(Guest post by Gordon Daugherty. If you like this, go see his Shockwave Innovations blog)
Anyone that has taken an accounting class or learned basic business financials knows the interaction between key elements of a P&L (revenue, cost, expense) and a balance sheet (assets, liabilities, equity). But it’s surprising to me how many companies with recurring/subscription revenue don’t understand the interactions between the elements that make up customer acquisition cost (CAC), churn and lifetime value (LTV). There are other important operational metrics to help steer your company (see related post titled “You Never Know What Operational Metrics You’ll Need – So Instrument Everything“) but these are some of the first to start with.
While serving as COO of a SaaS company, I came up with a simple graphic that I used to educate the company’s employees about these all-important levers of success. In this blog post I use the graphic to explain the basics and then explore various “what if” scenarios. Hopefully you will immediately identify some actions and opportunities that, if properly exploited, will improve your own success. There are numerous online resources to help with the exact mathematical formulas for CAC, CAC payback, churn rate and LTV. So instead of concentrating on the calculations, I’ll instead focus on the interactions and influences these key metrics and their underpinnings have on each other.
The concept of the graphic shown below is very simple. The black horizontal line represents time and the unlabeled vertical access represents relative profit. Your company spends money on sales and marketing to acquire new customers (aka – new logos). As a result, immediately upon acquiring a new customer you have lost money on the effort. You’re “in the hole” with negative profitability for that specific customer (called “CAC”). But that same customer starts paying their subscription, which allows you to progressively reduce your loss each month until eventually they’ve paid enough to reach breakeven (called “CAC payback”). At that point, you’ve recovered the cost to acquire the customer. From that point and until they eventually decide not to renew the subscription (called “churn”), you progressively accumulate net profit for that customer (called “lifetime value”). I’ve purposefully left out a couple of nuances that I’ll explain later just to keep the initial concept as simple as possible.
Now let’s cover those nuances I mentioned.
- CAC – Generally defined as sales and marketing costs divided by the number of new customers acquired over the same period of time (sales + marketing / new customers). The nuance comes in deciding what to include in sales and marketing costs. Most sales and marketing costs fit nicely into an expense category that’s even summarized on the high-level P&L as “Sales & Marketing”. But what about the hosting costs associated with that free trial or freemium offering that’s only in place to help acquire new customers rather than generate revenue? My fellow Capital Factory colleague, Jason Cohen, contends that marketing should pay for such offerings and I can’t disagree (see his blog post here). But even if you don’t split out your hosting costs that discretely on your P&L, you might decide to apportion some of them towards this CAC calculation. The main thing is to decide what should go into the numerator of this equation and stick with it unless something important causes you to make a change.
- CAC Payback – Generally defined as CAC divided by average MRR gross profit. When customers send their monthly subscription payments, you put the money into your bank account. Average out the amount paid by a group of customers acquired during a particular timeframe and you have your average monthly recurring revenue (average MRR). But during this same time, you’re pulling money out of your bank account to cover hosting and support costs. You’ve certainly got other costs in the company but these two in particular are directly related to supporting the subscription-paying customer. So they should be deducted from MRR to derive the MRR gross profit.
- LTV – Generally defined as the cumulative MRR gross profit accumulated over the number of months an average customer sticks around (remains a customer). The colors of the graphic above actually depict what I could describe as “Net LTV” because the cumulative LTV after acquiring the customer is offset by the LTV generated just to reach CAC payback (the part shaded in red). Just realize this nuance when you see various formulas for LTV because most are for gross LTV. Another issue is the high-risk prediction of when customers will churn (choose not to renew) in the future based on a near-term or short duration analysis of your cancellation rate. Jason Cohen also wrote a very insightful article about this issue.
- Averages – The metrics described here are all averages calculated using data over a period of time. If that period of time is too short, your results for the various metrics could vary a lot from month to month. But if the period of time is too long, you won’t notice important changes quick enough. So the trick is to figure out the right time period for averaging the data.
The Influence of CAC
As you can see from the graphic below, CAC directly influences both CAC payback and LTV (net LTV, that is). If you can reduce your average CAC, you don’t start off with as much negative profit. So with everything else being equal (MRR, churn rate, etc), you’ll achieve faster CAC payback and more LTV. This scenario I just described is represented by the parallel dotted line above the original one. The opposite is true (dotted line below the original one) if your average CAC increases (gets worse). How do you improve your CAC? Either figure out how to get the same number of new logos but while spending less on sales and marketing or with the same sales and marketing costs figure out how to acquire more new logos. Here is some related reading to help:
- Optimize Free Trial Conversions Using Nurturing
- Is Your Website Enabling Sales
- Improving the Quality of Your Marketing Content
- Increasing Webinar Attendance
The Influence of MRR Gross Profit
Increasing the average deal size and/or reducing the average hosting and support costs to sustain a typical customer will increase the slope of the line (shown below as the dotted line above the original one) and therefore achieve faster CAC payback and greater LTV (both gross and net). Of course, the opposite is true (dotted line below the original one). How do you increase your average deal size? Raise prices (see related post titled “Thought About Raising Your Prices Lately?“), sell to bigger companies that can write bigger checks or sell more offerings together to new customers.
The Influence of Churn
Improving your average monthly cancellation rate has the effect of reducing churn, which in turn means average customers stay with you longer. As you’ll see by the vertical dotted line at the far right of the graphic below as well as the dotted extension of the diagonal line, this increases your LTV (both gross and net). But if you do things that cause customers to cancel at a faster rate, you’ll obviously reduce your LTV.
The Influence of Upsell and Cross-Sell
Most companies with subscription offerings assume customers will eventually pay more for their subscription over time as their usage grows (called an “upsell”). Some of these companies also have multiple offerings (or have a roadmap that plans for additional offerings). When a customer that initially bought product A later buys product B, that’s called a “cross-sell”. As you can see from the dotted line in the graphic below, accomplishing upsell and/or cross-sell success improves LTV (both gross and net). In fact, the sooner they occur the more LTV is influenced. Very powerful and almost certainly worth time and energy marketing to your installed base to promote upsell and cross-sell opportunities. Compare the effort and related success to that required to acquire new logos and make sure you’ve got a healthy balance of both. These actions can even improve CAC payback if they occur before the payback has been achieved.
One possibility that some companies don’t consider is having gross LTV that is less than CAC. In other words, the average customer cancels their subscription before you’ve made enough money to consider them a profitable customer. Expressed in terms of the graphic I’ve been using, there would be no green-shaded area because the average churn event happens before CAC payback. Exceptionally high churn rates are often the culprit but hopefully you’ll realize from what’s been described in this article that it can even happen with respectable churn rates. If no examples are coming to you, consider these:
- Lots of sales and marketing expenditures but not near enough new logos – causes excessively high CAC
- Average deals size way too low – slope of the diagonal line in the graphic isn’t high enough
- Excessive hosting or support costs – impacts your MRR gross margin (slope of diagonal line isn’t high enough)
If you haven’t already done so, now it’s time to roll up your sleeves and do the calculations for these key metrics. Then step back and decide both what they are telling you and what you can do to influence them going forward. Incorporate this into your management system on a regular cadence (at least quarterly but possibly monthly depending on how transactional your business is). Measure, assess, refine, repeat.
- Joel York’s “SaaS Metrics Guide” and corresponding SaaS Metrics Rules of Thumb
- Jason Cohen’s “Why I Don’t Like the LTV Metric“
- Jason Cohen’s “The Unprofitable SaaS Business Model Trap“
- Jason Cohen’s “COC: A New Metric for Thinking about Cancellations in SaaS Business Models“