Many of the most watched software as a service (SaaS) metrics relate to the cost of acquiring customers. For example, the Customer Acquisition Cost (CAC) ratio, which (in my preferred definition for enterprise software companies) measures the amount of money a company spends on sales and marketing to acquire $1 in new annual recurring revenue (ARR).
I general I prefer looking at simple SaaS metrics in combination over creating compound metrics. For example, I’d rather see New ARR and Churn ARR independently rather than subtracting the latter from the former to arrive at Net New ARR. Why? Because there are many different ways of getting $1M in Net New ARR – for example, you can churn $2M and sell $3M or you can churn $100K and sell $1.1M. Those are very different situations operationally and the use of a compound metric that offsets one against the other potentially masks, rather than illuminates, the underlying situation.
One exception I make to my simple metrics rule is the LTV/CAC ratio, which I view as the ultimate SaaS metric. While it’s a compound metric that includes both customer acquisition cost and churn, it’s a good one because what you are willing to pay for something should be a function of what it’s worth – and that’s precisely what LTV/CAC captures.
The single most misunderstood SaaS metric I’ve encountered is the CAC Payback Period (CPP), which is generally defined as the months of contribution margin to pay back the cost of acquiring a customer. Bessemer defines the CPP as:
As usual, while they get the overall point right, I quibble with some of the Bessemerisms in the definition. For example, (1) most enterprise SaaS companies should use ARR not MRR (monthly recurring revenue) because most companies are doing annual, not monthly, contracts, (2) the “committed” MRR concept is an overreach because it includes “anticipated” churn which is basically impossible to measure and often unknown, and (3) I don’t know why they use the prior period for both S&M costs and new ARR – almost everybody else uses prior-period S&M over current-period ARR in CAC calculations on the theory that last quarter’s S&M generated this quarter’s new ARR.
Switching to ARR nomenclature, and with a quick sleight of mathematical hand for simplification, I define the CAC Payback Period (CPP) as follows:
Let’s run some numbers.
- If your company has a CAC ratio of 1.5 and subscription gross margins of 75%, then your CPP = 24 months.
- If your company has a CAC ratio of 1.2 and subscription gross margins of 80%, then your CPP = 18 months.
- If you company has a CAC ratio of 0.8 and subscription gross margins of 80%, then your CPP = 12 months.
All seems pretty simple, right? Not so fast. There are two things that constantly confound people when looking at CAC Payback Period (CPP).
- They forget payback metrics are risk metrics, not return metrics
- They fail to correctly understand the impact of annual or multi-year contracts
Payback Metrics are for Risk, Not Return
Quick, basic MBA question: you have two projects, both require an investment of 100 units, and you have only 100 units to invest. Which do you pick?
- Project A: which has a payback period of 12 months
- Project B: which has a payback period of 6 months
Quick, which do you pick? Well, project B. Duh. But wait — now I tell you this:
- Project A has a net present value (NPV) of 500 units
- Project B has an NPV of 110 units
Well, don’t you feel silly for picking project B?
Payback is all about how long your money is committed (so it can’t be used for other projects) and at risk (meaning you might not get it back). Payback doesn’t tell you anything about return. In capital budgeting, NPV tells you about return. In a SaaS business, customer lifetime value (LTV) tells you about return.
There are situations where it makes a lot of sense to look at CPP. For example, if you’re running a monthly SaaS service with a high churn rate then you need to look closely how long you’re putting your money at risk because there is a very real chance you won’t recoup your CAC investment, let alone get any return on it. Consider a monthly SaaS company with a $3500 customer acquisition cost, subscription gross margin of 70%, a monthly fee of $150, and 3% monthly churn. I’ll calculate the ratios and examine the CAC recovery of a 100 customer cohort.
While the formula outputs a long 33.3 month CAC Payback Period, reality is far, far worse. One problem with the CPP formula is that it does not factor in churn and how exposed a cohort is to it — the more chances customers have to not renew during the payback period, the more you need to consider the possibility of non-renewal in your math. In this example, when you properly account for churn, you still have $6 worth of CAC to recover after 30 years! You literally never get back your CAC.
Soapbox: this is another case where using a model is infinitely preferable to back-of-the-envelope (BOTE) analysis using SaaS metrics. If you want to understand the financials of a SaaS company, then build a driver-based model and vary the parameters. In this case and many others, BOTE analysis fails due to subtle complexity — whereas a well-built model will always produce correct answers, even if they are counter-intuitive.
