Understanding what the customer lifetime value to customer acquisition cost ratio actually means for a company’s ability to be profitable and successful.

The following is a guest post by Rajeev Dham (@rajeevdham), Vice President at Sapphire Ventures (@sapphirevc) and Nino Marakovic (@ninomarakovic), CEO and Managing Director at Sapphire Ventures.

By now, SaaS entrepreneurs and investors are familiar with the gamut of SaaS metrics — payback periods, magic numbers, net negative churn, customer lifetime value (CLTV), and customer acquisition cost (CAC), etc. If not, Bessemer Venture Partners’ 6 Cs Of Cloud Finance is a great start.

However, after recently determining the customer unit economics of one of our portfolio companies, it occurred to us that it’s worth shedding light on what SaaS metrics actually mean for a business’s ability to reach profitably while continuing to grow. After all, the ultimate fundamental value of a business is dependent on its ability to generate future positive cash flows, and not just revenue growth at all costs.

One SaaS metric often considered is the CLTV to CAC ratio. While it’s not advisable to rely solely on this metric to drive your business — given how challenging it is to ascertain due to the equation’s interdependent variables — we at Sapphire believe it can have tangible meaning.

SaaS conventional wisdom would propose that a 3x CLTV to CAC is good. But what does this really imply for a company’s potential for solid growth, coupled with profitability, at scale?  We hope this post will provide a framework to better understand how to appropriately measure and interpret this critical, but often less understood SaaS metric. Stated another way, we aim to help bridge the gap between the per-customer economics and overall (GAAP) profitability potential of a SaaS business.

First, let’s discuss how we think about defining and calculating the metric.

Definition & Pitfalls

CLTV to CAC should tell you how many dollars in lifetime customer contribution margin you are getting for every dollar of customer acquisition cost.  A return on investment (ROI) or net present value (NPV) calculation is a requisite evaluation tool when making decisions to pursue projects or purchase assets, so why wouldn’t you do the same when acquiring customers? After all, not all revenue growth is good growth, and public investors are becoming attuned to SaaS metrics that can indicate a paved path to profitability.

To calculate the ratio shorthand, take 1 / % annual logo churn to obtain customer lifetime, and multiply this by the average annual recurring gross profit per customer for your customer lifetime value (CLTV). Dividing by the upfront customer acquisition cost — fully-loaded sales & marketing spent to acquire one customer — will give you the CLTV to CAC ratio. However, relying on this shorthand should be avoided as it leads to a number of pitfalls:

  • Customer Lifetime. The customer lifetime may be the most challenging aspect of the equation to determine given most startups don’t have a large enough sample set of lost customers to truly understand their typical lifetime. But given how rapidly the technology landscape and prospects of an individual startup evolve, we don’t recommend using more than five to seven years for your lifetime. This is particularly the case if your business lack years of data to back-up a longer lifetime, or you’re not selling a sticky, mission-critical software solution. Furthermore, if you’re relying on 10 years of customer annual recurring revenue (ARR) generation to arrive at a “healthy” CLTV to CAC, your business may not be as healthy as you think.
  • Revenue per Customer. Instead of assuming static annual revenue per customer x lifetime, it is critical to determine the actual revenue produced by a customer year-to-year, particularly as some SaaS companies go to market with a “land-and-expand” model in which they deliberately sell low annual contract values (ACVs), only to expand significantly within the first year or two. We’d advise leveraging customer cohort data to truly understand customer expansion or churn behavior and at what point these may plateau (e.g., just because you typically upsell a customer by 10% in the first year may not mean this will repeat over their lifetime).
  • Customer Success. As SaaS practitioners have realized the importance of customer retention and upsell, dedicated customer success teams and significant expenses associated with this function have become more common. When calculating annual customer value, it is important to net out customer success costs. Oftentimes, the calculation implicitly does this by taking the gross profit per customer, but many businesses may overlook some portion of customer success costs that could be included in their operating expenses. In addition, remember these are ongoing expenses needed to retain or grow a customer versus acquire one, and thus should not be lumped into the upfront acquisition costs (CAC).

A Sample CLTV / CAC Analysis 

The below depicts a business (“Company A”) with a 3x CLTV/CAC achieved within a five year lifetime, which many SaaS practitioners today consider a healthy target. Company A has 70% gross margins(1) and is able to retain 100% of their recurring revenue over the lifetime of the customer. The Magic Number tells us for every $1 in upfront CAC, Company A generates ~86 cents in year 1 net new ARR ($100 ARR / $117 CAC). This will become important later on.

cltvcac1

 

Interpreting the Metric

So now what? How should you interpret something like this for your organization? To derive practical business value from this, we first layer in “at scale“ G&A and R&D that total ~35% of revenue(1). Deducting the upfront CAC from the total steady-state customer profit, we now arrive at a 12% steady-state profit margin per customer(2).

cacchart2

 

Not bad right?  Not so fast.  First, keep in mind that according to the “cumulative profit less upfront CAC” row above each customer will actually produce losses until year four, a well-known byproduct of the SaaS model and one that can have serious implications on the cash needs of your business.

