A New Way to Think about SaaS
This is the follow-on to my blog post Kill Your Income Statement
A ROI Approach to CAC
It’s clear that LTV, CAC and LTV:CAC ratio provide valuable insight into the health of my SaaS business and the profitability of my sales machine. So, am I going to kill my income statement, slash a couple of charts, rearrange my dashboard and call it good?
Actually, what I’m suggesting is something deeper: a new mindset with an ROI-driven approach in which I will behave in the same way as an investor who is purchasing an annuity; in this case, a decreasing annuity. CAC is the investment I’m making and LTV is the sum of all payments I will receive over time. In SaaS, the return on investment (ROI) from my sales expense is governed by the following formula:
ROI = LTV/CAC -1
With that in hand, the other thing I need to know in order to make my CAC investment decision is how long it’s going to take for me to earn the return on my investment. A 100% ROI that takes 10 years to earn provides a 7.2% compound annual return and is not as exhilarating as a 100% ROI that is earned in one year.
Unfortunately, because the return is provided as a declining stream of payments we need to use an IRR calculator or similar Excel formula to properly calculate the annualized return. This can be a bit tricky because theoretically the income stream continues to infinity. In my model, the default setting cuts off the decreasing annuity once 99% of the estimated LTV has been returned; others assume a cutoff of the annuity after a certain number of years under the assumption that a technology shift will cause mass cancellation.
Now that I have an approximation of the IRR, I can make an informed CAC investment decision factoring in my company’s weighted average cost of capital (WACC). At a minimum, my IRR needs to beat the pants off my WACC. I like to assume 30% WACC for private companies because I’m going to finance with a mixture of equity and expensive debt. 10–20% is a better WACC for public companies. My CAC investments need to someday provide enough return to overcome my WACC and payback our cumulative R&D and G&A investments to date and going forward. I’m going to aim high.
David Skok of Matrix Partners is one of my favorite bloggers on the topic of SaaS metrics. If you are confused by any of the terminology used here you can read his excellent primer on everything related to SaaS metrics. David’s two guiding principles for any SaaS business manager are: aim for a LTV:CAC ratio of 3x or greater and a payback of your CAC of 12 months or less. Taking the bookends of 3x LTV:CAC and 12 month payback of CAC, this produces a ROI of 200%, and an IRR of 91%.
How did he come up with 3x LTV:CAC? Perhaps he was recalling the good ol’ days, when LTV equaled revenue and churn was 100%? That’s right, I’m talking about the days of perpetual software when the LTV:CAC looked somewhat like this:
My CAC Looks Good for This Month — What About Next Month?
Knowing the IRR on CAC helps provide a guideline for making a high-return one-month decision on our CAC investment but the reality is that I’m really making a whole series of multi-month or even multi-year decisions about CAC when I hire a sales team, launch a new territory or embark on a marketing program. What I really need to know is the value of my sales machine based on the present value of cash flows it will generate in all periods going forward.
I like to do this with a spreadsheet using the input variables of CAC (how much do I want to invest), LTV:CAC estimate, and my expected new contribution dollars each month (MRR x estimate contribution margin). I then will perform a discounted cash flow (DCF) analysis using the net present value formula in Excel and apply it to all future cash flows using my discount rate (WACC).
Below, I have shown an example where I have modeled a new sales territory with a CAC of $2 million per month, LTV:CAC of 4x and a payback period of 10 months. The result is an initial MRR of $333K and, at 60% contribution margin, contribution dollars per month of $200k/month.
I have ignored the time and cost to get this team fully productive though it would be easy to add this into the DCF. You can see the cumulative cash flows from this sales territory or sales team on Chart 1. I’m not increasing the size of the team of the team over time. I’m keeping a consistent $2m per month spend on CAC.
This sales machine has a cash low point of about $10 million and total cumulative cash flow of over $290 million over 8 years, which has a net present value of $72 million using a 30% discount rate.
Chart 1: Cumulative Cash Flow Over 8 Years Based on $2m CAC/Month & LTV:CAC of 4x
Authors note: Cash low point would be above $0 and the present value would be $97 million if I could get all customers to pay upfront for the initial 12 months of service.
A Model for Valuing the Whole Business
From the DCF analysis, I can see that a $2 million/month CAC investment with a 4x LTV:CAC produces a portfolio of $2m investments each with a separate, though related, return profile. If the customers pay monthly, then I’m going to need my sales team ramp-up costs PLUS $10 million in order to acquire this portfolio that is going to yield a $72 million return. If I can get the customer’s to pay for 12 months in advance, my cash low point stays above $0 and I’m only going to need to pay for my sales ramp-up costs.
If I want to take the next step, I can incorporate R&D and G&A expenses into my cash flow and present value analysis and I will know if my business is generating any value. Using DCF to value a business has gone out of fashion in tech, where the option value of a winner-takes-all outcome predominates the buying decision of the average public market investor, but present value of future cash flow is the intrinsic value of any business and seeing it rise from period to period means intelligent business decisions are being made.
You Have a Portfolio of CAC investments. Now What?
So, I’ve killed my income statement, shredded my MRR chart and I’m about to be an investor in a portfolio of decreasing annuities. I’ve got my LTV:CAC and my payback period all figured out. Now what?
Like any investor, I’m going to track the performance of my annuities, individually and collectively. The most important is the actual contribution dollars vs. expected but it can also be helpful to track contribution margin and churn vs. expected in order to understand the reason for any delta.
Charts 2, 3 & 4: Tracking Portfolio Performance
It is also helpful to track each “portfolio.” For most SaaS companies, this means tracking cohorts, which are usually groups of customers that were acquired in the same period, either monthly or quarterly. Like any investor, if your portfolio is under performing or over performing versus expectations then you are going to want to know which elements are contributing to the delta. In the case of SaaS these elements are your cohorts.