Monday, October 03, 2011

CAC, LTV, MRR - Translating SaaS Financials into Actions

“If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is.”  - John Louis von Neumann

I’m sure that most of you have seen the various metrics floating around with CMRR, CLTV, Churn Rate and ASC starring in equations that sometimes cause one to cringe while sipping the day’s first coffee.

Let’s look at one of the basic formulas for SaaS Financials:

This simply says that if you want to become profitable one day, you must make sure that your Customer Acquisition Costs should be less than your Customer Lifetime Value. In other words, the total amount of revenue you will generate from a customer, throughout the years or months that they derive value from your SaaS offering, should be more than the cash you spend on acquiring that customer.

Simple? It almost doesn’t pass the DUH Test. But in this article we'll look more carefully at the implications.

Acquisition vs. Retention
There is a notion in the industry that the costs to acquire a new customer are 5 to 7 times more expensive than the costs to retain an existing customer. Whether one agrees with the numbers or not, it is widely accepted that acquisition is more expensive than retention, yet most SaaS companies will spend far more resources and executive attention on growth through new customers than keeping the current customers satisfied, or in other words, reducing the Churn and up-selling to the current base. In fact, in every company I have consulted, the issues of Churn Management and Operational Excellence were far down on the priority list.

I guess hunting is far more exciting than farming.

Therefore, we will examine on how to grow the right hand side of the equation - the CLTV, not on how to lower the left side - the CAC.

Breaking down the CLTV

CLTV = Lifetime * ARPU * Gross Margin.

I hope I am not losing you here. Take another sip from your Latte. It is not complicated – sixth grade math.  Stick with me, the actionable items will follow shortly.

ARPU means the ‘Average Revenue Per User’ for the time period defined as Lifetime. So if you count by months, Lifetime would be the number of months the customer remains loyal, and the ARPU would be the average that the customer would pay per month. If your value is calculated by years (lucky bastard!) then Lifetime would be how many years you retain the customer and the ARPU is average revenue per year from the customer.

Gross Margin is the ratio of total Revenue to the Costs Of Goods Sold (COGS) – how much does it cost you to give service to your customer.

For the Gross Margin to grow, the COGS should shrink, or at least stay stable as your revenue grows. So the lower the COGS are, the more you retain for your Christmas party.
As a simple example, let’s assume that your average customer sticks around for 19 months, that the average monthly payment from a  customer is $430 and that your gross margins are 72%, then the CLTV = 19 * $430 * 0.72 = $5882.4.
Just imagine that with a little effort you could cause the Lifetime to grow to 21, or the ARPU to $460 and multiply the new CLTV by the number of customers...

What can we do about it?
Without going into details of how the various numbers are calculated we can still learn much about these equations and derive actions from them.
The bottom line is that you want to have the highest CLTV value possible. Looking at the equation, it means that your Lifetime, Gross Margin and ARPU values should grow.

Needless to say that for each of these three values, books could be written. Nevertheless, the paragraphs below cover the main points and map the actions one can take, and their direct impact on the equation’s variables.

In order for this value to grow, a SaaS provider should invest managerial attention into customer retention, or lower Churn. That means improving your customer service and responsiveness. Meassure and monitor the support KPIs. Run a weekly Customer Success meeting with Support, Operations, Sales and PS.  Build a community and best practices around your product to enhance loyalty.
Be as transparent with your service levels as you can. Award loyalty with small gifts. Document  your Churn data and analyze it – understand the reasons customers leave you and determine the trends.
Provide meaningful SLAs and act on them.

Average Revenue Per User
Translate ARPU into: “up-selling you service”. This means a strong group of farmers in your sales team. Use software to monitor user behavior. Think of value-added services that you could sell for a fraction of the recurring cost. Identify and keep in touch with your champion inside the customer’s organization and seek opportunities to sell more services or branch out to new groups within the organization.

Gross Margin
Lowering COGS means an effective and efficient Service Operations. This starts with a good team of dedicated professionals, a rigorous set of practices such as Change Mgmt, Incident Mgmt, Event Mgmt, etc. and a robust monitoring and alerts infrastructure.
Automation and Delegation  - maximize what silicon and your customers can do instead of having people on your end doing it. That means create as much automation as possible around manual processes. Provide self-help, self-registration and self-configuration for your customers to run.
Understand the financials of the hosting services you are using. Don’t stick to the current solution just because you have been doing it for a long time. Circumstances would have changed, new solutions are offered every month, and a fresh look might save a lot of recurring costs.

In conclusion, we looked at one of the equations that every venture capitalist (i.e. your board members) tells you to watch, and transformed it into actionable items that your company should deal with. To pass that threshold of profitability, it probably won’t happen with that “major deal we’re about to sign”, but with improvements across the board in every aspect that tilts the right side of the equation.

For some good readings on SaaS Financials there are Bessemer’s 5 Cs, and Joel York’s excellent articles on the financials of SaaS.