As the old saying goes, to build a successful company, you must “make something people want.” For any startup to survive, it needs users. But similar to growth, not all customers are created equal.
At AirTree, we use metrics like CAC payback and the LTV / CAC ratio to understand how a startup acquires users and what their behaviour looks like in the longer term. Before we dive into the metrics, it’s important to note you shouldn’t look at a single metric in isolation. They each form a small piece of the puzzle that investors use to evaluate a business.
What is CAC?
Customer Acquisition Cost (CAC) is the cost of acquiring a paying customer. At a high level, it’s calculated as:
This is different from Cost Per Acquisition (CPA), which measures the cost of acquiring anything that isn’t a paying customer, like a lead or free trial. The way to approach CAC vs CPA is influenced by the business model, as seen in the table below.
To ensure you’re measuring CAC properly, start by tightly defining what a paying customer looks like. In TikTok’s case, the paying customers are advertisers, not individual users. Next, it’s helpful to dig into each variable in the formula above and think critically about how your acquisition funnel shapes it. Some questions to ask are:
- What expenses does sales & marketing include?
The salaries of all people working on sales & marketing (S&M) should be included. The overheads (rent and equipment) associated with these people should also be included. Lastly, make sure to also include money spent on tools for S&M.
- How long does it take someone to progress through your sales funnel?
The formula above doesn’t account for the fact that you may spend money now to acquire users in 3 months. For example, in freemium models, customers typically take a few months before they convert into a paying customer. In SaaS, sales cycles can often take a month or longer. To calculate CAC accurately (and make good marketing decisions as a result), it's important to figure out the average time from the first marketing touch point to acquiring the paying customer. This is less relevant if your sales cycle is extremely short or your marketing spend is very consistent. If it’s not, you’ll want to adjust your calculation to ensure that the expenses fuelling CAC correlate with the timing of when someone becomes a paying customer. A quick workaround for this is to calculate CAC as S&M spend in the previous quarter / total customers acquired in the current quarter. For most companies (especially in the early days), focusing on this on a granular level can help you allocate your marketing dollars more effectively.
What is CAC payback?
A profitable business needs profitable customers. One of the best ways to measure this is to look at CAC payback. The CAC payback period measures how long it takes for you to earn enough gross profit from a customer to pay back the S&M costs of acquiring them. This is also referred to as “fully loaded CAC payback” and is calculated as:
Alternatively, it’s calculated on a per-user basis as:
Note that the Monthly Recurring Revenue (MRR) figure used in this calculation should only include net new MRR, which is equal to expansion MRR plus MRR from new customers less MRR lost from churn. Tracking CAC payback from the early days can allow you to figure out if your sales engine is working. This allows you to make adjustments, test new channels and creates a culture where your team focuses on allocating capital efficiently.
What does good look like?
CAC metrics can tell a valuable story about a company’s growth engine. Generally speaking, faster CAC paybacks are better.
Here are some SaaS benchmarks for CAC paybacks across different revenue stages.
It’s also important to look at CAC alongside other metrics. Our approach is to look at peer benchmarks and adjust for things like the business model, the go-to-market strategy and the customer type.
The two most common metrics we look at alongside CAC payback are logo retention and net dollar retention.
For example, longer CAC paybacks for SaaS businesses are generally OK if net dollar retention is strong. But if you sell a D2C product that people typically only purchase once, you’ll want to make sure you recoup your CAC spend on that first transaction (after accounting for gross margins). Within SaaS businesses, selling to enterprise companies with long sales cycles will look quite different to a product-led company that targets businesses of all kinds.
As you can see in the table above, CAC payback and retention are natural complements. If your CAC payback is worse than your peers, but retention is stronger, then it’s likely that you’ll recoup your S&M cost on customers, even if it takes a bit longer. On the flip side, if your CAC payback is outperforming your peers, but your retention is low, that might be a sign that you’re unlikely to recover your S&M expense. By looking at CAC payback in conjunction with retention, you can effectively determine whether your implied CAC payback is likely to be realised.
From the benchmarks, we can see that CAC payback is lowest at the earliest stages. This is because early adopters are cheapest to acquire. As your company grows, competition will likely increase and each incremental dollar of marketing spend becomes less effective.
