Technology: Driving Profitable Growth
A Balanced Approach to Measuring Efficient Growth in as-a-Service Companies
In the Tech as-a-Service landscape, there are a variety of sales-related metrics and KPIs to choose from, and in today’s economy, knowing the right metrics to track and manage profitable growth is essential. There is no one-size-fits-all measure that paints the full picture for a company. This is especially true in times of economic uncertainty wherein shareholders and boards are focused on the efficiency of their investment dollars and might be easily misled by not having a complete picture.
As a result, Alexander Group recommends a balanced approach, using a combination of unit economics and company-level metrics, to track profitable growth through four lenses:
- Customer Acquisition Cost (CAC) Payback Period
- Lifetime value (LTV) to CAC Ratio
- Magic Number, sometimes referred to as SaaS magic number
- Retention, in terms of revenue
Viewed holistically as well as individually, these lenses provide an accurate assessment of potential challenges and opportunities for a company’s go-to-market model. No one metric tells the complete story, as its often the case that a company may be viewed as healthy across one metric and yet maintain challenges with other metrics.
This article will give an overview of each of these metrics individually and in junction with one another. Each metric will be explored in how it’s defined, how it should be interpreted and how it should be used. Additionally, several hypothetical scenarios will be explored to highlight how to interpret the metrics holistically.
CAC Payback Period
In any business, break-even analysis can be a powerful and informative tool for planning, setting pricing and analyzing costs and product performance. In the as-a-service landscape, this analysis is referred to as the CAC Payback Period.
The CAC Payback Period describes the average amount of time (months) it takes for a company to recover the initial cost of acquiring one customer, which is effectively the break-even point. There are two components to this metric: 1) the cost of acquiring a new customer and 2) the average expected monthly cash flow per new customer.
|The first step in calculating the metric is defining CAC; Alexander Group calculates CAC by taking the sales and marketing expenses attributable to acquisition activities for the period over the number of new customers acquired within the period. Next, divide your CAC by the ARPA (average MRR per account times gross margin) to solve for the number of months it will take to recover your CAC.
The interpretation of the CAC Payback Period varies based on cash-on-hand/available funding, but shorter is always better, as it means more cash in the bank. Benchmarking against peers is helpful, but even more important is to monitor how the metric changes internally over time. By tracking CAC Payback Period over time, companies can see the impact of various investments and develop a better understanding of the levers that cause this metric to move.
LTV to CAC Ratio
While the CAC Payback Period is a useful measure, it only captures the amount of time it takes to recover the cost of acquiring a new customer and doesn’t consider any future revenues after the break-even point. To understand the ROI you can expect from a customer throughout their lifetime, we use a different metric: LTV to CAC Ratio.
|We’ve already taken the first step to calculating this metric by solving for CAC, so the next step is to calculate the estimated lifetime value (LTV). Alexander Group calculates LTV by taking the ARPA, which we previously calculated above, dividing it by the average monthly logo churn, and multiplying the result by a churn constant of 0.75 to account for non-linear churn.
If the monthly logo churn results in an estimated lifetime over 10 years, Alexander Group suggests applying a 10-year cap to the customer’s lifetime. Note that average customer churn has a large impact on this metric, thus investments to improve LTV to CAC often include resources to support retention, such as post-sales support and customer success.
The higher the LTV to CAC, the better ROI on putting emphasis on new customers. Most sources suggest targeting an LTV to CAC Ratio of at least 3.0 or higher, but results will vary by growth stage, customer segment and company maturity. While many early-stage companies may struggle with calculating this metric, Alexander Group recommends that all companies track this metric over time to see how the expected ROI changes.
SaaS Magic Number
CAC Payback Period and LTV to CAC are unit economics that help companies understand profitability at a customer level. SaaS Magic Number, by comparison, is a company-level metric used to understand the effectiveness of sales and marketing investments within a specific period to drive revenue growth.
|To calculate the SaaS Magic Number, first subtract the prior quarter’s GAAP revenue from the current quarter’s GAAP revenue then multiply the delta in revenue by four, which will be the numerator. Finally, divide the numerator by the prior quarter’s total sales and marketing expense to get the SaaS Magic Number.
