Whenever I work with our SaaS portfolio companies I notice that nothing stirs up more emotions (both good and bad) than talking about Customer Acquisition Cost (CAC) Ratio. Although companies measure numerous KPIs, CACR is viewed by many CEOs and investors as the #1 indicator of the health of the company. Also, since it’s an operational KPI and not an accounting parameter, the calculation of CACR is open to interpretation (and therefore debate).
The emotion-stirring discussion about CAC Ratio usually revolves around 2 main issues: How to measure it, and what do the results mean.
CAC measurement often raises the following questions:
Should the calculation be done on revenue or gross profit?
Should it be done for new accounts only or also on renewals?
Should it include customer success costs?
Should it use Sales and Marketing (S&M) expenses of the same period or the previous period?
While several methods are acceptable, here’s how I believe you should calculate CACR:
CAC ratio should be calculated based on GAAP reporting, i.e. the delta in recognized revenue (or Gross Profit) divided by the S&M expenses of the previous period (regardless what is the length of the sales cycle, investments are always done ahead of time). Or putting in plainly:
In my mind there are some clear advantages to this approach:
1. It could be inferred from the financial statements of public companies. Let’s be honest: CAC Ratio is not rocket science, it’s simply a good scalability benchmark. Public SaaS companies are the baseline of that benchmark and they are only obligated to report GAAP financials.
2. It is simple and unified across the board (you want to compare apples with apples and you want all apples to be the same).
3. It normalizes all anomalies by ignoring multiyear accounts (they are recorded as bookings but don’t increase revenue), monthly deals etc.
4. It puts the right emphasis on the install base. Renewal, churn and expansion have a huge influence on the performance of the company, not just new sales
However, since it is a simplified way of looking at the company’s performance, one should be careful of drawing the wrong conclusions. In particular, a problematic CACR doesn’t necessarily indicate whether there is a problem in sales execution.
Since CACR takes into account all elements affecting revenue, there could be other reasons for low ratios:
1. Product issues. If your product is not good enough and your customers are not happy, there is no sales team in the world that can overcome this. I often find CACR trends as an initial indication of a product/market “misfit”.
2. Customer success issues. It is extremely hard to build a successful company without leveraging your install base. Low renewal rates and lack of expansion will translate immediately into a low CACR and should be considered as a red flag.
3. Inefficient marketing campaigns. High cost marketing programs (such as PPC) often have a negative ROI and tend to be overlooked in the overall noise of marketing. A low CAC Ratio may therefore be a symptom of marketing campaigns and a sign that they should be reviewed.
To summarize, CAC Ratio is definitely one of the key indicators of the overall health of a SaaS company. It should be very straightforward and easy to measure and benchmark against other private and public comparables. Nevertheless, the fact that only S&M costs are used in the formula doesn’t necessarily indicate that all of the issues are in those departments. One should use caution when speculating on the “root cause” of a low CAC Ratio and take a broader look across all departments.