If you are a SaaS business, then you must read this article for the following reasons:
- What is SaaS CAC Payback Period?
- How to calculate SaaS CAC Payback Period?
- Why is it important for a SaaS business to calculate this financial metric?
When it comes to business, we all need customers. And when talking specifically about SaaS companies, we spend aggressively on advertising, marketing, and offering products for a free trial to get customers on board.
Why not, the whole revenue model is based on monthly recurring payments that we want to retain. However, many SaaS businesses face the challenge of the customer acquisition cost (CAC) exceeding their revenues which impacts their bottom lines.
CAC is an important part of the SaaS business which is inevitable. You won’t get customers until you won’t invest money to acquire them. But, you would certainly want this initial investment to come back to you within some time. This is where the CAC payback period comes into the picture.
This is one of the important SaaS metrics that tells you the amount of time within which you will earn back your CAC. It is much like a point where your SaaS company would break even.
What is SaaS CAC Payback Period?
SaaS CAC payback period refers to the time period within which you are able to earn back the money spent on acquiring customers. There are multiple costs linked to customer acquisition. These include advertising, special offers, salaries paid to sales and marketing teams, money spent on running free trials, customer on-boarding, etc.
This cost is much like an investment that is spent today but which gives returns in the future.
CLTV CAC Payback
CAC is a metric that directly impacts your Customer Lifetime Value (CLTV). In fact, CLTV and CAC are calculated in relation to each other. This is because if, as a SaaS company, the average CLTV of your customers is less than the cost you incur for acquiring them, you would incur a loss. It’s only when you earn back the CAC that you would be able to gain.
Thus, tracking and reducing the CAC payback period is critical for a SaaS business. The sooner you recover the CAC, the more profitable is your SaaS firm.
CAC Payback Period Calculation
There are certain components that form part of the CAC payback period formula. Let’s define them first to understand how to calculate the CAC payback period.
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1. Customer Acquisition Cost (CAC)
CAC is the cost that you incur to acquire new customers. This cost typically includes salaries paid to the marketing and sales teams, advertising costs, free product trials, etc. It is basically the cost that a SaaS business incurs to persuade a client to purchase the product or service.
As stated earlier, the lower the CAC, the higher the profitability. Likewise, CAC must be lower as against the CLTV for your SaaS business must spend less on acquiring the customer and earn more during his lifetime.
Accordingly, CAC is calculated by summing up all the expenses incurred in hiring a customer.
2. Average Revenue Per Account (ARPA)
Average Revenue Per Account (ARPA) is the revenue that a SaaS business generates from a customer account. It is one of the critical metrics that is measured in SaaS companies. This is because it helps in identifying the products or services that generate the highest or the lowest revenues. Likewise, SaaS businesses can evaluate their performance across different periods and against competitors. Finally, ARPA also is a key metric used in forecasting the revenues of SaaS companies.
ARPA is calculated by using the following formula.
ARPA = (Total revenue for a given period (a month or year))/Total number of customer accounts in the given period
Note that ARPA is different from the average revenue per user (APRU). This is because APRU refers to the revenue earned from a single user who may have many customer accounts under it.
3. Gross Margin Percent
Gross margin percent or gross profit margin percent is another key metric used in SaaS businesses. It refers to the gross profit as a percentage of revenue. In other words, it measures whether the company has sufficient gross profit to cover its operating expenses and plow back profits into the business.
Accordingly, the gross margin percentage is calculated as follows.
Gross Margin Percent = (Gross Profit/Revenue) *100
Gross Margin Percent = ((Revenue -COGS)/ Revenue)*100
Now that we know the components of the SaaS CAC payback period, let’s have a look at the SaaS CAC payback period formula.
SaaS CAC Payback Period Formula
There are two ways in which the CAC payback period is calculated. One is to calculate the SaaS CAC payback period without considering the gross margin. The other method takes into account the gross profit margin to calculate the CAC payback period.
Saas CAC Payback Period Formula Without Gross Profit Percent
Earlier, the SaaS CAC payback period was calculated without taking into account the gross margin percentage. A CAC payback period without gross margin simply measures the speed at which the customers are acquired as well as the efficiency of customer acquisition.
On the other hand, it also serves as a key metric to track cash burn rate and the period a SaaS business has before it runs out of cash. Needless to say, a long payback period is an indicator of certain business challenges that need your attention.
For instance, either you could be spending too much on customer acquisition or you need to improve your ARPA.