Such cases aside, the real problem with being too focused on CAC Payback Period is that CPP is a risk metric that tells you nothing about returns. Companies are in business to get returns, not simply to minimize risk, so to properly analyze a SaaS business we need to look at both. That’s why I think, if you had to pick just one metric, that LTV/CAC is the best SaaS metric.
The Impact of Annual and Multi-Year Prepaid Contracts on CAC Payback Period
The CPP formula outputs a payback period in months, but most enterprise SaaS businesses today run on an annual rhythm. Despite pricing that is sometimes still stated per-user, per-month, SaaS companies realized years ago that enterprise customers preferred annual contracts and actually disliked monthly invoicing. Just as MRR is a bit of a relic from the old SaaS days, so is a CAC Payback Period stated in months.
In a one-hundred percent annual prepaid contract world, the CPP formula should output in multiples of 12, rounding up for all values greater than 12. For example, if a company’s CAC Payback Period is notionally 13 months, in reality it is 24 months because the leftover 1/13 of the cost isn’t collected until the a customer’s second payment at month 24. (And that’s only if the customer choses to renew — see above discussion of churn.)
In an annual prepaid world, if your CPP is less than or equal to 12 months, then it should be rounded down to one day because you are invoicing the entire year up-front and at-once. Even if the formula says the CPP is notionally 12.0 months, in an annual prepaid world your CAC investment money is at risk for just one day.
So, wait a minute. What is the actual CAC Payback Period in this case? 12.0 months or 1 day? It’s 1 day.
Anyone who says 12.0 months is forgetting the point of the metric. Payback periods are risk metrics and measured by the amount of time it takes to get your investment back. If you want to look at S&M efficiency, look at the CAC ratio. If you want to know about the efficiency of running the SaaS service, look at subscription gross margins. If you want to talk about lifetime value, then look at LTV or LTV/CAC. CAC Payback Period is a risk metric that measures how long you CAC investment is “on the table” before getting paid back. In this instance the 12 months generated by the formula is incorrect because the formula misses the prepayment and the correct answer is 1 day.
A lot of very smart people get stuck here. They say, “yes, sure, it’s 1 day – but really, it’s not. It’s 12 months.” No. It’s 1 day.
If you want to look at something other than payback, then pick another metric. But the CPP is 1 day. You asked how long it takes for the company to recoup the money it spends to acquire a customer. For CPPs less than or equal to 12 in a one-hundred percent annual prepaid world, the answer is one day.
It gets harder. Imagine a company that sells in a sticky category (e.g., where typical lifetimes may be 10 years) and thus is a high-consideration purchase where prospective customers do deep evaluations before making a decision (e.g., ERP). As a result of all that homework, customers are happy to sign long contracts and thus the company does only 3-year prepaid contracts. Now, let’s look at CAC Payback Period. Adapting our rules above, any output from the formula greater than 36 months should be rounded up in multiples of 36 months and, similarly, any output less than or equal to 36 months should be rounded down to 1 day.
Here we go again. Say the CAC Payback Period formula outputs 33 months. Is the real CPP 33 months or 1 day? Same argument. It’s 1 day. But the formula outputs 33 months. Yes, but the CAC recovery time is 1 day. If you want to look at something else, then pick another metric.
It gets even harder. Now imagine a company that does 50% 1-year deals and 50% 3-year deals (on an ARR-weighted basis). Let’s assume it has a CAC ratio of 1.5, 75% subscription gross margins, and thus a notional CAC Payback Period of 24 months. Let’s see what really happens using a model:
Using this model, you can see that the actual CAC Payback Period is 1 day. Why? We need to recoup $1.5M in CAC. On day 1 we invoice $2.0M, resulting in $1.5M in contribution margin, and thus leaving $0 in CAC that needs to be recovered.
While I have not yet devised general rounding rules for this situation, the model again demonstrates the key point – that the mix of 1-year and 3-year payment structure confounds the CPP formula resulting in a notional CPP of 24 months, when in reality it is again 1 day. If I one day make some rounding rules, I believe they will revolve around the average contract duration and the CAC ratio, but I am not yet totally sure.
That aside, hopefully, everyone has understood the real point. The CAC Payback Period is an often misunderstood metric because people forget that payback metrics are about risk, not return, and because the basic formulas – like those for many SaaS metrics – assume a monthly model that simply does not apply in today’s enterprise SaaS world.
(Cross-posted @ Kellblog)