For B2B companies, the general rule of thumb to target is a CAC payback of:
- <12 months if you’re selling into SMEs
- <18 months if you’re selling into the mid-market
- <24 months for enterprise accounts
SMB accounts tend to have smaller contract values and higher churn, while enterprise accounts have high contract values and low churn. As a result, enterprise companies can support longer payback periods. Lastly, if you’re in the fortunate position of having a CAC payback that is too low, it could be a sign that you’re under-investing in S&M.
How to improve your CAC Ratios
If you’ve made it to this part of the article, hopefully you have a sense of how to measure and benchmark your CAC payback. Now comes the most important part–optimising your payback period. We think about this across 3 dimensions–experimentation, retention and pricing.
- Focus on product-market fit: When you figure out exactly who your target customer is and your value proposition, each marketing dollar can be spent more effectively. Spending time segmenting your customer base and experimenting with various channels can target your S&M budget at the right personas.
- Optimise your sales funnel: You want to have a broad top of funnel, and then ensure that potential customers run into as little friction as possible when they’re contemplating a purchase. Experimenting with signup flows, implementing chatbots and building a knowledge base are just a few examples of things that can help.
- Think about PLG: PLG companies tend to be more capital efficient, as they can rely on word-of-mouth over paid marketing. When Atlassian launched its issue-tracking product, Jira, it effectively sold itself. Most customers signed up on Atlassian's website directly. Implementing PLG best practices is a good way to get people excited about your product.
- Don’t forget about existing customers: Acquiring a customer once and then selling them additional features, products or users is an easier way to improve CAC payback than acquiring new users. Don’t forget about cross-sell and upsell opportunities.
- Don’t obsess over LTV: You may be wondering why I haven’t spoken about LTV. Put simply, LTV is an output. For early-stage companies, it’s better to focus on the key inputs within your control, namely CAC and retention.
- Look at margins: Gross Margins are an important variable in CAC payback. For software businesses, the primary levers you can play with are hosting costs and customer onboarding costs.
- Pricing is an impactful lever: It’s quite common for SaaS pricing to change over time as the product and target customer changes. It’s worth experimenting with various pricing strategies to see what the market will accept. In many cases, early-stage companies are leaving money on the table. One pricing model that we’ve seen work quite well is usage-based pricing since it lowers barriers for customers to sign up, resulting in a lower CAC.
Why haven’t we mentioned LTV / CAC yet?
You might be wondering why we haven’t brought up the infamous LTV / CAC ratio. Great products provide value for customers long after they have paid back the S&M spend required to acquire them. Canva is a great example of this. Designers (and just about any employee doing creative work) get value from Canva on a daily basis, because it becomes a core tool required to do their job.
However, it’s worth noting that we (and many other investors) are hesitant to spend much time looking at LTV / CAC. At AirTree, we typically won’t look at it until the Series B or C round.
LTV or lifetime value is the net present value of the cash flows a customer generates over time. Here’s a simplified version of how to calculate it:
As you can see, LTV is a function of:
- Average Customer Lifetime, n: This is the inverse of churn, i.e. n = 1 / Annual Churn
- ARPU: Average revenue per user
- Gross Margin: Cost to service your customers
- WACC: Weighted average cost of capital
- CAC: As defined above
Now, let’s talk about why we tend to steer clear:
- It’s often hard to calculate: For early-stage businesses, it’s hard to know how your customers will behave over the long term. Conventional LTV formulas typically assume constant churn rates, whilst in reality, churn typically decelerates over time to reach an asymptote. Calculations can also be sloppy, with many teams making small mistakes like discounting revenue (instead of marginal cash contribution).
- The LTV variables pull at each other: As Bill Gurley explains, the LTV / CAC formula variables are not independent. For example, if you raise your average revenue per user (ARPU), net revenue churn will likely increase. Alternatively, if you increase marketing spend, your CAC will likely increase, and churn may also rise due to an increase in onboarding lower-quality customers. Despite this, many businesses forecast all metrics improving in tandem, a dynamic that is unlikely to play out in reality.
