SaaS Valuation FAQ Series – Part 5: The LTV:CAC Ratio and the Implications of Misallocating CAC to COGS

There’s something a bit magical about the LTV:CAC ratio. The idea of “a dime in, a dollar out” is the reason why the SaaS business model is so compelling: to the growth investor, it's the promise of partnering with a businesses into which heaps of CAC dollars can be invested, with the almost certain promise that multiples of those invested dollars will return to the fund and their LPs.

So it seems natural to conclude that the ratio between (fully discounted) LTV, and CAC, or the so-called “LTV:CAC ratio”, is of paramount importance to both SaaS company and their prospective investors (or, indeed, their prospective acquirers). Taking this as a given, then, how important is it to ensure that the ratio is calculated properly, and what might contribute to inaccurate assessments of the same?

Having pored over dozens of SaaS business' income statements, one of the things that jumps out is the allocation of SG&A, or specifically marketing and sales SG&A, between CAC and COGS. According to KBCM (formerly Pacific Crest), the average SaaS business spends 35% of revenue on Sales and Marketing, which is the input basis for total CAC spend. The same cohort of companies allocated 17% to COGS. In a SaaS company, COGS ought to include obvious expenses like hosting, but it should also include any trailing commissions that might otherwise be allocated to SG&A, and all reasonable ongoing customer support costs. COGS should exclude expenses like onboarding and training, unless those are explicitly offset against a separate revenue line item, and should otherwise be allocated CAC, as they are effectively a real and one-time cost associated with the full acquisition of a new customer. This is just one area where a company might be tempted to fiddle with the allocation between COGS and S&M expenses.

Let’s take a look at the implications of moving what ought to be CAC dollars, into COGS. In the two examples below, a $5M ARR B2B SaaS business with a fairly modest $10k average ACV, sports a 20% COGS and spends 30% of their revenue on Sales and Marketing expenses captured as CAC. With a 10% churn and 20% revenue growth targets, and a 25% cost of capital (discount rate), their LTV:CAC ratio is just 2.3:1. Given most investors are willing to take LTV:CAC on an undiscounted but Gross Margin adjusted basis, the ratio would be a less alarming 8:1. 

However, if we move just 10% of the CAC burden into COGS, we see the following comparative change:

Fully discounted LTV:CAC jumps to 3:1 and undiscounted up to 10.5:1. It’s comparatively easy to find 10% of your otherwise S&M spend to allocate to COGS, and in many cases it may be a totally legitimate reallocation, even under the auspices of the revised revenue recognition standards detailed in the relatively new ASU 2014-09 and IFRS 15 updates.

The punchline is this: one of the most economically critical SaaS ratios is highly sensitive to the allocation of expenses between the S&M SG&A, and COGS line items. It’s worth having a closer look at this allocation, as a SaaS company CFO, in anticipation of the scrutiny you can be sure to expect from prospective growth investors, or acquirers.

If you’d like an even better intuitive sense of how these numbers relate, please feel free to change the inputs in the interactive calculator, below:

SaaS Valuation FAQ Series – Part 4: Improving your SaaS metrics and the ‘Rule of 10%’

Q: If we are going to invest effort in ‘moving the needle’ with respect to just one of our core SaaS metrics, where will we get the most bang for our buck?

A: Please read on. The short answer is: CAC, followed by churn.

All other things being equal, if a genie granted you one wish, and that wish had to be which core SaaS metric you would wish to improve, by 10% in the right direction, then which would make the most sense?

First, a caveat: depending on their absolute values, it is clearly not equal effort to reduce your churn by 10%, versus decreasing your CAC by 10%. First, because reducing 10% churn to 9% seems far more reasonable than reducing churn from 3% to 2.7%, and second, because the various knobs that you must turn to achieve these two outcomes are fundamentally different. In the CAC domain, you’ll consider things like content marketing and inbound traffic, conversation optimization and buyer journey. In the churn domain, it’s all about engagement, retention, and upsell – all post-sales functions, mostly in the domain of customer success.

With that said, let’s dive in with an example. Let’s imagine MidChurn is a company with 10% churn and a $100 average CAC (across all channels). You are considering a new content marketing initiative, which you project will decrease your blended average CAC to $90. On the other hand, for about the same effort and expense, you are considering a new Customer Success initiative which you believe will help reduce churn by 1% (this could equally be an extra sprint of new features customers are dying for, that you’re confident will lower churn). Both of these initiatives result in a 10% improvement in the underlying metric, and we’ve setup the example such that both are of equal effort and expense. So, which should you invest in, and how should you measure the results?

