There’s been lots of discussion about the recent downturn in the valuation of technology businesses and while it’s more helpful to focus on creating value, rather than fixating on valuations, how do you understand the health of software as a service (SaaS) company?
It all starts with understanding the SaaS business model. Unit economics and specifically, LTV:CAC remain the best indicator. But what are these acronyms and why are they important?
Understanding unit economics and LTV:CAV
Unit economics are the revenues and costs associated with a particular business model and are expressed on a per unit basis. For SaaS businesses, the unit is a customer and the key unit economics are LTV:CAC.
LTV:CAC is the lifetime value (LTV) of a customer divided by the customer acquisition cost (CAC). LTV as its name suggests is the total lifetime value to the business of a customer. Many SaaS businesses are subscription based so often the figure is the value of the monthly subscription multiplied by the average number of months that a company retains a customer.
The customer acquisition cost (CAC) is the costs associated with maintaining the product, as well as marketing and sales costs. Looking at these numbers as a ratio helps you understand how effective a business is at making money. It also helps distinguish the donkeys from the unicorns.
For example, if a subscription for a product costs €1,500 per month and the average customer remains for 18 months before churning, the LTV of a customer is €27,000. If the cost of maintaining the product is €300 per month and the combined sales and marketing costs are €200 per month, CAC will be €9,000. This would give the company an LTV:CAC of 3:1.
In short, the company generates three euros for every euro spent - this is often given as an acceptable ratio (a greater one is even better) for a SaaS business. Once new businesses understand how to attract, retain and grow customers they often look to scale the business by investing in sales, marketing and support. This is effectively when businesses go from being a startup to a scale-up.
The SaaS Business Model: Why LTV:CAC is Important
SaaS businesses have unique characteristics which means it makes sense for them to be measured differently. They typically incur high up-front costs to deliver their products and acquire customers, but they follow the path to profitability by retaining and adding customers over time, many of whom upgrade or buy more.
SaaS businesses typically operate on a subscription basis, so monthly subscription value is low, but lifetime value is high. This makes retention vital. Three levers which help reduce churn are accurately qualifying prospects during the sales process, so sales reps are selling to the right types of customers, as well as excellent account management and support.
The attraction of predictable recurring revenue
What makes SaaS businesses appealing to Wall Street is the subscription model generates predictable recurring revenue. Being able to predict with a high degree of accuracy how much revenue a business will generate each month, quarter and year brings confidence to management and investors alike.
It’s this accuracy and confidence which explains why many SaaS businesses focus on growth and sales, rather than immediate profitability. If a business has a healthy LTV:CAC and operates in a large untapped market, the right play is to pour fuel on the fire and acquire customers quickly, rather than building slow and posting steady profits.
In Marc Benioff’s book Behind the Cloud: the Untold Story of How Salesforce.com Went from Idea to Billion-Dollar Company - and Revolutionized an Industry he advises measuring a fast-growing company on revenue, not profitability. “It’s just not appropriate to stress profits over revenue in the beginning when you are starting out and building a company,” says Benioff. The fact is many SaaS businesses are selling new products and creating new markets - getting to market first is important.
For all this talk of ratios and recurring revenue, the real strength of LTV:CAC is it’s customer-centricity. It forces companies to focus on the long-term success of its customers. The leading SaaS businesses have figured out that having a product which solves for the customer and provides compounding value remains the best SaaS growth play.