In this lesson, you’ll learn how to calculate important financial metrics for Software as a Service (SaaS) companies, such as Lifetime Value (LTV), Customer Acquisition Costs (CAC), LTV / CAC, and the CAC Payback period; you’ll also learn their advantages and disadvantages and why they can be deceptive unless they’re properly adjusted.

Resources:

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Table of Contents:

0:00 Introduction

1:16 The Short Answer

5:44 Part 1: Why the “Lifetime Value” Calculation is Tricky

13:32 Part 2: Calculating Customer Acquisition Costs (CAC)

15:30 Part 3: Is LTV / CAC Useful or Deceptive?

19:52 Part 4: A Better Alternative: CAC Payback Periods

23:32 Part 5: Other Common SaaS Metrics

26:43 Recap and Summary

The Lifetime Value (LTV) Calculation

You start by estimating how many years the average customer will stay and keep paying, multiply by the amount paid per year, and then multiply by the company’s gross margin percentage (sometimes with other adjustments included).

The most common formula for "average lifetime," which could be in months, quarters, or years, is:

Average Lifetime = 1 / Churn Rate

So, if the company has annual contracts, and 20% of customers cancel each year, the “average” customer stays for 5 years.

But it’s not quite that simple for startups because these lifetime estimates tend to be wildly overstated and must be discounted for market, product, customer, and funding risk.

A better formula for a company with annual contracts is:

Average Lifetime in Years = 1 / (Annual Cancellation Rate + Discount Rate)

You could factor in price increases if they’re contractual and set in advance, or you could just use the current rates.

LTV = Average Amount Paid per Year * Average Lifetime in Years * Gross Margin %

The Customer Acquisition Costs (CAC) Calculation

The main questions here are which expense to include and whether the company discloses enough information to separate out these expenses.

You typically include expenses such as marketing salaries/benefits, paid advertising, commissions paid on new customer sales, and executive time/money spent to win new customers.

Including salaries and benefits for sales reps and employees is more complicated because you should, technically, split it between new and renewal sales reps; similar splits apply to expenses such as employee onboarding, overhead, and travel.

Uses of LTV / CAC

LTV / CAC is a useful metric, if calculated and adjusted properly, but like all financial metrics, it’s not a "law of nature."

The biggest issue is that most startups have a very limited data set and operating history, which means that LTV can be greatly overstated unless you adjust it based on a Discount Rate.

LTV / CAC is best used to compare two similar startups in similar growth stages to assess which one is operating more efficiently and winning higher-value customers.

There is a “rule” online that an LTV / CAC of 3x or above is “good” or the “target” for most SaaS companies, but this is a very rough guideline at best.

It’s true that no company wants a very low LTV / CAC, such as a number below 1x, but there is so much subjectivity in the calculation that strict rules do not necessarily mean that much.

The CAC Payback Period

A better alternative to LTV / CAC is the CAC Payback Period, which tells you the number of months it takes a company to recoup the average sales and marketing costs required to win a new customer.

There are different ways to calculate it, but one common method is as follows:

CAC Payback Period = Monthly Customer Acquisition Costs / Net New Monthly Recurring Revenue

Net New MRR = (Additional Monthly Subscription Revenue from New Customers – Lost Monthly Subscription Revenue from Cancelling Customers) * Gross Margin %

This metric is more useful because it’s shorter term and does not require predictions about customer behavior in 5-10 years; you also don’t need to adjust it based on the Discount Rate, price increases, cancellation rates, or anything else.

Shorter is better with this one, so a company that recoups its sales and marketing costs in 6 months rather than 12 months is viewed more favorably, assuming the same contract lengths.