- It can lead to bad marketing decisions: Focusing too much on LTV can lead marketing teams to make poor capital allocation decisions. High LTVs can paint a rosy picture of the future, resulting in overblown marketing budgets with less focus on having shorter CAC paybacks.
For these reasons, we tend to spend less time looking at LTV / CAC ratios. Whilst it certainly can be a useful tool for comparing marketing channels, it’s often oversimplified and can lead to lower-quality decision making. However, if you’re looking for a benchmark, we look for a minimum LTV / CAC of 3x for mature SaaS businesses.
Ultimately, the role of a founder/Startup CEO is to allocate capital in the most efficient manner. S&M expenses can represent a significant portion of your overall spend. The best companies have a strong grip on the various dimensions of CAC payback and can benchmark performance, run experiments and dynamically adjust when situations change.
Digging deeper into CAC payback
The formulas we discussed above for measuring CAC payback are great, but they do make one fundamental assumption. They assume that the customers you acquire will behave the same way going forward. To be even more granular in measuring payback periods, we need to look at the individual variables of CAC payback:
- CAC per user: This is a one-off expense, so we can leave it as is.
- Average MRR per user: Our formula assumes that the monthly revenue a user contributes in the initial period will be constant in the months ahead. It fails to account for revenue expansion or contraction.
- Gross Margin: Our formula assumes that your gross margins will stay constant over time.
This may not sound like a big problem, but let’s look at 2 extreme examples. As a base case:
- CAC per user: $100
- Average MRR per user: $20
- Gross Margin: 50%
Using our formula above, this would imply a CAC payback period of 10 months ($100 / ($20 x 50%)).
Now, let’s take the following metrics and make some assumptions about revenue retention and gross margin in the longer term:
- Bull Case: Say that this cohort of customers loves your product so much that in their 2nd month on your platform, they double spend to $40 and stay put at this level. Let’s also assume that your gross margin increases to 80% through some engineering wizardry. This would mean that in Month 1, this cohort of users contributed $10 of gross profit, but in the following months, they contributed $32. By the end of Month 4, you would have earned $106 from this cohort ($10 + $32 + $32 + 32), and so your CAC payback is a little less than 4 months. Great news, go spend more money!
- Bear Case: Now assume that this cohort doesn’t love your product and cuts spending in half to $5 per month. As a result, you have to invest more in customer success, decreasing gross margins to 20%. This cohort only contributes $1 of gross profit after Month 1, meaning it would take you 91 months to pay back the $100 you spent to acquire the cohort. Not so good!
This is an extreme example, but if you want to be a world-class capital allocator, you need to measure CAC payback effectively. Some of this will depend on how much historical data you have around retention, but you can always make helpful assumptions.
Here’s how to think about the 2 primary variables:
- Cost of Goods Sold (COGS): Your gross margin profile will likely change over time, which will vary by business type. For software businesses, the typical levers in COGS are application hosting costs, customer support/account management expenses and software licensing and subscriptions required to produce the product. Every business will vary, but hopefully, your margin profile improves with scale, allowing you to eke out a few more dollars per customer. Unless you have strong visibility into margin expansion, you should be conservative with this.
- Retention / Churn: This one is a bit tougher, but if you have enough historical data on net dollar retention (NDR), you should use this to forecast how your new customers are likely to behave. If you have NDR > 100%, your CAC paybacks will be lower than you think, and vice versa if NDR < 100%. Separately, if you plan to make changes to your pricing model, you should also make some assumptions around churn, given that you’re likely to lose some customers during a pricing hike. It’s good practice to keep assumptions in line with your target customer, i.e. consumer SaaS will have lower retention than enterprise SaaS.
To mechanically model this out, you can use a setup similar to the below to toggle with assumptions around retention and gross margin. In this example, you can see that CAC is paid back at the beginning of Month 14. Without this level of granularity, CAC payback would have been calculated as 12.5 months. You can find the spreadsheet here.
Ultimately, the role of a founder/Startup CEO is to allocate capital efficiently. Sales and marketing expenses can represent a significant portion of your overall spend. The best companies have a strong grip on the various dimensions of CAC payback and can benchmark performance, run experiments and dynamically adjust when situations change.