SaaS CAC Payback Period (without gross margin percent) = CAC/ARPA
Gross Margin Adjusted CAC Payback
Many SaaS companies today include gross margin percentages when calculating the CAC payback period. When calculating the gross margin, a SaaS business takes into account the product delivery cost and cost of customer support services provided until such a cost is recovered.
Now when it comes to CAC, it includes expenses like advertising, free trial cost, salaries of sales and marketing teams, etc. But it doesn’t take into account product delivery cost and cost of product support services.
Thus, Gross Margin Adjusted CAC payback takes into account both CAC and product delivery cost. Thus, instead of simply considering the cost and the speed at which the customers are acquired, it also considers the profit-making ability of the firm.
Further, considering gross margin in CAC payback period calculation also increases the payback period as compared to the one without gross margin.
Thus, both ways of looking at the CAC payback period are good. This is because where one helps in knowing the customer acquisition efficiency, the other helps in getting a clear view of the firm’s profitability.
Thus, Gross Margin Adjusted CAC Payback = CAC/(ARPA X Gross Margin Percent)
CAC Payback Calculation Example
Let’s assume that your CAC for a customer is $150 and on average pay $60 per month. Out of this subscription fee, your SaaS company makes a profit margin of 25%.
Thus, CAC payback period = $150/($60 *25%) = $150/$15 = 10 months
How to Reduce the CAC Payback Period?
Note that the CAC Payback calculation involves three elements. These include Customer Acquisition Costs (CAC), Customer Service Costs, and revenues.
Further, each of these elements involves a host of procedures that need improvement from time to time. So let’s understand the various components of CAC payback and how a SaaS business can reduce it.
1. Reduce Customer Acquisition Costs
Customer Acquisition Costs (CAC) refer to the sales, marketing, and customer service costs that a SaaS business incurs in order to acquire a customer. These costs are calculated as a percentage of the total number of customers acquired during a given period.
Thus, if a SaaS business needs to optimize its CAC, it can do so in the following ways:
- Reduce spending by acquiring a consistent number of customers
- Acquire higher-paying customers by spending a consistent amount to bring them on board
- Reduce spending and acquire more profitable customers by spending less to bring them on board
- Incur more costs and acquire good quality customers
It is important to note that increasing CAC if observed alone is quite dangerous for a SaaS business. Thus, a SaaS business must analyze its CAC relative to other SaaS metrics.
For instance, the CAC of a SaaS business can be compared with the CAC payback period.
Thus, the CAC efficiency of a SaaS business increases if its CAC payback period reduces and its LTV to CAC ratio increases at the same time.
2. Segment Customers
It is important for a SaaS business to sell its product or service to the right customer group. A SaaS business selling its product to every category of consumers is certain to get bust soon.
That’s why SaaS businesses segment their target market into various groups. For instance, there can be higher-paying customers, lower-paying customers, one-time buyers, retainer buyers, and the like.
Note that a SaaS business cannot convert all the sale opportunities that come its way. Also, it cannot reduce its customer churn rate to zero. Also, not all customers will pay the SaaS firm equally.
Therefore, it’s important for a SaaS business to spend its resources on the customer segments who need its product and can resolve their problem using the same.
A business that spends resources on customer segments that do not need the firm’s SaaS product is likely to lose money.
Such businesses will also overlook the customers who have the potential of generating profitable returns to the SaaS business. That’s because there are too many alternatives to SaaS products available in the market.
Failure on the part of the SaaS business to redirect its customer acquisition efforts may cost the business hefty losses.
3. Make Changes To Customer Acquisition Model
The average Annual Contract Value (ACV) is one of the critical SaaS metrics that determine the customer acquisition strategy of a SaaS business. Accordingly, the higher the ACV of a SaaS business, the higher is the amount of money that it has to spend in acquiring customers.
This does not mean that a SaaS business should spend money endlessly in acquiring customers if it has a higher ACV. It has to design its customer acquisition model in such a way that the cost spent is symmetric with the projected ACV of the SaaS business.
For instance, a SaaS business having an ACV of say $100 cannot spend money endlessly on its sales representatives. It will have to take the support of a self-sign-up model so that it does not end up spending too many resources on customer acquisition.
Thus, a SaaS business can have a customer acquisition model that combines both hiring sales personnel and having a self-sign-up process in place.
