SaaS Customer Acquisition Costs
I had a meeting with a really smart founder today who asked the question: what is a reasonable customer acquisition cost (CAC) in a SaaS business and when will a potential investor red flag my CAC metrics and customer acquisition strategy? I responded with an abridged version of “it depends on the company and unit economics”, which is broad, but true. If I had more time I would like to have drilled down into the technical aspects of how Life Time Value (LTV) and the net present value rule dictates an acceptable CAC range. So here is a more comprehensive overview of how to analyze CAC and gain a sense of what is a reasonable figure:
What’s Life Time Value and how do I calculate it?
Life time Value of a user is the sum of the discounted annual cash flows generated per customer over the ‘x’ number of years (lifetime) said individual remains a customer. If you have no historical data for your business, look at larger comparable public companies, which will report churn figures in their annual shareholder reports. You can then divide this rate by 1 to determine an implied customer lifetime in years. For LTV purposes, customer cash flow refers to gross margin: revenue less non-marketing related variable costs of goods sold (COGS). For example, lets assume that a hypothetical company, ABC co., acquires 10 customers in year 1 that generate $100 in annual revenue, require non-marketing related COGS of $20, annual maintenance sales costs (customer satisfaction, technical support etc.) of $20 and maintain an average customer lifetime of 10 years (10% churn rate). If the discount rate applied is 10%, the LTV comes out to $36.87 (see figure 1).
What is CAC and how do I calculate it?
Like capital expenditures, we can (attempt to) split sales & marketing costs into distinct growth and maintenance components. We used the “maintenance” sales component to calculate annual LTV cash flows in the example above. These costs include all required costs to keep a specific cohort as customers. They include customer satisfaction, technical support and ongoing customer engagement costs. For CAC, we need to determine the upfront “growth” component of marketing costs in year 1. CAC is essentially the initial cash outlay required to acquire an individual customer. Calculating this can be tricky. You need to estimate the associated sales & marketing costs (wage expense, campaign expense, event expense etc.) that are directly related to acquiring each new customer cohort. To continue from the example above, if we assume that ABC co. spent $60 in marketing wage expense, $30 in email campaigning and $20 in local pop-up event costs to acquire the 10 customers in the year 1 cohort, CAC comes out to $11.00 (see figure 2).
The LTV/CAC ratio
To determine whether a specific CAC is acceptable, we need to look at the cohort’s LTV/CAC ratio. The CAC by itself is not enough, hence my abridged answer to today’s founder as “it depends on the company”. Analyzing CAC depends on the unit economics of the business and the resulting net present value (NPV) of each customer. As a refresher, in project management we accept projects with an NPV greater than 1 (indicating future benefits outweigh upfront costs). Here, our net present value is the LTV (discounted cash flows per user) minus the CAC (initial marketing outlay to acquire said customers). For the business to make any sense, this number has to be positive (LTV/CAC greater than 1.0x). The CAC value that results in an LTV/CAC ratio of 1.0x becomes our floor value when answering the question: what is an acceptable CAC? If the ratio is less than 1.0x, CAC costs are unsustainably high and you are spending more money acquiring your customers than you will ever recoup from them in profit.
In reality, the LTV/CAC ratio needs to be substantially higher than 1.0x to generate a positive net profit and cover all other non-marketing related business costs (taxes, interest, other operating costs etc.). In a perfect world, the value will be high enough to fund capex internally without having to tap public/private markets and create a completely self-sustaining business. An acceptable ratio depends on the industry, however in the SaaS world a generally agreed upon satisfactory ratio is 3.0x. In our example, ABC co. currently generates an LTV/CAC ratio of 3.35x. so we can rest assured for now that their customer acquisition strategy is sustainable and profitable. However…
Take this analysis with a grain of salt: the CAC and LTV figures will most certainly change over time. A company may benefit from decreasing maintenance sales costs (through adoption of online AI assistants for instance), or suffer from deteriorating LTV if industry competition stiffens. As a result of a dynamic competitive environment, acquisition strategies and associated growth marketing costs will evolve. It is therefore important to track CAC over time at the cohort level (this can be done in financial models using cohort “waterfalls” — I can help you out if you need a hand). For example, if a rival company to ABC co. brings a competing product to market in year 3. a pricing war could ensue. If variable costs can’t adjust in lockstep, gross margin per customer will suffer. ABC co. may then need to reinvent its customer acquisition strategy and/or streamline it’s customer satisfaction process to control costs and maintain a profitable LTV/CAC ratio.
Accounting for Virality
This simplified example does not take into account the powerful virality factor inherent in many SaaS business models. Unfortunately, while this is an important growth factor, it is difficult to model and forecast: how do you accurately determine whether or not a customer joins due to internal sales efforts or as a result of viral marketing/word of mouth? Regardless, to conservatively account for this, the standard is to incorporate a “virality coefficient” into the LTV calculation. In the ABC co. example, we could assume a moderate 10% coefficient for the year 1 cohort. Accordingly, we would multiply the $36.87 LTV by 1+10%, which results in a virality adjusted LTV of 3.69x. Consider this ‘1+x%’ coefficient as indicating that x% of the current cohort will help the business acquire one new similarcustomer over his/her lifetime. While the virality coefficient may be far, far higher than 10% in reality, it is important to remain conservative as accounting for and subsequently defending the corresponding growth effect is complex.
Breaking out Marketing Costs
For a young company, it is hard to break sales & marketing costs into growth vs. maintenance. Many employees wear multiple hats and serve multiple roles. It may be overly cumbersome and uneconomical to allocate the hours an individual employee dedicates to customer satisfaction vs. customer acquisition. In this case, a simple estimate will have to suffice. However, as always when making estimates based on unknowns, it is best practice to remain conservative. Doing so serves to improve operational insight and gain investor trust during pitch presentations and meetings.