Calculating The LTV:CAC Ratio

First, about measurement: regardless of which is more effective, the appropriate metric to measure is the LTV:CAC ratio. Particularly if you calculate LTV as the fully-burdened, fully-discounted figure that reflects the true economic value of a customer, then the LTV:CAC ratio represents the present value of investing one more incremental dollar in customer acquisition; assuming you have the capital to invest, and so long as this ratio is meaningfully greater than one, then you should be investing as heavily as you possibly can! (If you’re interested in learning more about how to calculate fully-burdened LTV, please click here). Now, let’s do some math: plugging the above figures into our LTV calculator and assuming an annual contract contribution of $300 and a 20% discount rate, we get an LTV:CAC ratio of 12.6:1. Reducing the churn to 9% yields an LTV:CAC ratio of 13.0:1 and reducing the CAC to $90 yields an LTV:CAC ratio of 14.0:1.

This is an interesting result. Again, assuming that the efforts are equal in cost, reducing CAC appears to be at least 7% more effective than reducing churn by 10%, in this example. Let’s exaggerate churn to 50% to see if that makes any difference. Same $300 contribution, $100 CAC and 20% cost of capital, and our LTV:CAC ratio is now 4.6:1. Reducing churn 10% to 45% yields a LTV:CAC of 5.0:1, and reducing CAC from $100 to $90 yields an LTV:CAC of 5.1:1. Even when cranking up churn to SMB customer segment levels, the value of reducing CAC still trumps the equivalent % reduction in churn! In fact, increasing churn to a whopping 80% yields a 3.1 LTV:CAC ratio; a 10% decrease in churn yields 3.4:1, and a 10% decrease in CAC yields the same 3.4:1.

The SaaS Rule Of 10%

With this, we give you the ‘SaaS rule of 10%: a 10% decrease in CAC is always more valuable than a 10% decrease in churn’; this applies for all but the very, very highest churning SaaS business.

So, next time you’re contemplating a fancy new customer retention initiative consider this: if you have a super effective content marketing plan or a landing page optimization strategy that will drive a ton of inbound traffic and increase conversions, it’s likely the better investment of otherwise limited resources.

How Does The Rule Of 10% Affect Your Metrics?

Only your data can answer this question. Please try our interactive calculator, below. If you'd like to discuss your numbers and their implications further, please submit your email and we will reach out to discuss. Alternatively, please contact us directly.

SaaS Valuation FAQ Series – Part 3: Customer Acquisition Cost (CAC) Recovery Time

Q: How does my CAC recovery time affect the rate at which I can grow, without taking on any outside capital?

A: It relates directly; the more quickly that you can recover your CAC dollars, the more quickly you can use existing customer generated revenues to fuel additional organic growth. In all practical regards, this economic relationship is the geometric growth factor which is precisely the opposite of churn.

CAC recovery time is an extraordinarily important metric in the SaaS world. Simply put, it is the amount of time (typically measured in months), that is required to recover the cost of acquiring a single additional customer, when considering the fully-burdened contribution margin of that same new customer.

Our last post on LTV includes a calculator that determines your CAC recovery time as a function of ARPC, Contribution Margin %, Churn, and your Discount Rate (weighted average cost of capital, or WACC).

By way of example, let’s assume that our example company MidChurn sports a $10,000 ARPC (Average Revenue Per Customer), a fully burdened Contribution Margin of 70%, and an average CAC across all customers of $5,000. (For the purpose of this example, we will ignore segmentation effects, while remarking that they are often the source of tremendous insight regarding exactly where CAC dollars should and should not be invested.) CAC recovery time in this simple example is 0.7 years (CAC of $5k, dividing into 70% of $10k ARPC, yielding ~0.7 years).

What Does Your CAC Recovery Time Say About Your Business?

The fact this figure is less than one year indicates clear health; CAC recovery times of up to 18 months can be considered sustainable, however clearly shorter recovery times are better.

Now, assuming that there is no delay between the investment of CAC dollars, and the acquisition of a new customer – in other words, assuming that growth is entirely bound by the dollars that we have to spend acquiring new customers, that we know the average CAC, and the delay between investment and acquisition is negligible (none of these assumptions are realistic, but for the purposes of this example, please bear with me), then the rate at which we acquire new customers is 100% bound by our CAC recovery time.

Let’s continue the example: MidChurn invests $5k to acquire a customer that produces $7k / year in re-investable contribution margin. Ignoring fixed expenses, this means that for every new customer landed, that new customer generates enough contribution margin to fuel the acquisition of another new customer in 0.7 years.

