Friday, October 17, 2008

Bessemer SaaS Law #2

Bessemer SaaS Law #2. Customer Acquisition Cost (CAC) and Customer LifeTime Value
(CLTV) are the best indicators of long term value creation.

It can be argued persuasively that SaaS is a lousy business model because your costs are front-loaded and your revenue only arrives in modest monthly or annual payments. However, as we know from the cable industry, subscription businesses can be very profitable over time. The key to long term financial health is to keep customers happy so their payments keep coming, and coming, and coming…and over time add up to some really large numbers. But in this context, how do you calibrate your sales and marketing investment and how do you know if these tradeoffs make sense and are ultimately “profitable”? The answer of the first question can be found through the CAC Ratio. This single number is the key to determine your level of sales and marketing investment and is very simple to calculate by looking at a quarterly GAAP P&L: you just have to divide the annualized net gross margin added during the quarter by the sales and marketing costs of the previous quarter. CAC Ratio (Q408) = [GM(Q408)-GM(Q308)]*4 Sales & Marketing Costs (Q308) The CAC ratio determines the payback time on your sales and marketing investment: a CAC ratio of 0.5 for example means that half of your investment is paid back per year, so it is a two year payback period. So how should you use this ratio? The punch line is that a CAC ratio of a third (0.33) or less is bad – this suggests it takes you at least three years to payback your initial customer acquisition costs – so you should slam on the breaks on your sales and marketing spending until you can improve your sales efficiency. At the other end, anything above one (1) means you should invest more money immediately and step on the gas (and please call Bessemer immediately because we want to fund you!) as your customers are profitable within the first year.

To answer the second question and make sure you are building a profitable business, the key indicator to look at is the Customer LifeTime Value (CLTV). The CLTV is the net present value of the recurring profit streams of a given customer less the acquisition cost. A profitable business will have a positive CLTV. To make the calculation simple, let’s assume that a customer generates $1 of annual recurring revenue for a company with a CAC ratio of 1.0, a 70% Gross Margin and 10% each of R&D and G&A costs. The $1 of revenue will generate $0.7 of gross margin and $0.5 of profit each year ($0.7 less $0.1 of R&D and $0.1 of G&A costs). Over 5 years, this customer will generate $2.5 of profit (5 years x $0.5/year). A CAC ratio of 1.0, means a $0.7 upfront acquisition cost, making the CLTV equal to $2.5-$0.7= $1.8. This is equivalent to ($1.8/5) = $0.36 of annualized profit or 36% profit margin. The calculation can be refined with a better allocation of the S&M costs (part of them are used to support current customers) and by discounting the profit streams (in this example, a 15% discount rate would reduce the CLTV to $1.23 or 25% annualized profit margin). For young companies it may be more of an art than a science to estimate the lifetime period of the customer as your churn data is still limited, but we very conservatively take 3-4 years for SMB customers, and 5-7 years for enterprise customers.

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