SaaS Metrics — What am I aiming for?

In my last post I presented LTV:CAC and CAC Payback as the two most important metrics for SaaS businesses.

LTV:CAC tells us how profitable a business will be at maturity and CAC Payback tells us how much cash it will take to get there. Therefore, these are the two most important metrics, and entrepreneurs should monitor them religiously.

Management should strive to improve these two metrics. But founders often ask us “how good does my LTV:CAC and CAC Payback need to be?”

In this artcile, I will explain why for SaaS businesses to ‘work’, they need to have LTV:CAC of at least 3x. I will also show that for capital efficient returns, CAC Payback should ideally be less than 12 months.

I will then demonstrate unit economics in action through a worked example.

In a previous post I explained that LTV:CAC is a great predictor of profitability at maturity.

As it turns out, there is a direct mathematical relationship between LTV:CAC and ‘steady state’ contribution margin.

By ‘steady state’ we mean once the business has stopped investing in growth and is just spending enough on sales and marketing to replace churn and maintain a constant revenue.

‘Steady state contribution margin’ is the percentage of revenue that is left after taking off variable cost of sales, and sales and marketing costs (churn replacement only). It is what is left over to cover fixed overheads before getting to ‘steady state operating profit’.

The chart below shows how for a given gross margin, steady state contribution increases with increasing LTV:CAC. This improvement is steep at first, but as LTV:CAC increases, the rate of contribution improvement starts to slow.

So, what can we learn from this?

Well, below 3x LTV:CAC it’s going to be almost impossible to make a highly profitable business. Benchmarks (such as those published by Pacific Crest) tell us that even the largest SaaS companies have an overhead base of at least 30% of revenue. Therefore, to leave enough room for a ‘meaningful’ profit margin (say 10%) we need contribution margin to be greater than 40%. Unless LTV:CAC is at least 3x, this will be tricky.

Between 3x and 5x there is a steep improvement in contribution margin (roughly ten percentage points improvement). At 5x LTV:CAC, contribution margin is high enough that a very profitable business should be possible.

Beyond 5x, there are still benefits to be had, but we start to see diminishing returns. Doubling LTV:CAC from 5x to 10x only yields a further ten percentage points improvement in contribution margin.

So in conclusion:

LTV:CAC needs to be at least 3x for a business to have a chance of profitability, but really management should be aiming for 5x to make a great business.

I will explain the maths of this relationship in a later post.

CAC payback is an indicator of how much cash a business will need to spend on sales and marketing to reach a certain size in a certain time.

Again there is a mathematical relationship here, although it is more complex than the LTV:CAC rule. I will delve into the maths in a later post, but the rule of thumb that we apply at Smedvig Capital (and has been written about by various other commentators) is:

CAC Payback needs to be less than 12 months for a business to have a good chance of capital efficient growth. But for enterprise SaaS businesses with high value clients, this can probably be stretched to 18 or even 24 months.

This is a slightly more nuanced, less objective rule than the LTV:CAC rule because the amount of cash one is willing to invest depends on the expected size of prize and appetite for risk.

For most SaaS businesses, CAC Payback needs to be less than 12 months to provide the capital efficient growth that attracts investors to SaaS in the first place. But for enterprise SaaS companies with high value, low churn customers (and thus high LTV:CAC), a higher CAC Payback period (18–24 months) can work.

So that’s the theory, but to demonstrate the impact of unit economics, let’s do a worked example.

Thought experiment: unit economics in action

Imagine we have three SaaS businesses with identical P&Ls. Each is raising a £7m Series A round to invest in sales and marketing acceleration.

Three ‘identical’ P&Ls.

All three are run rating £2m Annual Recurring Revenue (‘ARR’) and growing 10% month on month. All three have a gross margin of 75% and all three are spending just under 50% of revenue on sales and marketing and a further 50% on overheads (tech, product, finance, admin). They are all loss making to the tune of -£0.5m. They look like three good, early stage businesses.

But with different underlying unit economics.

Company A has low CAC, quick CAC Payback, small contract values (Monthly Recurring Revenue, ‘MRR’), high churn, low LTV. This is the sort of profile we might expect from a consumer subscription business for example.

Company B has very high CAC, long CAC payback, large contract values, low churn and high LTV. This is more like the profile of an enterprise SaaS business selling large, bespoke, contracts into blue chip companies.

Company C is somewhere in between. Perhaps the metrics of a SaaS product aimed at small and medium sized businesses.

