This page is a supplement to the the SaaS Metrics 2.0 blog post. It provides detailed definitions for each of the key metrics used in that post.
Calculating LTV and CAC for a SaaS startup
Unit Economics is a very powerful way to analyze the long term profitability of a SaaS business.
I am often asked for the details of how to compute the various elements, such as CAC and LTV. This post gives the formulae.
CAC – Cost to Acquire a Customer
CAC is defined as follows:
There is a problem with using this formula in the early days, as you may several expensive people in the team that should scale to handle a far number of customers as you grow. In that case, your CAC will be too high. I suggest doing a very simple adjustment to the Sales & Marketing expenses to take only a portion of those salaries and expenses in the early days. That will give a better indication of how CAC will look in the future when you are at scale.
Note that if the Customer Churn rate is a monthly % or yearly %, then the Customer Lifetime will be for the same time period. Here is a monthly and annual example to illustrate the point:
a) If the Monthly customer churn rate is 3%, then the Customer Lifetime will be 1/0.03 which is 33 months.
b) if the Annual customer churn rate is 20%, then the Customer Lifetime will be 1/0.20 which is 5 years.
Lifetime Value of Customer
In the situation where there is no expansion revenue expected over the lifetime of a customer, you can use this simple formula:
which can also be expressed as follows:
Once again if ARPA is monthly, the churn rate should be monthly.
To truly get an accurate picture of LTV, you should take into consideration Gross Margin. i.e.
However in most SaaS businesses, the gross margin % is high (above 80%), and it’s quite common to use the simpler version of the formula that is not Gross Margin adjusted.
Ron Gill, NetSuite: I’m surprised at how often I see a SaaS product architected in a way that means they’ll never clear a decent gross margin. Including GM in the calc is a great way for you to see there is a big lever on LTV/CAC that is worth focusing on.
For NetSuite, we’ve not only calculated LTV/COCA, but also calculated r-squared of each of the components (to see what has driven improvement) and sensitivity analysis on them (to see what might drive it in the future). GM is an important component.
More complex case
In the specific situation where you expect ARPA to change over the lifespan of the customer due to expansion revenue, this simple version of the formula will not work. We ran into this situation with ZenDesk, where there is a pretty reliable increase in revenue over the life of a customer.
Here’s a graph showing what would happen if you had a cohort of 100 customers that initially started paying you $100 a month, but increased their payment by $5 every month. The monthly Customer Churn Rate is 3%:
As you can see the expansion revenue initially is greater than the losses from churn, but over time the churn takes over and brings down the value of that cohort.
I asked my partner, Stan Reiss, to help with the math to calculate LTV in this more complex situation. Here is what he came up with:
a = initial ARPA per month ( x GM %, if you prefer)
m = monthly growth in ARPA per account
c = Customer Churn Rate % (in months)
(This formula makes an assumption that revenue increases at a roughly fixed rate every month for the entire lifetime of the customer. That probably doesn’t hold true for many SaaS businesses, but the goal is to get a rough idea, not to have the absolute perfect answer.)
LTV : CAC Ratio
Our guideline for a successful SaaS business is that this number should be higher than 3.
Ron Gill, NetSuite: It is most important to track this metric over time to make sure you’re driving improvement. And, look at investment and how it will impact.
(The guideline assumes you are using the simpler LTV formula that does not include a Gross Margin adjustment, and that you have a Gross Margin of 80% or higher.)
Months to recover CAC
To be perfectly accurate, this should include a Gross Margin adjustment as follows:
However in our guideline which states that Months to Recover CAC should be less than 12, we are assuming that you are using the simpler formula, and have a Gross Margin of 80% or higher.
The Metrics to help understand Bookings
|MRR||The Monthly Recurring Revenue at the end of each month. Computed by taking the MRR from the previous month and adding Net New MRR.|
|ARR||Annualized Run Rate = MRR x 12ARR is annual run-rate of recurring revenue from the current installed base. This is annual recurring revenue for the coming twelve months if you don’t add or churn anything.|
|ACV||Annual Contract Value of a subscription agreement.|
|New MRR/ACV||The increase in MRR from new customers in the current month.|
|Churned MRR/ACV||The lost MRR from churning customers in the current month.|
|Expansion MRR/ACV||The increase in MRR from expansion in your installed base in the current month.|
|Net New MRR/ACV||Net New MRR = New MRR + Expansion MRR – Churned MRRThis is the sum of the three different components that will change MRR during each month.|
|Bookings||The total dollar value of all new contracts signed. Usually taken as an annualized number even if the contract period is longer than one year.Since the bookings number might have a mix of different durations (e.g. month-to-month; 6 months; 12 months) this number is not very helpful for understanding the business.To really understand what is going on in your SaaS Business, you should look at the following components:a) What happened with new customers:
b) What happened in your installed base:
The sum of all of the above:
|Billings||Billings is the amount that you have invoiced that is due for payment shortly.|
|Revenue||Revenue is amount of money that can be recognized according to accounting policy. Even if it is paid for upfront, usually subscription revenue can only be recognized ratably over time as the service is delivered.If more money has been paid than can be recognized, the difference goes into a balance sheet item called Deferred Revenue.|
|Average Contract Length||Assuming a mix of different contract lengths, this gives you the average duration in months or years.|
|Months up front||Average of months (or years) of payment received in-advance with new bookings. Getting paid in advance has a big positive impact on cash flow. This metric has been used at both HubSpot and NetSuite in the past as a way to incent sales people to get more paid up front when a new customer is signed. However asking for more money up front may turn off certain customers, and result in fewer new customers, so be careful how you balance these two conflicting goals.|
|ARPA – Average monthly recurring Revenue per Account||This number is tells you the average monthly revenue per customer. It is useful to look at this for just the new customers booked in the month. Plot a trend line to show you the average price point that your new customers have chosen.|
Bookings, Billings and Revenue – An example
Since there can be some confusion around the difference between bookings, billings and revenue, here is a simple example to help clarify them: Imagine you signed a new contract with a customer with a one year term, specifying that you provide your service to them for $1,000 per month, with an upfront payment of six months:
- Your bookings would be $12,000 (the entire contract value)
- You would bill $6,000 in the first month, then $1,000 per month from the seventh month onwards.
- You would recognized $1,000 in revenue for each month of the contract. (This is dictated by GAAP accounting policy.)
For the example above, the balance sheet and income statement impact of these items is as follows:
- Bookings do not affect either the balance sheet or the income statement.
- When you bill $6,000 in the first month, but can only recognize $1,000 in revenue (income statement), and the other $5,000 goes into deferred revenue on the balance sheet (a liability).
- Each month thereafter until another $1,000 can be recognized as revenue (income statement), and that reduces the deferred revenue liability on the balance sheet.
The Metrics for Churn
The following shows the metrics to understand Churn: