“Churning” is probably not the best choice of words in the title of this article, since it can have negative connotations in any business – especially a recurring revenue model. However, I do want to draw attention to the concept of churn – the rate of client termination – because it:
- Is an essential element for measuring customer satisfaction and brand loyalty.
- Provides predictive insight for revenue growth.
- Is a key component of one particular KPI that leaders of SaaS companies should focus on in their quest for profitability and growth.
The basic financial statement metrics to measure liquidity, capital efficiency, etc. are all relevant to operating a SaaS business, but somewhat lacking when supporting timely decision making. Fortunately, the equity participants in the technology sector have established a set of SaaS-specific KPIs as critical operating levers for recurring revenue models. I’ll not rehash all of those KPIs here, and I will provide the general disclaimer that there is more than one way to calculate some SaaS KPIs. Calculations can be significantly influenced by how your company describes and measures Sales and Marketing costs as well as funnel economics, and your company’s revenue mix.
If your finance team is not currently providing you with a dashboard of SaaS KPIs then make that their highest priority. Think about it this way; is your most urgent need for your finance team to be historians reporting on the past, or providers of business intelligence that facilitates predictive and perhaps prescriptive decisions? Once you have a KPI dashboard in place with a goal of “churning” out profits to fuel growth, I suggest you focus on one key SaaS metric. If you fully understand, measure and manage with this KPI at the top of your scorecard, then by default you will comprehend all the other SaaS , how they interact, and how to align these operating metrics towards profitability or free cash flow. I’m not touting a magic bullet to profitability, but a meaningful metric that once mastered will provide a scalable path to funding growth.
What is this crucial SaaS KPI? It is the “LTV to CAC ratio.” LTV is the Lifetime Value of a client and CAC means Client Acquisition Costs. This metric can provide your company with an excellent indicator of future cash flows.
Let’s first define CAC. Stated simply CAC is cost of acquiring a client. How much do you have to spend in sales and marketing to develop a Lead into an Opportunity and then to convert them to a client? To determine a valid CAC you need to have a grasp of your marketing economics and your sales process. The most important variable in determining CAC is the period of time to measure the investment in sales and marketing for prospect conversion.
My recommendation is to focus on two key elements of your sales process when making this determination ) the time to convert a specific Lead(s) related to a specific marketing campaign(s), and 2) the key sales metric, Days to Close (the number of days a Lead/Opportunity takes to sign a subscription agreement). If you have one or both you should be able to define a meaningful period of investment for prospect conversion. Then divide the total spend on sales and marketing funds during the defined time frame, by the number of new clients added during that same time period. That’s it, you now have the key KPI – CAC!
To complete the ratio, LTV can be determined several ways, although I advocate a triangulation of your best answer when you calculate:
- A monthly client churn rate
- A theoretical churn rate
- Historical cohort data for monthly recurring revenue
Let’s use the monthly client churn approach to keep it simple. We will assume 3% of your client’s churn – or terminate – each month. You will also need to know
- Average Revenue per Account (“ARPA”) or Monthly Recurring Revenue divided by your number of client accounts (“MRR”), and
- Your Gross Margin.
Let’s assume for our example that CAC is $750, ARPA = $100 and your Gross Margin is 75%.
OR
LTV = ($100 ARPA * 75% GM)/3% Churn = LTV $2,500 or stated another way 33 months of future net MRR.
The LTV to CAC ratio or our coverage of Sales and Marketing expense equals $2,500 LTV / $750 CAC or 3.33. SaaS experts agree that a ratio of greater than 3 is excellent, but the right target for you really depends on your strategic plan, product maturity, and market opportunities.
By knowing your LTV to CAC ratio you will also capture another important SaaS KPI, the CAC payback period.
Based on our example the CAC payback period is 10 months.
what does all of this mean, and how does it help leaders of SaaS organizations invest their efforts wisely to enable their business to grow?
After recouping your sales and marketing costs to land a client by month 10 of the subscription period in this example, your company will have remaining or future net revenues of $1,742 over 23 months to invest in other areas of the operations. Moreover, you now have a predictable period of time to expand the account, and perhaps the additional value of a client referrals or case studies for marketing purposes.
To summarize, everything else about SaaS operating metrics is for the most part the cascading benefit of knowing and mastering your LTV to CAC ratio.
You have to know your churn rate and how product management, pricing, and client delivery impact retention, and you must have the ability to measure the investment to acquire clients. With these known elements of the operation, the LTV to CAC ratio will allow you to identify and leverage critical inflection points for investment in scale and growth.
Mastering this SaaS KPI will help you ACCELERATE strategic and give your company a powerful strategic advantage in the marketplace.
If you don’t feel rock solid on your KPIs and particularly this key ratio to help assess your company’s LTV to CAC ratio, give us a call.
To start the conversation, contact us at info@vcfo.com, or reach out to our offices here.
