SaaS companies make their money by selling subscriptions.
This presents a challenge as they work to acquire, retain, and monetize customers.
In an excellent article on SaaS Metrics and Customer Economics, David Skok explains these challenges and the metrics that help you stay on top of them.
Unlike other business models, SaaS companies must accomplish two sales: acquire the customer and retain the customer.
1. Acquire the customer. In the initial sale you acquire a customer. Your buyers’ journey to acquisition includes these stages: They become aware of a problem, examine their options to solve it (including you), learn to trust you, and make a decision.
But the first purchase is small. It’s just the first monthly subscription payment or perhaps an annual contract.
2. Retain the customer. In order for the lifetime of customer revenue to exceed the cost to acquire the customer, you need to keep the customer happy. Your second sale keeps your customers happy and retains them so that you can maximize their lifetime value.
The financing problem for a SaaS company is that you spend up front to acquire a customer, but your revenue from the customer accrues over a long period of time.
This creates a strain on cash flow. The revenue from the customer doesn’t pay the cost of acquiring the customer for many months.
If that’s the cash flow picture for one customer, what happens if you start to grow and add more customers?
The more customers you add, the deeper the trough before you become cash positive.
On the other hand, the more rapidly you grow, the greater the reward once you become cash positive.
Since many SaaS businesses are in a “winner take all” market, fast growth and the financing to support it are vital.
Given this economic picture for a growing SaaS company, David Skok asks: “How do you know if your SaaS business if viable?”
The key metrics to collect are:
- Customer acquisition cost (CAC) — Skok says that companies tend to underestimate the cost to acquire a typical customer.
- Lifetime value of the customer (LTV) — Lifetime Value is a function of your ability to monetize the customer and to keep churn rates low.
Skok recommends “two guidelines that can be used to judge quickly whether your SaaS business is viable. The first is a good way to figure out if you will be profitable in the long run, and the second is about measuring the time to profitability (which also greatly impacts capital efficiency).”
How profitable will I be in the long run? Long term profitability derives from work to reduce churn rates and lower the cost of acquisition. It also comes from analysis of customer segmentation and allocation of customer acquisition resources to the most lucrative segments. These are the levers you can move to improve the ratio of LTV:CAC.
How long will it take for me to get there? Skok says months to recover CAC gives a reasonable prediction of how well a SaaS business will perform.
In the graph below you can see that when CAC recovery goes beyond twelve months, growth stagnates.
Skok concludes with three suggestions about how to use these ratios:
- Push the accelerator. If these two guidelines tell you that your business is doing well, it may be time to push the accelerator and grow faster.
- Evaluate lead sources. Some leads cost more than others. But if the leads are lucrative, it may be worth the acquisition costs to buy them. You can also decide whether you can afford to pay more for a lead. If your customer revenue is $500 per month, then you can afford to spend $6,000 to acquire a customer ($500 * 12 months = $6,000).
- Make segmentation choices. If you have different segment options, look at which ones have the fastest time to recover CAC or the highest LTV:CAC ratio.