It’s tricky to disentangle all the individual metrics to get a read on how the three businesses will perform overall.

But, they all have the same P&L so should all be pretty similar… right? Well, let’s see where they end up five years after the investment.

Very different outcomes five years later.

Company A: Disaster

To be fair, Company A has grown to a respectable £13m ARR. However, growth has all but stopped now. It burnt through the £7m investment in just over three years and had to raise another £2.6m. It is still not through break even. More worryingly, even if we strip out growth costs, the company would still be loss making (steady state EBITDA ~ -£1.3m).

Company C: Solid investment

Let’s jump to Company C. This has been a great investment. It is now at £22m ARR, growing 11% per year and has reached break even without needing any more cash. It is dropping £1.7m EBITDA whilst still growing, and if we strip out growth costs, its ‘steady state’ EBITDA is £3.5m.

Company B: Big win… eventually

Company B is a really interesting one. After 5 years it is smaller than Company C at £17m ARR. It burnt though the £7m investment in 23 months and needed to raise a further £4.6m — much worse even than Company A. However, it has reached break even (just). More excitingly, it is now growing the fastest at 18%, and if we strip out growth costs its steady state EBITDA is £4.1m. So it is poised to become a more profitable business than Company C and is arguably a more exciting business (depending on your risk appetite).

So, could we have predicted this outcome?

We should have seen this coming.

Well Company A had a LTV:CAC ratio of 2x which should have been a pretty clear warning that it would struggle to become profitable.

Company B had a super high LTV:CAC (15x) which highlights its potential to be a ‘big win’. However, its long CAC Payback period (24 months) was a warning that it would take a lot of cash and a long time to get there.

Company C had a solid LTV:CAC of 5x and a similarly strong CAC Payback of 12 months. This should have told us that it would get to a good level of profitability without burning too much cash. A nice, lower risk, investment even if Company B ends up being the bigger win.

So despite all three businesses having the same P&L, we could easily have predicted their divergent outcomes, just by looking at two metrics.

Avoiding traps: when to invest and when to hold back.

Finally, let’s look at how Company A and Company B evolved over time. This will demonstrate how unit economics can help us to avoid traps when deciding whether or not to invest in sales and marketing. We will ignore Company C for now because it is straight forward — a good investment from the get-go.

Take company A (red line) first. Because it has such a quick CAC Payback (6 months) it was able to acquire new customers and revenue very fast. It grew faster than the other two companies initially and after twelve months it had grown ARR 5 fold to £10m (left hand chart). Consequently its burn had come down the most, to about -£2.5m after 12 months (middle chart), and it had burnt through the least amount of cash, just under £4m (right hand chart).

However, because churn was so high (hence low LTV:CAC at 2x), as soon as it reached any scale, it had to invest huge amounts in sales and marketing to replace churning customers just to tread water. By 24 months, almost all of its sales and marketing spend was going on churn replacement rather than new growth and so growth all but stopped (left hand chart). EBITDA never got to break even and plateaued at -£1m (middle chart). The business continues to lose money today and will never become profitable (dotted line).

The trap: in the first 12–24 months, management could have looked at the stellar growth rate and decreasing burn and decided that everything was going smoothly. It would have been easy to make the mistake of investing further to accelerate growth when in reality they needed to do the exact opposite — cut sales and marketing spend and focus on fixing churn. A quick look at LTV:CAC would have told them this.

Company B (orange line) has a long CAC Payback (24 months) so it took a long time and a lot of money to get going. After 12 months it had only reached £5m ARR (left hand chart) and after 3 years it was still the smallest company despite spending the most on sales and marketing (right hand chart).

However, because it has such low churn (hence high LTV:CAC at 15x), as it began to grow it gathered momentum. The customers it acquired (at high cost) stuck around and spent lots of money. By the end of 5 years, it has a large, stable, base to build from and almost all new investment goes into growth. By year five it is growing the fastest (left hand chart) and is through break even (middle chart). Importantly, because it has a stable base of revenue, it can chose to ‘turn-off’ growth spending at any time to increase profit (dotted line, middle chart).

The trap: management may have lost their nerve and chosen not to invest further when confronted with sluggish growth and high burn early on. This would have been a mistake. Now is exactly the right time to accelerate sales and marketing to win market share and push through the cash trough (right hand chart). Armed with CAC Payback and LTV:CAC numbers, management could have seen what was going on and had the confidence to press on.

Originally published at www.smedvigcapital.com on February 8, 2017.