4. Customer Service Costs
An important aspect of customer success is the kind of experience customers have while onboarding as well as post-sales. Accordingly, one of the crucial components of customer success in the case of a SaaS business is customer service.
SaaS businesses that are able to maintain a long-term relationship with their customers are able to deliver an excellent experience to their customers.
But providing customer service calls for a huge cost and hence may increase the CAC as well as the CAC payback period for the SaaS business.
Thus, one of the key strategies that SaaS businesses can adopt to optimize their CAC payback is to spend on customer acquisition according to the revenues that a customer contributes to the firm.
For instance, many SaaS businesses provide dedicated account managers to their key customer accounts. Also, they may provide premium support to customers subscribing to the company’s premium plans. Likewise, SaaS businesses may provide basic support services to customers purchasing basic product plans.
This means that there is no definite price plan for providing customer services just like customer acquisition. A SaaS business must spend resources according to the contribution that customers make towards the firm revenues.
5. Avoid Selling To Bad Customers
Every business has customers who remain dissatisfied despite receiving enhanced customer support and post-sales service. These are bad-fit customers as the SaaS product can never meet the goals of such customers.
A business that continues to serve bad-fit clients will soon come across a situation when its service costs will exceed its revenues. Thus, it will lead to negative monthly margins for the SaaS business.
A negative monthly margin means that a SaaS business will never be able to recover its investment. Thus, it is important for such a business to get rid of the bad-fit customers.
Instead, the SaaS business should focus on its profitable customers. It should focus on giving such customers an excellent customer experience, attain high NPS scores, receive great customer reviews, and much more.
6. Improve Product Pricing
Many SaaS businesses do not make an effort in improving the pricing of their product. They set the pricing of their SaaS product randomly and not systematically.
Such businesses take into consideration the pricing of the competitive SaaS products and make an upward or downward adjustment to the pricing of their own product. That is, they do not follow a systematic approach in determining the pricing of their SaaS product.
For instance, some firms adopt the ‘cheap pricing’ approach to price their SaaS product. They give the cheapest offer so that customers get attracted and end up purchasing the product. The SaaS business adopting such an approach might get customers. However, such a business should not expect to derive high value from such an offer.
Likewise, there are SaaS businesses that make product enhancements. However, they do not change the price of their SaaS product accordingly. Note that an improved SaaS product delivers more value to the customers. As a result, such a product must demand a good price for the additional value it is creating for customers.
Remember, the value of a SaaS product reflects the willingness of its customers to pay for the product. If a SaaS business fails to increase the price of its product up to this level, it will certainly lose money.
7. Create Upsell Opportunities
A SaaS business must always have price tiers for its product instead of a single price. Having price tiers for a SaaS product means charging according to the value given to the customers in a specific price tier. In addition to this, price tiers also consider the willingness of customers to pay for a specific price tier.
Note that SaaS businesses that create price tiers based on product features or a value metric can help them in creating opportunities.
8. Customer Retention Process
Since a subscription-based business depends on recurring revenues, customer retention is extremely important for a SaaS business.
A SaaS business that loses customers before it recovers its Customer Acquisition Costs means a great loss for the business. Thus, a SaaS business must focus on having a strong customer retention process in place.
What is a Good CAC Payback Period?
A short CAC payback period may be good for a SaaS business. Many SaaS businesses consider a CAC Payback period of 12 months to be an ideal one. In fact, they use this number as a rule of thumb.
However, the rule of thumb does not help a SaaS business in determining the accurate time it would take for it to recover its Customer Acquisition Cost (CAC).
A SaaS business should consider the competitors in the industry and calculate an average industry CAC payback period. This is a great way to determine the CAC payback for a SaaS business.
Note that the industry CAC payback is dependent on the go-to-market strategy and consumer form. In addition to this, there are two more SaaS metrics on which the CAC payback is dependent. These include customer retention and net dollar retention.
Let’s consider an example to understand this.
Say, IKIGAI, an online CRM solution sells its cloud-based CRM solution to enterprise-level businesses. This means it has long revenue periods. In addition to this, IKIGAI also has a team of highly paid sales representatives. Also, a new sales representative at IKIGAI takes a long period of time to reach his full productivity and begin providing value to his sales team.
In this case, it may seem that IKIGAI will have a better payback period as compared to a product-led company that has a self-serve freemium model to approach businesses of all sizes.
However, analyzing the CAC payback period alone is not a good approach. It must be analyzed alongside other metrics like customer retention and net dollar retention.
