Determining how much to spend to acquire a new customer is critically important. Almost all companies want to add new customers, growing top-line revenue, but only should do so if they’re growing in a smart way. Bad growth, where the unit economics don’t make sense, isn’t worth pursuing and can kill a company in the long-run.
That said, the analysis behind determining how much to spend to acquire a new customer should generally be conducted as it would be when acquiring any other asset – with a detailed review of the asset’s cash flows.
It’s surprising then that some industry commentators (i.e. the blogosphere) seem to take such a basic view of the relationship between Customer Lifetime Value (“LTV”) and Customer Acquisition Cost (“CAC”), particularly when discussing software-as-a-service (“SaaS”) companies. When it comes to analyzing SaaS companies’ unit economics, the discussion is typically centered on the ratio of LTV to CAC (the “Ratio”), and often in nominal terms – i.e. without explicit reference to why the length of a customer’s lifetime is so important in determining the appropriate value of the Ratio.1
Of course logic suggests a customer’s value to a company should exceed the cost to acquire that customer, but analyzing this relationship between LTV and CAC as a simple ratio doesn’t tell the full story. The concept of time value of money is ignored, and it shouldn’t be, or you may spend way too much for each new customer acquired.
Let me explain why.
Where the discussion stands today
I’ve come across many detailed discussions regarding how to calculate LTV, as a function of (i) Recurring Revenue, (ii) Gross Margin, (iii) Churn Rates, (iv) Revenue Growth Rates, etc.2 Whether it’s monthly, quarterly or annually, industry participants are clearly conscious of what to expect in terms of an average customer’s future cash flow streams.
Industry participants need to get more specific with this Ratio, by adding the nuance of “length of lifetime,” because as a simple ratio it overvalues cash flow streams in the future. Particularly if your company has a low annual churn rate (i.e. 5% to 20%), the overvalue assigned to those later years’ cash flows can be significant.
Below, I’ll provide a quick overview of the concepts behind a Discount Cash Flow (DCF) analysis, and an example of why it matters when determining the appropriate relationship between LTV and CAC – enhancing the Ratio.
Discounted Cash Flow (DCF): an Overview
To borrow liberally from Wikipedia:
A DCF analysis “is a method of valuing a project, company, or asset [read: customer] using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital [read: required rate of return] to give their present values. The sum of all future cash flows, both incoming and outgoing, is the net present value [read: max. acceptable customer acquisition cost], which is taken as the value or price of the cash flows in question.”
Presumably, a company’s management team has a decent handle on the assumptions factoring into an average customer’s LTV, or future cash flows, as described above: “the value of a customer.” The management team then needs to establish the company’s required rate of return to determine an acceptable average CAC to target, based on those LTV factors.
It’s not as simple as adding-up the future cash flow streams to arrive at a nominal LTV figure because cash received today is worth far more than cash received in 10 years.
Let’s assume that the required rate of return is calculated on a quarterly basis (my preference, coming from the world of commercial real estate) – a Quarterly Internal Rate of Return (QIRR) – and is determined to be 75%; (note: this QIRR has been arbitrarily selected for illustrative purposes, but most early-stage SaaS companies should be targeting returns well into the double-digits).
Let’s also assume the following:
- Annual churn = 20%
– Implies a customer lifetime of five (5) years
- Annual recurring revenue (ARR) = $20,000
- Annual revenue growth rate = 0%
– Conservatively assuming no year-over-year revenue growth
- Gross margin = 80%
In this example, the nominal LTV over the five years of the customer’s lifetime is $80,000 – ($20,000 x 80% x 5 years) – and to get to the targeted 75% QIRR, the company is able to spend approximately $28,000 to acquire that customer.
Here, the Ratio happens to work-out to 2.8x – ($80,000 / $28,000) – which is very close to the “3.0x” rule of thumb so often referenced, and that’s intentional. It seems reasonable, right?
But what if the investment period (i.e. customer lifetime) is 10 years, not five? Perhaps the annual churn rate is reasonably expected to be only 10%, not 20%.
To then get back to a 2.8x LTV to CAC ratio, all else equal, you’d be increasing your CAC to more than $57,000 – approximately double – and in the process, lowering the QIRR on that customer from 75% to only 16%. That’s not the same investment. Based on your target QIRR, you’re paying way too much for each new customer.3
The Point Is:
The value of cash flow streams in the later years of a customer’s lifetime are less valuable than those in the early years. Simply adding-up all cash flow streams into a nominal LTV figure, not adjusted for time value, is misleading.
Business and market conditions may dictate that a company occasionally spend more than its targeted CAC, or that it’s able to spend less. However, especially early-on, companies want to be careful not to under- or overspend for each new customer – i.e. not to lose-out on business or lose money doing business – particularly if you know how to be more exact regarding a newly acquired customer’s value.
When developing a more comprehensive business plan with many variables and assumptions, this can make a big difference.
Enhance the Ratio.4
1. Some commentators discuss the Ratio alongside the concept of “months to recover CAC,” as it relates to managing a company’s working capital, and while this payback period is important to consider, it is distinctly different than a company’s rate of return associated with acquiring a new customer.
2. For Entrepreneurs “SaaS Metrics 2.0” provides a great overview of all things SaaS analytics, but ultimately misses the final piece of the equation regarding a customer’s “length of lifetime” as it relates to the Ratio – additionally, several of the examples referenced above are derived from this source.
3. For the math behind these figures, please send us an email.
4. Andreesen Horowitz’s blog post “Understanding SaaS: Why the Pundits Have It Wrong” and Bessemer Venture Partners’ “Bessemer Cloud Computing Law #2” rightly discuss the concept of applying a discount rate to future cash flows when determining LTV, but assume the reader knows why it’s relevant.