Stop using CAC ratio to determine sales/marketing efficiency

CAC ratio is one of the fundamental metrics that SaaS businesses first discover when they research key KPIs for subscription business. CAC stands for Customer Acquisition Cost and the concept of the CAC ratio was first put forward by Bessemer Venture Partners. In fairness to Bessemer, they published subsequent articles that added more nuance to the calculation of the CAC ratio, but the SaaS community has pretty much taken their original calculation and never looked back.

The CAC ratio is calculated by looking at the quarter over quarter increase in gross margin divided by the total sales and marketing expenses for that quarter. Gross margin is the total revenue minus cost of goods sold. So, if you sell a software subscription for $100 and it costs $20 in hosting and customer support to handle that new subscription customer, your gross margin is $80. The sales and marketing expenses for the quarter are the fully loaded expenses for all sales and marketing salaries, advertising spend, PR, etc.

Here’s the formula for CAC ratio, assuming you’ve just finished the second quarter of your fiscal year:

[Gross Margin Q2 — Gross Margin Q1] × 4
 — — — — — — — — — — — — — — — — — 
Sales and Marketing Expenses for period Q2

The gross margin above is annualized, which is why it’s multiplied by 4. If you wanted to calculate your CAC ratio for a single month’s performance instead of a quarter, you could use the same formula above and just multiple by 12 instead of 4. So let’s say in Q1 you earned a total of $80 of gross margin and in Q2 you earned $120. In Q2 you spent $20 on sales and marketing.

Your CAC ratio would be:

[$120 — $80] × 4
 — — — — — — — — — -

So, your CAC ratio would be 160 / 20 or 8. Often people will look at the inverted CAC ratio, basically taking 1 divided by the CAC ratio. In this case, the inverted CAC ratio would be 1/8. That is supposed to indicate the revenue payback period. So, if you invested $20 in sales/marketing per the example above, you’d recover that in 1/8th of a year. The common wisdom is that if your CAC ratio is above 1, you should accelerate sales/marketing investment. If it’s between .5 and 1, you’re in a sweet spot and can either accelerate spend or not depending on the situation. If you are less than .5, you are not acquiring customers efficiently. If you think about the inverted CAC ratio, this is saying that if you can recover your sales/marketing investment in less than a year, keep spending. But if it takes more than 2 years, pull back.

The problem is that this equation is flawed in a number of ways. I’ll highlight one of the flaws with a real world case study that I experienced.

I founded ShareFile and after it was acquired, I had the opportunity to run several other SaaS products that were part of the company that acquired my business. One of those products was very mature, with thousands of customers and over $50M in annual revenue. Retention of the base was quite good, better than most of the other products in the business unit. And NPS was strong at 65, the highest in the business unit and excellent compared to other SaaS benchmarks. We didn’t do much sales/marketing for this product, but the revenue payback on our spend was quite good at around 3 months.

However, because we had such a large base of existing customers and did not spend a huge amount on new customer acquisition, the CAC ratio on the business looked horrible. It was actually negative. The numerator in the CAC ratio was dragged down by churn on the very large existing customer base. We didn’t have a churn problem. Retention was actually quite good for a product targeted at small businesses. This example points out a major flaw in the CAC ratio: for products with non-zero churn (typically products targeted at the consumer or SMB segments), a large customer base relative to sales/marketing spend drags the number down.

As a thought experiment, imagine if we took our existing mature product and “created” a new product that was exactly the same as the existing product but just called it “Version 2.” Version 2 has the same features, support, and sales/marketing channels but since it’s a new product it has zero customers. Even thought everything about it is identical from a business perspective, Version 2 has a much better CAC ratio than the core product. Crazy right

Here’s my proposed replacement for the CAC Ratio. I call it the Payback Ratio. The denominator of the Payback Ratio can be the same as the CAC ratio: the sales/marketing expense over any interval of time you want. The numerator is the 3-year gross margin of customers acquired during that period. Here’s the equation:

[3-Year Gross Margin for customers acquired during period]
 — — — — — — — — — — — — — — — — — — — — — — — — 
Sales and Marketing Expenses for period

You may ask why we chose 3 years. I prefer 3 years as a proxy for Lifetime Value (LTV) because if you are looking at subscription income streams 5–10 years out, your current assumptions about churn probably don’t apply since the market can change dramatically over that time horizon. Also, as you get past 3 years you need to start applying a discount rate to future cash flows which makes the model much more complicated, and choices about what discount rate to use can materially change the model. Finally, as a business owner, you’re looking for investments that can provide ROI over a reasonable time horizon. Three years felt like the maximum reasonable time horizon to look at when I’ve been running growing SaaS businesses.

So how do you calculate 3-Year Gross Margin? I’ve blown out the equation a bit below. The important thing is to take into account the churn of your newly acquired customers and not just multiply your new MRR by 36 months.

[Gross Margin MRR sold in period] × 36 x [Churn Factor]
 — — — — — — — — — — — — — — — — — — — — — — — -
Sales and Marketing Expenses for period

For example, let’s say you acquired $100 in new MRR last month. You have 80% gross margin so you acquired $80 in gross margin MRR. Customers sign annual contracts and renew at 90%. In that example, for the first year you’d earn the full $80 in gross margin. The next year you’d earn 90% of $80, or $72. The final year in the three year period you’d earn 90% of $72, or $64.8. So over 3 years, you’d earn a total of $80 + $72 + $64.8 = $216.80.

For those SaaS businesses with customers on monthly/quarterly contract or companies that have different churn rates as customers age (which is most SaaS businesses I’ve seen), calculating this churn factor above can be a bit more complicated if you want to shoot for accuracy. I’ve included a simple spreadsheet linked at the bottom of this article that should make it pretty easy. There’s a row for each month and you can adjust the churn rate each month if you want to for accuracy. Or you can just pick a number and drag it down to all of the rows if you don’t have good data by cohort for churn.

One common objection to the CAC ratio is that for businesses with longer sales cycles, it’s not appropriate to compare sales/marketing expenses in the current period with MRR acquired in that period. Sales investments in the current quarter may pay off one or two quarters from now. I have no problem with changing the denominator to the appropriate period for my Payback Ratio. If you want to use the current period for MRR sold and the previous period for sales/marketing expenses, no problem. What we’re trying to get at is the cost to acquire a dollar of MRR, so use your best judgement.

So what’s a good Payback Ratio? In my opinion, anything over 3 is great. That essentially means an investment of $100 today in sales/marketing returns $300 in cash flow over the next few years. As you approach a Payback Ratio of 1, you’re in very dangerous territory, especially for a startup. That means $100 of sales/marketing investment will take 3 years to earn back. Most startups try to recover the cost of customer acquisition in a year or less, so I’d recommend trying to stay close to 3 and only drift toward 2 or below as your business reaches scale ($50M+ in revenue) and cost of capital is much lower than at the startup stage.

For large public companies in mature businesses like wireless carriers (Verizon, AT&T etc), you’ll often see payback ratios of 1 or less. Their category is very stable and predictable, and cost of capital is nearly zero right now for public companies with good credit.

It’s about time we switch to a more accurate metric for calculating sales/marketing efficiency for subscription businesses. Let’s stop using CAC Ratio and starting using Payback Ratio.

Payback Ratio Spreadsheet:

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