July 13th •
SaaS metrics indicate the health of your business
See the big picture with LTV and CAC
Use churn rate as an indicator of customer satisfaction
SaaS business is inherently different from other types of businesses, especially when it comes to long-term profitability.
Here is the SaaS definition by Gartner: SaaS, meaning “software as service” is a “software that is owned, delivered and managed remotely by one or more providers. In our experience as a Saas marketing agency, we agree with that definition here at Klicker.
The provider delivers software based on one set of common code and data definitions that is consumed in a one-to-many model by all contracted customers at any time on a pay-for-use basis or as a subscription based on use metrics.”
Let’s try to define SaaS in more simple terms – SaaS is basically the web or cloud-based software that you rent by paying a fee.
SaaS business revolves around the idea of small incremental payments rather than big upfront payments, so making use of data and careful calculations become extremely important. You can’t make weighted decisions without data in SaaS.
Keeping your initial expenses in check is another problem SaaS businesses face – you’re expected to onboard as many customers as possible and provide top-notch customer service to prevent customers from canceling, but you can not afford to hire star support and sales people at the very start.
There are two key metrics that SaaS business owners track: CAC and LTV. This guide is intended to explain the metrics and show you how to calculate both. Complement this post with our comprehensive guide on SaaS metrics for clear understanding and deeper learning.
CAC is designed to show you how much you’re spending to acquire a single new customer. Customer Acquisition Cost SaaS, therefore, is determined by two factors—marketing expenses or the cost of creating leads, and sales cost or the cost of turning the lead into a customer.
Simply put, when you add up marketing and sales expenses and divide them by the number of customers acquired you will get the CAC figure. Here is exactly the same formula presented visually:
CAC = Sales & Marketing Costs/Number of New Customers
For a tackling a start-up marketing plan, this CAC SaaS formula might present a somewhat inaccurate picture because it doesn’t take into account the scalability factor – the team members you just hired will be handling more customers in future as your business grows. In such case, you can adjust your Sales and Marketing figure so that it contains only a portion of the sales and marketing people salaries.
Same applies if your company has made a large investment into SEO or product launch. The investments will bring results at a later stage but they are already affecting your CAC, so you might want to adjust them accordingly.
CAC metrics is used by both business owners and investors. When it comes to CAC, software business owners see it as an indicator of profitability. For the investors, CAC illustrates the scalability of business. Another way to make use of CAC is to optimize advertising budgets. Low marketing budgets at a launch stage might be too detrimental for SaaS business, but reducing the cost of customer acquisition will positively affect company’s profit margin.
You can improve CAC by optimizing your website and reducing the number of shopping cart abandonment, developing a new way of extracting money from customers and implementing a contact acquisition system or CRM for better sales management.
Assume you have 100 customers. That number will turn into 0 after a certain period and that period is defined by your customer churn rate. Customer churn definition then looks as follows:
Customer Churn = 1 – Retention Rate, with Retention Rate formula being as follows:
Retention Rate (Customer) = Number of New Users/Total Number of Users
Retention Rate (revenue) = Number of New Users Revenue/ Total Revenue
When calculating churn rate, don’t take into account the “activation” step or the trial period if the person ended up canceling the trial, however, if the customer continued to use the product you can include that trial period into churn calculations.
The average customer lifetime is defined as follows:
Customer Lifetime = 1/Customer Churn Rate
Depending on whether you take a monthly or yearly Customer Churn Rate, the lifetime of the customer will show the figure for the same period. For example:
Take a Monthly Customer Churn rate as 5%, then the Customer Lifetime will be 1/0.05 which is 20 months.
For yearly churn rate of 15%, the Customer Lifetime will be 1/0.15 which is ~ 6.5 years.
LTV or lifetime value of a customer is one of the most important SaaS metrics because it shows you the complete picture of your business.
So what is LTV? The LTV is defined as the amount of money each customer is expected to pay from the moment the user becomes a customer and until the moment he leaves. LTV gives you a general idea on how many repeat purchases you can expect, which also points out at how much you should be spending on acquiring customers for your business. LTV value is based on ARPA and customer churn rate over a certain period.
ARPA (average revenue per year) is defined as total revenue divided by the number of subscribers.