Second, remember this 12% is the steady-state margin. This implies Company A is not spending on new customers for growth, and instead relying solely on its existing base of customers — a highly unlikely and undesirable scenario.

What is more likely is that Company A (or most companies for that matter) will spend to grow. And remember, Company A needs to spend $1 to generate 86 cents of new business revenue. Thus, Company A can afford to grow revenue at ~10% before producing losses (12% margin * 0.86 Magic Number). For example, if Company A wants to grow at 30% in any given year, it will have to spend 35% of revenue on sales & marketing investment in order to do so, which would be deducted out of the 12% steady-state profit margin they have to play with.

While we aren’t here to dictate what metric your business should perform to, we do believe that avoiding common pitfalls when calculating CLTV to CAC and using a framework to truly understand its implications on long-term profitability and growth potential can be more valuable to you than the “3x” metric itself.

  1. Based on Pacific Crest’s SaaS company list; data sourced from Capital IQ. R&D + G&A as a percentage of revenue averaged 39% in 2014, yet includes several companies who are not yet “at scale.” Median 2014 gross margin in Pac Crest SaaS set equaled 65% vs. 70% used in analyses.
  2. Note that this profit margin effectively spreads the CAC over the lifetime of the customer to find the average margin, as this would be the case in a steady-state business with multiple customers exhibiting the below characteristics.

 Special thanks to Phil Orr for all his help with the article. Information provided in this post is subject to the following disclosures.

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rajeev_dhamRajeev Dham is a vice president at Sapphire Ventures, joining the firm in 2013. He worked on the firm’s investments in KruxLocalyticsLookerNutanix,PubNubScytl, and Square, and he is actively involved with AlteryxLavante, and Recommind. Previously, Rajeev worked for Silver Lake, a technology-focused private equity firm, where he evaluated middle-market and growth equity investments across the software and internet sectors. Prior to his private equity career, Rajeev worked for the investment banking division of Goldman Sachs.

Rajeev holds an MBA from Harvard Business School and received a BS in business administration from the University of Southern California, where he graduated Magna Cum Laude.

 

nino_markovic (1)Nino Marakovic is responsible for the overall investment strategy, execution, operations, and performance of Sapphire Ventures. Currently, he is a board director/observer at Integral Ad Science, KruxOpenX, and Zend. He is closely involved with Sapphire’s investments in BoxiovationMuleSoftScytl and Square.

Before Sapphire Ventures, Nino was a partner with meVC, Draper Fisher Jurvetson, and IVF Ventures. Prior to venture capital, Nino worked as an investment banker at Morgan Stanley, Goldman Sachs, and Robertson Stephens. He has a BA in economics and psychology from Williams College and an MBA from Stanford Graduate School of Business.

  • Thomas Mensink

    Interesting post, thanks a lot! I spent some time thinking about the phrase “Company A can
    afford to grow revenue at ~10% before producing losses”. I don’t really
    get this, could you please elaborate on this? I see that an $1 investment
    results in $0.86 net new ARR, and that with an average 12% profit margin, this
    results in ~$0.10 (or 10%) profit. What do you mean with losses?

  • http://angusdavis.com/ angusdavis

    Regarding this sentence: “To calculate the ratio shorthand, take 1 / % annual logo churn to obtain customer lifetime, and multiply this by the average annual recurring gross profit per customer for your customer lifetime value (CLTV). Dividing by the upfront customer acquisition cost — fully-loaded sales & marketing spent to acquire one customer — will give you the CLTV to CAC ratio.” A few problems with that explanation are, First, It’s typical to subtract CAC from from the present value of future cashflows to arrive at a calculation of CLTV — failing to do so inflates the LTV to CAC ratio from, say, 3x to 4x. Second, since we’re primarily talking about small firms reading this article, it’s not realistic to assume their NPV discount rate will be 0%, as this calculation does — capital is costly for early stage companies. Some popular resources (e.g. Joel York’s Chaotic Flow site) ignore the discount rate issue when calculating LTV, while others (e.g. Insight Venture Partners’s Periodic Table of SaaS Finance + Operating Metrics) will assume quite high discount rates in their model. Third, it is not appropriate to use “logo churn” when calculating any sort of revenue metric, it is more appropriate to measure revenue churn. It doesn’t matter how many (count) customers you churn, as much as it does how much revenue ($$) you churn — which can be influenced negatively by price concessions or positively by expansion of revenue within an account (“logo”).