What we have articulated is another geometric growth factor, which offsets nearly exactly the opposite phenomenon, which is churn. In other words, if MidChurn experienced absolutely no customer attrition and no delay between CAC investment and customer acquisition (and, had an unlimited number of customers available and willing to buy, assuming the marketing and sales dollars are invested), then it would grow precisely as a function of its CAC recovery time. Even netting our assumed annualized churn of 31% against this figure yields 170% annualized growth which, if our assumptions hold indefinitely, assures that MidChurn will continue to nearly triple revenue year over year, without cessation.

This example is not particularly farfetched: we regularly discover companies with little to no outside funding, achieving 100%+ annualized growth, serving the SMB-market and fading double digit annualized churn with little to no ill effect.

CAC Recovery Time vs Churn

The other conclusion that one draws from this analysis is that the efficiency of customer acquisition, as measured by the CAC recovery time, is significantly more important than churn, all other factors being equal.

As a final example of this organic growth formula in action, let’s ask the question: assuming no outside investment, would you rather own ‘Company A’ with 5% annualized churn, but a 2 year CAC recovery time, or a ‘Company B’ with 50% churn and a 6 month CAC recovery time? (How the answer to this question would change if you took on outside Growth Capital will be the subject of a future post).

The answer is simple: ‘Company A’ has the potential to grow organically at a maximum of 55% taking into account a 95% retention rate, whilst ‘Company B’ has the potential to grow at 252% in spite of just a 50% retention rate; there is no comparison - the typical obsession with churn absent consideration of CAC recovery time simply doesn't make sense (again, acknowledging that we have assumed no bounds to nor delay between investing CAC dollars and finding and signing up customers, which is clearly not entirely realistic; adding a delay changes the math somewhat, and the assumption of unlimited customers is also worth challenging, but reamins realistic for a growth stage company serving a new market).

What should your CAC Recovery Time Be?

Only your data can accurately answer this question. Please try our calculator below to determine your maximum theoretical organic growth rate and CAC recovery time, inputting ARPC, Contribution Margin, CAC and annualized churn.

SaaS Valuation FAQ Series – Part 2: Customer Life Time Value (LTV)

Q: Should I use revenue and churn alone to calculate LTV, or should I also consider COGS and the time value of money?

A: The answer is that you should consider COGS and the time value of money (discounting at your cost of capital), and the other marginal costs of servicing and retaining a customer. Few companies do all of the above.

LTV as it is often calculated, skews more as a vanity metric than one that reflects real managerial accounting or fully discounted economic value. Most companies do the following to calculate their customer LTV:

So, for example, if the ARPC of our MidChurn example company is $10k, and the churn is 10%, then the average customer lifetime is 1/10% = 10 years, and the customer lifetime value is therefore calculated as 10 years X $10k / year = $100k.

Further, if we calculate the average Customer Acquisition Cost (CAC) (not CAC delineated by segment, cohort, nor marketing channel, but just average CAC), is $50k / customer, then all appears absolutely fantastic: we acquire customers for 50% of what they are worth to us, and we should be spending up to 70 or 80% of our calculated LTV on new customer acquisition, all day long. So applying this logic, we are actually underspending on CAC relative to what makes economic sense.

But this approach is flawed, and in at least two major ways:

First, back to accounting 101, the real value of a customer is not measured by the revenue they drive, but rather the contribution margin they add, net of cost of goods sold (COGS). Furthermore, the real contribution to the bottom line, on an incremental basis, must also include expenses like customer success and support hours (and renewal admin, and some amount of R&D to keep the product fresh and relevant), which are often missed when burdening SaaS COGS (which often include only infrastructure and hosting costs, and don’t account for the other post-sales support resources that are necessary to retain customers and are therefore representative of the true ongoing COGS).

There’s more – the other miss here is that the value of dollars earned in the out years must be discounted at what is called the weighted average cost of capital, or WACC. In most growth stage SaaS businesses, one can comfortably use a figure of at least 20% as representative of the cost of capital (if the company has access to venture or mezzanine debt for growth), but is closer to 30% for any outside growth equity investor, taking their target internal rate of return (IRR) target as a proxy.

Calculating Your True LTV

Set against the backdrop of these facts, what is the real LTV of MidChurn? Well, without getting into the details of what goes into the various COGS and non-COGS expenses (the subject of future article), let’s assume that their income statement COGS is 30% of revenue, yielding a 70% gross margin. Further, let’s assume that another 10% can fairly be attributed to other SG&A costs, on an incremental basis. So, the real incremental contribution of each dollar of recurring revenue is 60%, or 60 cents. Finally, let’s take the lower end of the 20 – 30% range as the WACC for MidChurn, presumably because they are at sufficient size and scale to attract somewhat less expensive money.

