From Olivier Verhage – Kennet Partners (@olivierverhage)
Over the past few months I spoke to quite some entrepreneurs who told me they are postponing their fundraising round and to focus on profitability instead. And yes, I think this is a good thing. As an entrepreneur you might wonder what my role would be if our prospects don’t need the funds anymore, (un)fortunately there are still a ton of companies that need to learn to understand their unit economics so to grow in a capital efficient and sustainable way. Most companies are best positioned to invest in growth once they really understand how every dollar that is invested to acquire a new customer impacts growth. So yeah, I’m generally happy when someone tells me that they’d like to get to profitability first and then raise a growth round as it gives us much more confidence that we are investing in a company that can eventually become a cash machine. In this blog I will briefly outline the key metrics that matter, most of which are interlocked where any small change in one of your inputs has an enormous impact on your outputs (growth, cash and profitability).
CAC – Customer Acquisition Cost:
I’d say this is the most important metric, the reason why CAC matters that much may be an obvious one for many SaaS entrepreneurs: you invest a ton of marketing money and sales commission to acquire a customer in month 1, but you only get paid in monthly instalments in the next 12-24 months. That’s why it’s called Software-as-a-Service, you don’t get your license fee paid as a one-off perpetual license, you are providing a service product and therefore CAC has a huge impact on your cash flow. Here’s the CAC formula:
To get an idea of what a good CAC payback looks like, there are two things that we need to look at which are Life Time Value (LTV) and the Annual Contract Value (ACV) or Annual Revenue per Account (ARPA). However, before we jump into LTVs it’s important to understand customer churn first.
Churn – Discontinuing Subscribers:
I’m sure many SaaS entrepreneurs are familiar with churn; customers that discontinue their software subscription, it’s a thing that happens to (almost) all subscription companies. The important thing to understand here is that there may be a big difference in customer (#) churn versus value ($) churn. As an example, imagine you have 2 customers, e.g. customer A and B. Customer A brings in 25% of revenue and B the remainder of 75%. If you lose customer A in absolute number terms your churn is 50%, but in value it would only be 25%. The magical thing about churn is that it can be negative, i.e. when your expansion revenue of existing customers is greater than the amount of revenue that you’d lost from customers that churned. This is why I can’t stress it enough that entrepreneurs should focus on up-sell and cross-sell opportunities, it’s one of the most efficient ways to increase your LTV. Many businesses start out with a single price product, so if that’s the case it’s time to start thinking about variable pricing, e.g. seat based, load based, lead based, etc. In terms of what percentage of churn is acceptable, it all depends on the type of product you are selling. Some lightweight SaaS products have high customer churn (e.g. 20-30% customer churn for SaaS tools priced under $10k/year) but with significant up-sell potential whereas heavy enterprise solutions may have near zero customer churn and less up-sell potential. It’s therefore important to look at both customer (#) churn as well as value ($) churn and the up-sell potential to existing accounts.
LTV – Life Time Value:
So now let’s look at the LTV of your customers, to get to this number most entrepreneurs present me with a discount formula that looks like this:
Im personally not a big fan of using this particular formula as it usually results in unrealistic LTVs. Often, a business has only been around for a few years and so there’s no accurate data on churn and in other cases companies are generating massive negative churn (due to up-sell and cross-sell). So to get to a realistic LTV, I never really look much further than say 4-5 years ahead as there’s usually no accurate churn data and there’s a chance that a more advanced tech company will come up that will eat into your (once thought so steady) customer base. So if your typical Annual Contract Value is something like $25k, a Customer Lifetime of 5 years makes $125k and adjusting for a gross margin of 90% and 10% yearly churn this gets you a Life Time Value of $66k. If we were to use the formulas presented above we would get a Customer Lifetime of (1/0.10) = 10 years and with an Annual Revenue per Account of $25k on say a typical software gross margin of 80%, this would yield an LTV of (25*0.9) / 0.1 = $225k.So now we understand what determines CAC and a realistic LTV, how do we know what a good CAC payback looks like or what LTV / CAC ratio you should aim for? As a rule of thumb, many investors say that your LTV should be 3 times greater than your CAC (or your CAC should be 1/3 of your LTV). I think that an LTV of 2-3 should be the minimum that you need to build a viable business, 5 is good and higher than 7-8 is excellent. Many businesses may brag how great their ratios are, but the number I care most about is CAC payback: how long does it take to actually pay back for the cost of acquiring a customer?
Again, it’s difficult to give you an exact number here, but generally speaking a payback of 12 months can be considered “good”. I’ve seen SaaS businesses with a payback of 6 months or less which is terrific, but often these are companies that sell relatively inexpensive SaaS products, e.g. software tools rather than life-changing enterprise solutions. Products that are relatively inexpensive (say up to $10k/year) often have very short sales cycles (days or weeks rather than months) and so CACs are lower and payback is faster. On the downside, light software products may be less sticky and thus may result in more customer churn.
GM – Gross Margins:
This may be an obvious one for many entrepreneurs, but it happens too often that entrepreneurs present me with COS (Cost of Sales) that only includes their hosting costs to get to their Gross Margin. The second thing that we need here is the customer success and support team that is required to actually make the product work. These costs are part of your Cost of Sales and so a lower Gross Margin will drag down your LTV. This all goes back to the concept of building a product that is simple and doesn’t require much customisation or a rigorous on-boarding process, here it are the engineers and product managers that can make the biggest impact. A proper SaaS business typically has a Gross Margin that varies between 80 – 97%, with companies that have efficient on-boarding procedures, simple products and short sales cycles operating in the upper range.
So if you have a sustainable LTV to CAC ratio (higher than 3) and the number of months to recover your CAC is right (under 12), you have built a viable business. Going back to the story of getting to profitability first, it’s not a necessity, but it helps you focus on the right things. If you are currently talking to investors and you are burning loads of cash, don’t just tell them that you are growing like crazy, but make sure you got the “CAC/LTV and payback story” up your sleeve to be able to explain what’s going on in your business and why it makes sense to invest more.