When interpreting the SaaS Magic Number, the general rule of thumb is that 0.5 is poor (cost of growth is extremely high), indicating that investors should be wary to invest in sales and marketing, 0.75 is moderate but worthy of further evaluation and 1.0 or greater is strong, indicating that cost of growth is efficient and sustainable.
Companies interested in growing revenue should track the SaaS Magic Number. Early-stage companies and those with high growth expectations need to pay even higher attention to this metric, as it’s an important proof point that investors look at to ensure their investments will yield growth.
However, SaaS Magic Number is not a complete measure of sales efficiency, as it does not inform the root cause for the lack of growth. For example, a poor SaaS Magic Number could be the result of high churn, a lack of expansion opportunities or a high CAC. Using the other core measures in this article, a company can identify the root cause of the poor Magic Number. Additionally, the SaaS Magic Number does not account for the mix between recurring and non-recurring revenues, which are valued differently and have different margins.
Retention – Net (NRR) & Gross (Churn)
For any business with a recurring revenue model, tracking Retention KPIs is crucial to understanding the health of the installed base of customers. These metrics will inform whether the installed-base revenue is growing and, if so, through either account expansion, reduction of churn or both. From a metrics perspective, Retention is looked at in two ways: Net and Gross.
|The Net Revenue Retention Rate (NRR) indicates whether the installed base is growing by measuring the net change in ARR from existing customers throughout the year. Alexander Group calculates NRR by taking the ARR at the start of the year, subtracting churned ARR, adding expansion ARR and then dividing it by the starting ARR.
In addition to NRR, there is also GRR, or Gross Revenue Retention, which is like NRR except that it excludes expansion growth. GRR measures to what extent a company can retain recurring revenue from its existing book of business and can indicate if the company has a churn problem. When these two metrics are used in conjunction, it paints a clearer picture of the health of the installed base and provides a better understanding of how customers feel about your solutions and service offerings.
Putting It All Together
We’ve covered five different metrics, their uses and how they are calculated. So how should you look at them together? Imagine three companies with the following sample KPIs and you’ll note some interesting observations that can only be made by looking across multiple KPIs.
|CAC Payback Period
|LTV to CAC Ratio
|SaaS Magic Number
|Net Revenue Retention
|Gross Revenue Retention
In the example above, comparing ABC Co. & DEF Co: while the SaaS Magic Number, NRR and GRR remained the same across both, the CAC Payback Period and LTV to CAC Ratio are significantly different. This is a perfect example of why it’s essential to look at efficient growth through multiple lenses and understand the levers that drive each metric. If investors looking at DEF only evaluated the SaaS Magic Number, NRR and GRR, they might value the company the same as ABC. However, ABC is far more efficient (in part due to lower CAC and better margins) and, as such, will likely prove to be the more attractive option to investors.
In the example, XYZ displays a strong SaaS Magic Number, a healthy CAC Payback Period and strong Net Revenue Retention. However, XYZ’s LTV to CAC Ratio and Gross Revenue Retention are both subpar compared to ABC and DEF. XYZ is a company that is good at selling to new customers and expanding existing customers, as evident by the strong SaaS Magic number and NRR figures. However, XYZ has a revenue churn issue, as shown by poor LTV to CAC and low GRR. The company and its investors should focus on determining the root cause of churn and investing in programs to retain customers and revenue.
The proper evaluation and management of Tech as-a-Service needs to rely on multiple metrics. Knowing the right metrics, their respective definitions and implications and how they work together to tell a story are essential to tracking profitable and efficient growth in today’s landscape.
If you would like to dive deeper into as-a-Service KPIs and how they may inform a company’s valuation and strategy, please contact Alexander Group, a leading go-to-market strategy consulting company focused on helping clients achieve profitable revenue growth.