SaaS metrics: CAC & LTV

How can we tell if a SaaS business is healthy

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Given SaaS dynamics, what’s an investor to do in assessing whether an early SaaS company will yield a good financial return? Thankfully, there are a few key guideposts.

We first need to measure Customer Acquisition Costs (CAC); the simple way to do so is to add up the quarterly sales and marketing expense for a company and divide that by the number of new customers acquired in the quarter.

But how do we know if that CAC is worth it — or whether the company is simply spending too much money to acquire customers that will never yield a positive financial return?

To answer this question, we need to look at the lifetime expected earnings of that customer or Customer Lifetime Value (LTV), which is calculated by

(Annual Recurring Revenue x Gross Margin) ÷ (% Churn + Discount Rate)

As a general rule: if LTV is 3X or greater than CAC, that’s a good sign that the business model is working.

If the LTV is close to or less than CAC, then we know that something is out of balance; it suggests that the company is spending more money to acquire the customer than it expects to generate in profits over the customer’s lifetime.

This could be because the company hasn’t figured how to effectively monetize its customers. Or that customers are leaving before they’ve spent enough money on the platform to cover the costs to acquire them. Or that the company hasn’t figured out an effective way to scale its customer acquisition costs.

Whichever it is, you better investigate! And then there’s the ultimate proxy for customer satisfaction — Churn.