Let’s consider the above example again. Suppose that IKIGAI has a payback period lower than its peer firms. However, it has an excellent customer retention rate. In fact, its customer retention is the best in the industry.
Now suppose that IKIGAI has a customer retention rate of 100%, that is, it never loses a customer. However, its customers pay back over time. In other words, the net dollar retention of IKIGAI is more than 100%.
Thus, in such a scenario, IKIGAI will be able to regain all of its sales and promotion expenses. Furthermore, it will break even on each customer it adds even if that takes 24 months or more.
Now suppose that IKIGAI has a CAC payback period of 6months, but it loses the majority of its clients by the third month. In this case, IKIGAI will never be able to regain its purchase costs.
The only way through which IKIGAI can realize its inferred CAC payback is customer retention.
Why CAC Payback Period Is Important?
It is important for a SaaS business to determine its CAC Payback period for the following reasons.
I. Enables Business To Set Reasonable Goals
As mentioned earlier, many SaaS businesses do not determine the time period it will take for their business to regain its marketing expenses. Such businesses rely on industry estimates for CAC payback that may not work for them.
Thus, it is important for SaaS businesses to calculate CAC payback based on company budgets and internal data. This way they will have payback figures based on real company data.
II. Enhances Risk Management
The Customer Acquisition Costs (CAC) of a SaaS business indicate the costs that it incurs to acquire customers. This figure alone may not help the business in determining whether it will be able to recover the CAC and in how much time?
However, if a SaaS business calculates its CAC payback, it gets to know the estimated time period within which it will be able to recover CAC. This will bring some amount of certainty and will help the business in understanding the amount of risk it is facing in real.
Also, it will help the business in taking calculated risks and make better decisions with regards to undertaking further marketing or not.
III. Gives A Snapshot of the Company’s Health
CAC payback when analyzed with other performance metrics helps a SaaS business to get a view of the company’s health. By analyzing its payback, a business gets to know its cash flows coming into the business.
It helps a business to understand how much it can spend in acquiring a customer and what the future growth of the business is going to be.
For instance, a SaaS business having a very long payback period indicates the inefficiency of the customer acquisition model of the business. Further, CAC payback viewed along with other metrics like LTV CAC ratio helps a business to know how much profit a specific customer is for the firm.
IV. Helps To Raise Funds
A SaaS business, like any other business, is in need of working capital to meet its day-to-day operations and for technology upgrades. The CAC payback period figures of a SaaS business indicate how much working capital of the business is tied up in CAC.
A firm with a shorter CAC payback is able to regain the CAC costs in a shorter period of time, say 6 months. However, a business with a longer CAC payback period is able to regain its CAC costs in a longer period of time, say 15 months.
If the SaaS business with a longer payback period wants to regain its CAC within 6 months, it needs to spend more on the marketing and sales team. This will help the business to grow within a short period of time.
Note that businesses with a shorter CAC payback are able to influence their growth rates more effectively relative to those having longer paybacks. Thus, it is easy for businesses with a shorter CAC payback to raise working capital funds. The investors get attracted to businesses that have shorter paybacks as they are able to effectively manage for growth or efficiency.
What is an Average Payback Period?
Average Payback is one of the methods to evaluate the average time it takes a business to regain its initial investment. It is an important metric that CFOs use to determine the effectiveness of an investment in an enterprise.
As mentioned earlier, average payback helps a business to analyze alternative investment opportunities. That is, it helps the business to know what is the opportunity cost of not investing in an alternative investment with a given payback. Thus, it improves the decision-making of a business owner and helps him to zero down on projects that give returns in the shortest payback.
A SaaS business can use the following average payback period formula to know the time period within which it can regain its initial investment:
Payback Period = (Initial Investment – Opening Cash Flows)/(Closing Cash Flows – Opening Cash Flows)
Say, for instance, a business invests an initial amount of $ 10,000. Further, it has opening cash flows of $8,000 and closing cash flows of $15,000. Using the above formula, the company’s CAC payback is:
CAC Payback = ($ 10,000 – $8,000)/($15,000 – $8,000) = $2,000/$7,000 = 0.28 years
Note that the average payback period method has certain disadvantages. It does not take into consideration the discount rate to account for risk and the time value of money.
Further, this metric just tells the amount of time it will take a business to regain its initial investment and start earning profits. However, such a metric does not indicate how much profit a business is likely to generate once the initial investment is regained.