Kill Your Income Statement
TL;DR SaaS is different from perpetual software. We are making investments in sales expenses today that produce a return many months or years from now. The income statement can and is misleading as a measure of the performance of our historic sales and marketing investments. I recommend using LTV:CAC as the primary tool for managing the spending decisions in your SaaS business.
I confess. I did it. I killed my income statement! I used to love that document with its bold and unambiguous declarations — revenue equaled the amount of sales, cost of goods sold was what it cost to produce the revenue, and sales margin was a measure of the efficiency of my go-to-market strategy. Then the SaaS years happened and my bright cheerful income statement became dark and brooding, confusing and contradictory: revenue became a stubbornly slower growing beast that shared only a fleeting resemblance to the contracts we closed; my sales/revenue ratio became meaningless and net income became a depressing pit of negativity. So, I killed it and I have no regrets.
Next, I’m going after my MRR charts: the colorful little line charts that look something like this:
Charts 1 & 2: MRR and Net New MRR
Why would I send these to the shredder too? New MRR may well be the first metric that most SaaS execs reach for after closing the quarter but is it a vanity metric? Our sales team could have been out selling dollars for 95 cents all quarter. Or worse yet, since we are talking about SaaS, they could have been selling 12 month subscriptions to dollars for 95 cents! I might feel good if net new MRR goes up but it really doesn’t reveal the truth about the health of our business.
“This is lunacy!” you scream. “Net new MRR is the guiding light, the ‘True North’, by which every SaaS CEO or CFO measures success. If you kill your most crucial KPI how are you ever going to navigate your business?”
The New King
Author’s note: what is written below assumes that my company has found the oft-elusive product market fit and that we have a repeatable sales model.
I’ve pledged my allegiance to a new top-level KPI: the oft-overlooked LTV:CAC ratio — this is the ratio of lifetime value (LTV) to customer acquisition costs (CAC). Sure, you might have seen this ratio buried somewhere as the 7th item on your dashboard, probably listed under the innocuous category of ‘Unit Economics’, or maybe you have it on a slide somewhere in the back of your Board deck but is it the very first thing you look for after the close of the quarter? Until recently, my answer was “no” but LTC:CAC has moved up to the #1 spot on my management dashboard because I’ve started to appreciate it for what it is: the very heartbeat of the company.
In the subscription economy, it is much harder to answer basic questions regarding profit margin and sales costs as related to revenue because even though customer acquisition costs, which are generally equal to sales and marketing expenses, are known to us today the bulk of the revenue and the cost to service that revenue occurs in the future. We need to make estimates on all the future profits we will receive, after deducting costs to provide and service this revenue, for the entire lifetime of the customer, or cohort.
Why do LTV, CAC and the LTV:CAC ratio matter so much to me that I’m prepared to go around metaphorically burning spreadsheets and slashing charts in order to make room for them? The answer is simple: our business has reached the point whereby we want to run it with a profitable sales operation; one that does, or one day soon will, produce more than enough cash to pay for our R&D and G&A expense. We need to know if we are succeeding in deriving profit from our sales activity.
Isn’t the CAC and LTV Contained Somewhere Within the Income Statement and MRR?
MRR charts usually go up and, in SaaS, income statements in the early years usually show red for OpEx. Here are two examples.
Chart 3: Business #1 MRR
Chart 4: Business #2 MRR
Table 1: Income Statements of Business #1 and Business #2
These two companies have exactly the same OpEx per month, same gross margins and the same new MRR per month. Business #1 has a LTV:CAC ratio of 0.95x and Business #2 has a LTV:CAC ratio of 2.0x.
I have graphed the cumulative cash flow (excluding R&D, G&A and the initial sales ramp up costs) for the business above using a range of LTV:CAC ratios from 0.95x to 4.00x.
Chart 5: Cumulative Cash Flow Varying Only LTV:CAC — Based on 1 Month Pre-pay
We can see from charts #5 that a LTV:CAC below 1 is going to produce a business that loses money forever. A LTV:CAC between 1 and 2 will make money eventually, and will get there a little more quickly if we have 1-year upfront payment terms, but will it make enough cash to recover our R&D and G&A investments that have been ongoing prior to and through this sales ramp period?
If this was my business, I would want to know which of these lines I was traveling along: the one that will never generate cash or the one that will generate health cash flow at some point in the future. So, from now on, I’m going to look to LTV:CAC as my guiding light.