ARPA = Total Revenue/Number of Customers (take monthly numbers for both figures)
Here is how to calculate customer lifetime value once you figure out the ARPA and churn rate:
LTV = ARPA/Revenue or Customer Churn
These customer lifetime value formula excel at getting the job done, but have some variations depending on your customer base. Apparently, the cost of losing a high-value customer is not comparable to losing a low-value customer. That’s why it’s better to use the Revenue figure in the denominator and not the Customer Churn. Not understanding these principles is one of the main reasons startups fail.
Gross Margin is another metric that is recommended to take into account for lifetime value calculation.
LTV = ARPA * Gross Margin %/Revenue Churn Rate
When you track your LTV to Customer Acquisition Cost ratio, it shows whether you are spending enough or too much on customer acquisition. Another way to make use of LTV is to measure marketing channels effectiveness and prioritize channels that bring most valuable customers. Also, you can use LTV to identify where to focus your customer retention efforts.
On a side note, small businesses might find that calculating customer lifetime value is irrelevant as they have a small number of customers and the LTV will change from month to month due to small sample size.
Factors that affect LTV
The LTV formula looks very simple but, in reality, there are a lot of factors that business owners tend to overlook.
One of them is the fact that a revenue per customer will change over time. In more simple terms, the customer can start as a basic member and then upgrade to premium or splurge on in-app purchases.
In such situation, the expansion revenue will overtake the losses from the churn, but still, after some time the churn rate will decrease the value of high paying customers. Here is how you can calculate LTV if your business has a significant cohort of customers characterized by gradually increasing revenue:
LTV = a/c + m(1-c)/c2
This metric is considered to be optimal if it reaches the value of 3. The metric helps you understand whether your management decision is driving constant optimization and improvement. Any deviation from 3 will show that you are either wasting money or are missing the opportunities because of not spending enough.
LTV: CAC is a great way to determine whether you should cut down on marketing costs or increase your budgets.
The sooner you recover CAC, the better it is for your business. If it will take you too long to recover a low-value customer, there is a chance that the customer will churn before the recovery will take place and you will face a loss. Here is how you can determine Months to recover CAC:
Months to recover CAC = CAC/Average MRR per customer
Where MRR stands for monthly recurring revenue at the end of each month. MRR is calculated by adding MRR from the previous month and adding Net MRR for the current month. Monthly Recurring Revenue formula is therefore:
MRR = MRR (previous month) + Net MRR (current month)
Ideally, the number of months to recover should be less than 12 months, assuming you are using a simple LTV formula and have a Gross Margin of minimum 80%. This figure is determined by analyzing top SaaS companies metrics, but don’t panic if you spend more time of CAC recovery – put a plan into place and focus on reducing the metric instead.
Also, some companies can spend more months recovering customers because they have access to cheap capital.
ARR – Annualized Run Rate (also sometimes referred to as Annual Recurring Revenue) = MRR x 12ARR. This is a yearly recurring revenue for the coming 12 months if you don’t churn anything.
ACV – Annual Contract Value, measures the value of the contract over 12 month period. ACV SaaS metric is different from ARR since it shows how much on average your contract is worth over a given period, while ARR is not an average metric.
New MRR/ACV – additional MRR from new customers in the current month
Churned MRR/ACV – MRR you lost from churning customers (by means of account cancellation or downgrading the account)
Expansion MRR/ACV – additional MRR from existing customers (by means of transferring to a more expensive plan)
Net New MRR – New MRR + Expansion MRR + Churned MRR
Average Contract Length – this gives you the average duration of all your contracts in months or years.
Months up front – this number shows the average of months of payment received upfront. If you have been able to get your customers pay upfront, this has a great impact on your cash flow. However, you need to keep track of new customers as they might be taken aback by the need to pay upfront.
ARPA (average revenue per year) is defined as total revenue divided by the number of subscribers. The number shows the average monthly revenue per customer.
Number of new customers – number of customers added this month
Number of churned customers – number of customers lost this month due to churn
Net New Customers = Number of new customers – Number of churned customers
% Customer Churn = Number of churned customers/Total Number of Customers
%MRR Churn = Churned MRR/Previous months MRR
% MRR Expansion = Expansion MRR/Previous months MRR. Optimal % MRR Expansion should be close to negative.
Customer Renewal Rate = Number of customers who renewed their contracts/Total Number of contracts up for renewal
Gross Dollar Renewal Rate = $ value of renewed contracts/Total $ value of contracts up for renewal
DRR (Net Dollar Renewal Rate) = $ value of renewed contracts + Expansion MRR/Total $ Value of contracts up for renewal
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