The following table sets forth the real, discounted, annual incremental contribution dollar value, for the 10 year expected lifetime of the customer:

Another way to express this in a formula is:

Why is LTV important?

If the CAC of $50k prevails as accurate, then the customer that we thought was worth $100k, is worth just $25k.

What’s worse, we are literally losing $25k of economic value (spending $50k to extract $25k), for each customer that we acquire. MidChurn Inc is a money losing machine.

To right this particular ship, we would need to reduce CAC to at most 70 or 80% of the LTV, or let’s say $20k. And even then the CAC recovery time (the subject of a future article), would be 3.3 years, when a ‘healthy’ SaaS business should be aiming to fully recover CAC within 12 – 18 months at the most.

Curious to know how your real LTV stacks up?

Only your data can accurately answer this question. Please input your numbers into the calculator below, or get in touch to us to get further input on your metrics. 

SaaS Valuation FAQ Series - Part 1: The Quick Ratio

Q: What’s more important as a determinant of financial value: growth or churn?

A: Probably the most common single question we get – and the Quick answer is the Quick Ratio, which accommodates both.

The Quick Ratio is the ratio between New/Upsold MRR and Lost (churned)/Downgraded MRR:

Let’s take a simple example of an early stage SaaS growth business (HighChurn Inc.) with an SMB focus, currently running @ $1.2M ARR ($100k MRR) and aiming to grow 50% heading into a new calendar/fiscal year.

To achieve this, they must add 50% x $1.2M = $600,000 of net new annually recurring revenue (ARR) over the course of the calendar 12 months.

Assuming no churn, the company would need to add $600k / 12 months = $50k of total new MRR (or $4,167 new MRR per month) to be on track to hit their growth target.

However, as an SMB focused offering with a typical 3% gross monthly churn (~31% annual churn), they will lose 3% x $100k = $3,000 of MRR in January of our example year, and so will need to add an additional $3,000 of new revenue to make up for that and stay on pace for their growth target for the year.

So, they will need to acquire or upsell a total of $4,167 + $3,000 = $7,167 of new MRR in January.

About 40% of their customer acquisition effort (and CAC) is committed to replacing lost revenue, and 60% goes towards acquiring new customers or upselling existing ones.

The quick ratio here is $7,167 / $3,000 = 2.4, and is only marginally above the minimum accepted healthy figure of 2.0, existing in a range where churn is clearly hurting growth prospects.

Quick Ratio In A Lower-Churn Market

How would these numbers differ if we were talking about MidChurn Inc., focused on the lower churning mid-market, where typical annualized churn is on the order of 10%? Let’s do the math: 10% annual churn implies just 0.9% monthly churn, ignoring up-sales and downgrades. MidChurn’s loss on a $100k MRR base is just $874 in a month.

Now, MidChurn can achieve the same growth target with just $4,167 + $874 = $5,041 of new customer acquisition in January.

And the Quick ratio? It’s $5,041 / $874 = 5.8, well above the ‘magic number’ of 4.0.

How much more quickly would MidChurn be growing if they achieved the same gross customer acquisition figure as HighChurn of $7,167 of MRR? MidChurn would add net $7,167 - $874 = $6,293 of new MRR in January, and would keep that growth up through the remainder of the year, ending up with 76% annualized growth, not having spent a single dollar more on customer acquisition (we are holding CAC constant, here).

Finally, how much would HighChurn need to add in new MRR in order to achieve the same 5.8 quick ratio that MidChurn sports? The answer: 5.8 X the $3,000 churned MRR = $17,299 new MRR each month.

That implies $17,299 - $3,000k = $14,299 of net new MRR monthly, $171,593 annually, for a 172% growth rate!

As you can see, it’s difficult for a high churning company to have both a healthy Quick Ratio and a realistic growth rate; it’s much more realistic – in terms of the raw volume of necessary customer acquisition – to achieve 50 – 100% annualized growth when your annualized churn is kept in the low double digits.

Stay tuned for future posts in this series, covering subjects like cohort and segment analysis, CAC recovery time, LTV:CAC ratios, whether or not to use gross margin or revenue in LTV calculations, and whether or not you should be discounting your LTV dollars in the out years of customer lifetime (and the resulting implications for real Life Time Value).

What Is Your Ideal Quick Ratio?

Only your data can answer this question. Please try our interactive Quick Ratio calculator, below. If you'd like to discuss your numbers and their implications further, please submit your email and we will reach out to discuss. Alternatively, please contact us directly.