirm to their board and investors that they are indeed experiencing softness in some segments.
In other words, it can take up to six months before the scissors come out and the operating plan gets a haircut. And in retrospect, 90% of the time you’ll say you waited too long (in fact, I’ve never heard of a CEO or CFO saying “we acted too soon.”)
In order to expedite that crucial “come to SaaS Jesus” moment, here’s my scorecard to snuff out degradation before you’re in a real hole.
Note: None of these trends in isolation necessarily mean you are up against a nasty rip tide, but experiencing a collection of them certainly means you should seriously consider battening down the hatches.
TL;DR:
New hire salaries are changing faster than pipeline growth
Multi Product Attach is plateauing (or even dropping)
Customers are downgrading to cheaper plans
The velocity of early renewals is slowing
Customers are no longer buying multi year deals that ramp
Registration volume is dropping
(Former) Slam dunk deals are hitting the deal desk for discounting
Rep call volume per deal is increasing
Effective commission rates are climbing
Contribution margin by segment is falling
CAC Payback Period by segment is increasing
Customers are paying you slower
New hire salaries are changing faster than pipeline growth
When times are good, it’s a candidate’s market. And companies are happy to lean in if it means they can land top talent.
When times are bad, people suck it up and stay in the same roles they are in longer, and are also less demanding about comp packages when they do make a jump.
But shifts in the labor market always lag company performance - one has to come before the other.
There’s usually this awkward in-between period where you start to notice you’re hiring people at $10K, $15K, $20K more than you budgeted, and it doesn’t feel comfortable anymore, given the day to day conversations you’re having about the business.
Call it a vibe, call it a premonition, but when this happens you have to measure the rate of change in average salary by department and compare that to the rate of change in pipeline growth rates.
Mostly advice: Each quarter you should check how many salaries came in over budget to plan. Either you have a budgeting problem, or there’s a runaway labor market.
Multi Product Attach is plateauing (or even dropping)
Shrink is Churn’s somewhat less ugly cousin
If multi product expansion is a big driver to your net retention rate, you’re in for a rude awakening when customers not only don’t buy additional modules, but rationalize one of your products for another
Let’s be honest - like most families, every company has a favorite
siblingproduct. And when customers like you, but can no longer afford the same wallet share, the step brother who got loved up in good times has to goDataDog is legendary for their multi product attach. They’ve successfully ramped customers from one to two to three …. to six or more products over time.
DataDog 2023 Investor Day Presentation
But when macro clouds arrive, you’ll see certain customers drop a product, and the bars get cut down
Mostly advice: This isn’t something to shrug off - as it’s usually a leading indicator for total churn (and a confession that one of your engines for future growth wasn’t as strong as you thought it really was)
Customers are downgrading to cheaper plans
Not all features are as economically resistant
When times are good, customers may not blink an eye to take the higher priced, bells and whistles - “Premium” plans sell better in good times, “Starter” plans sell better in recessions
But when the tide starts to roll out, the “ability to [xyz] in 10 seconds vs 20 seconds” feels like overkill
Downgrading in plans is another form of Churn, more specifically Shrink, which we discussed above
The velocity of early renewals is slowing
Early renewals are usually brought about by one of two compelling events:
Customers want to buy an additional product and it just makes sense to co term all their products together
The customer is growing faster than they anticipated and needs more licenses / usage
If customers aren’t knocking on your door to renew their products three or four months ahead of time anymore, there’s a good chance your expansion pipeline will suffer, or potentially worse you are sitting on a bunch of churned eggs that haven’t hatched yet
Mostly advice: The worst thing you can do is force customers into early renewals by overly discounting. That is mortgaging tomorrow’s future to pull forward cash. It’s not worth the long term trade off… You should only discount the renewal if it’s the actual renewal time and you think they will churn entirely for a competitor.
Customers are no longer buying multi year deals that ramp in size
When customers feel less certain about their futures will stop committing long term and embedding estimated growth for a slightly better deal
This is because:
a.) These deals usually require up front payment at the start of each calendar year, and companies are now more conscious about their cash balances
b.) They don’t think they will hire as many people as they originally might have thought, and therefore don’t need to pre-purchase licenses that will sit on the shelf
Mostly advice: Compare the weighted average contract length in your install base (e.g., 25 months) vs the most recent quarter’s weighted average contract length (e.g., 19 months) to sniff out a trend. Also keep track of the growth in your remaining performance obligation over time.
For all those unfamiliar with this space man term, RPO is all unrecognized contracted revenue.
