February 18, 2024 | Read Online
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In SaaS, we hear the phrase unit economics all the time, but what does it really mean? Here’s a layperson’s definition:
Unit economics is figuring out how much money you make or lose every time you sign up a new customer.
A business's unit economics determine its long term growth potential, profitability, and sustainability. Investors evaluate unit economics to determine the overall health and invest-ability of a business.
Unit economics is based on a number of granular factors, including the following:
Average Revenue Per Account (ARPA) - the amount each customer pays for the product. This is often expressed as Average Revenue Per Account (ARPA). If you have 100 customers and a total of $100k in ARR, then ARPA is $1,000.
Gross Profit - the amount of revenue left over after the cost of sales. Note, that "cost of sales" in this case isn't sales and marketing costs. It's Cost of Goods Sold, "COGS." In SaaS, COGS include product infrastructure and hosting costs as well as the salaries of post-sales support, services, and customer success teams.
Gross Revenue Retention (GRR) - the rate at which we retain a cohort of customer revenue over a given period of time, typically a quarter or a year.
Customer Acquisition Cost (CAC) - the amount we spend on sales and marketing to acquire each new dollar of ARR/MRR.
CLTV/CAC Ratio, a classic measure of unit economics
CLTV/CAC is a ratio that describes the relationship between the lifetime value of a customer relative to the cost of acquiring them. And it's built on the metrics outlined above.
On the surface it's a simple formula:
CLTV/CAC Ratio = CLTV/CAC
But underneath, there's some complexity. Let’s unpack it...
Customer Lifetime Value (CLTV)
The formula for CLTV is as follows:
CLTV = (ARPA * Gross Margin) / (1 - Gross Retention Rate)
We calculate CLTV on the Gross Profit our customers generate. To get gross profit per customer, we simply multiply Average Revenue Per Account (ARPA) by Gross Margin.
If you think about selling a physical good rather than software, Gross Profit is easier to understand. If I buy widgets wholesale for $1 and sell them to customers for $5, Gross Profit is $4 and Gross Margin is 80%.
Once we have Gross Profit, we divide it by gross churn rate to get lifetime value. You’ll often see churn rate expressed as [1 - Gross Retention Rate], the inverse of gross retention.
Assuming a gross retention rate is 85%, we would divide by (1-.85), or .15.
Here's a full example where ARPA is $1000, Gross Margin is 75%, and gross churn rate is 15%:
CLTV = (1000 * 75%) / (1 - .85)
CLTV = 750 / .15
CLTV = $5,000
In this example, the annual Gross Profit per account is $750. When we divide it by the churn rate, the average Gross Margin-adjusted lifetime value is $5,000.
We can also express this in terms of time by dividing $5,000 by the $750 annual Gross Profit per customer giving us an average tenure of 6.7 years.
There you have it, Customer Lifetime Value.
Now CAC...
Customer Acquisition Cost (CAC)
CAC is the total of all sales and marketing expenses we incur to win new business during a given period.
It includes marketing and sales team salaries and commissions as well as paid ads, event sponsorships, and any other expenses related to marketing and selling our product. Often, CFOs will also allocate a portion of customer success team expenses to CAC based on the percentage of their time spent generating sales.
If we spend $1 million on Sales and Marketing to acquire 1000 new accounts during a period, our CAC would be $1,000 per customer ($1,000,000 / 1,000 = $1,000).
CLTV/CAC Ratio
In our hypothetical examples above, the lifetime Gross Profit of a customer is five times the cost to acquire it. The math is simple:
CLTV = $5,000
CAC = $1,000
CLTV/CAC Ratio = $5,000 / $1,000
CLTV/CAC Ratio = 5
In SaaS this ratio should be 3:1 or higher. If only all companies were run as well our hypothetical little SaaS company!
Drawbacks and shortcomings of LTV:CAC
While CLTV/CAC is a well-worn SaaS metric, it has many drawbacks to be aware of.
First of all, it's a compound metric. Compound metrics can obscure nuances of the business as one metric is stacked upon another.
This is especially true of CLTV/CAC given the numerous metrics that make it up. SaaS companies that serve different customer segments and industries will find this figure too generic. But, we can solve for this by calculating CLTV/CAC on a product or market segment basis [1].
Second, CLTV/CAC is based on historical results, and it doesn’t adjust for historical shifts in market conditions and go-to-market tactics.
As a SaaS company evolves, so do its selling motions. Ideal client profiles change, pricing plans are reworked, and staffing models change over time as the product and company grow.
All of these changes can impact GTM effectiveness, and a simple CLTV/CAC calculation largely ignores these dynamics.
Third, CLTV/CAC focuses on gross retention, but expansion plays a massive role in unit economics. A company with net revenue retention (NRR) greater than 100% grows despite its new customer acquisition performance. These companies are often more profitable and have higher enterprise value than their counterparts with NRR less than 100%.
Finally, the basic CLTV/CAC calculation doesn’t discount future cash flows to account for the time-value of money.
Despite all these drawbacks, CLTV/CAC is a good "gut check" metric that investors will continue to use when determining a company's prospects for sustainable growth and profitability.
How to improve unit economics
While CLTV/CAC is a useful investor metric, it's not very helpful on a day-to-day operational basis.
That said, SaaS operators can impact unit economics by focusing on the atomic components of the CLTV/CAC Ratio as described above: increasing ARPA, reducing COGS, and increasing gross retention.
We can improve Gross Margin by raising prices while keeping Cost of Goods Sold constant. We can also improve it by maintaining price points while increasing delivery efficiency. For example:
Each of these examples results in lower COGS.
Reducing customer churn has the obvious impact of increasing gross retention which directly impacts lifetime value.
Using our example above, improving retention by just one percentage point, from 85% to 86%, adds five months to the average lifetime of a customer. A 6%+ improvement.
We can also improve unit economics by reducing CAC relative to each new dollar of new ARR/MRR we bring in by:
As John Wanamaker famously said [2],
“Half the money I spend on advertising is wasted; the trouble is, I don’t know which half.”
It's common even for mature, publicly traded cloud companies to spend $.50 - $1.00 to acquire an incremental $1 of ARR.
Some spend even more.
During the post-COVID run-up, we saw some companies paying as much as $2.50 to acquire $1 of ARR! Sales and marketing is typically the largest expense category you'll find on a SaaS P&L.
How are you making an impact?
As you can see, managing unit economics is a team sport. It involves everyone from sales, marketing, product, support, services, and customer success.
Managing and improving unit economics is a matter of focusing on the measures that lie beneath the CLTV/CAC Ratio: revenue per account, gross profit, gross retention, and sales and marketing costs.
Which one are you and your team focused on improving this year?
🤘
[1] Breaking down CLTV/CAC is laborious and time-consuming exercise for finance teams because they need to calculate ARPA, COGS, retention, gross margin, and CAC by product or segment. Even still, its usually worthwhile and necessary to do this work to evaluate performance for various segments of the business.
[2] Thank you David Karp, for the reference to the Wanamaker Dilemma in our discussion last week!
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