Deferred revenue goes out at most 12 months, so RPO was created to extend even further to capture all of a multi year commitment. It includes both Deferred Revenue and any unbilled portion of a multi year contract.
For a 3 year contract you’d have 12 months in deferred revenue and 36 months in RPO. Of the 36 months, 12 months would be current RPO and 24 months would be non-current RPO.
RPO is not a GAAP number and, therefore, does not appear on the balance sheet. Instead, companies report it in the “Revenue from Contracts with Customers” section of their public filings to make sure they get “credit”.
It’s really popular for consumption based businesses where customers pre-pay, or commit, to lots of usage.
Registration Volume is Dropping
This is the predecessor to conversion rates dropping
Conversion rates are a function of registration volume x quality of registrations
If the top of the inbound funnel is tightening, reps have to chase crappier quality leads to try to hit their quotas
(Former) Slam dunk deals are hitting the deal desk for discounting
“We never really had to discount the mid market banking sector before”
This is an example of an anecdotal observation you might hear in the sales bullpen, which may unearth a larger trend
Every company has a customer segment that’s their “white hot center”. I worked at a cyber security company where we could throw up a no-look shot from the parking lot for mid market neo banks and it would go in
If you see deals that were usually “priced right” start popping up in discounting approval discussions, something is going on
Mostly advice: Don’t just look at your discounting by segment and deal size - also log what economic sector the customer who’s asking for the discounting in plays in. It could very well be something more micro, like something specific to the travel / hospitality industry.
Rep average call volume per deal is increasing
This leading indicator is a derivative of sales cycle length
More calls per deal usually indicate more steps in the approval process
Most companies are obsessed with number of days to close a deal, but less concerned with activity based metrics at the rep level
But if your average SMB rep is doing six calls per sale when it used to be three, something is up
The same goes for the number of demos you have to do - this is expensive System Engineer capacity
Mostly advice: You have to think that every hour of a rep’s time is both a real cost (salary) and an opportunity cost (at bats). If you don’t care about activity based metrics, you don’t truly care about pipeline. Number of days to close a deal is a meaningful stat, but reactive. You want to be proactive in period if you think something is brewing.
Effective commission rates are climbing
We are seeing this now as a result of hiring during COVID - talent was more expensive and reps in SMB were getting mid market comp packages…
But the deal sizes they are taking down in the post COVID era are smaller
Nevertheless, the amount they are making per deal stayed the same
So the amount the company is paying out per deal is rising
At the end of each period you should benchmark your commission rate. If you start to pay a total stack greater than 12% on any deal, you are getting over your skis
This is simply the total cash commission payout for the period / total ARR additions
This will also expand if you are adding more sales management. During COVID we saw manager to rep ratios shrink, which means more mouths to feed on each deal
Contribution margin per segment is falling
Contribution margin isolates variable performance by stripping away all the other “stuff” the organization provides.
This allows managers to reward those parts of the biz that are outperforming, and call out those that are underperforming.
The outcome helps decision-makers allocate resources more effectively.
And the resulting contribution margin represents the amount of revenue available to cover fixed costs and contribute towards operating profit.
Tech companies should look at the contribution per sales segment (SMB, Midmarket, Enterprise) as well as geography (North America, Europe, Asia) to identify which areas of the business are getting better or worse on a unit economic basis
CAC Payback Period by Segment is Increasing
And you can go a level further and look at the CAC Payback period within that Segment (or Geo)
If it’s going up, you are either:
Investing in your S&M engine faster than returns (a stage most companies go through purposefully)
You’ve scooped up most of the early adopters and it’s getting incrementally harder to land a new customer
Your customers have less money to spend and are getting harder to convince
If CAC Payback Period is increasing due to #2 or #3, then you might be facing headwinds that will eventually work it’s way down the P&L to impact EBITDA margins
Customers are paying you slower
In my opinion, this is the easiest way to determine if you are in a downturn - are your customers taking longer to pay you? It will punch you in the nose if they are.
Businesses might hold onto their capital, delaying payments to suppliers / vendors until they have more clarity on their own financial situation.
If you see an average Days Sales Outstanding (DSO) shoot up from 32 days to 47, something is in the water.
Mostly advice: If they’re nice enough to ask for more time and don’t just stiff you, realize that some customers might deliberately negotiate longer payment terms to improve their own liquidity (even if they don’t need it), using the economic situation to their advantage.
You can consider this too - never let a good crisis go to waste.
