Why SaaS companies should focus on their ARR:CAC ratio (over other metrics)

To keep track of both profitability and sales performance, SaaS companies need to know how much they’re spending on acquiring each new customer.

It can be very tempting to focus on the LTV:CAC ratio, which can be the most obvious choice. However, our opinion is that this isn’t your best option if your business runs on a recurring revenue model. On the other hand, the ARR:CAC ratio – which is largely undervalued nowadays – seems to make much more sense for SaaS business models.

A quick reminder

The LTV:CAC ratio measures the relationship between the Lifetime Value of a Customer (i.e. total profit they brought in) and the cost incurred to acquire them.
The ARR:CAC ratio measures the relationship between your actual annual revenue and the Customer’s Acquisition Cost.

The LTV:CAC ratio is currently the best-known

CAC is indeed a crucial metric for your marketing team…

CAC stands for Customer Acquisition Cost.

When calculating it, you’re basically measuring the total cost of sales and marketing efforts, divided by the number of customers generated.

Knowing your CAC is crucial because if you’re spending too much on acquiring customers, it will end up taking way too much time to pay back your costs…

The great thing about CAC is that you’re pretty much free to do whatever you want with it. For instance, you can easily choose to increase (or lower) your CPC bids or decide how many times your ads will be shown: it is adjustable to your strategy.

Important tip‍

only include your paying customers in your CAC! 

✓  If you offer a free trial, only compute it after the actual paying signup.

✓  Exclude all your freemium customers from your CAC.

However, your CAC should regularly be confronted with your (real or potential) revenue, so as to ensure that your sales and marketing strategies remain profitable… This explains why the LTV has become so popular among marketing teams over the past few years.

… but LTV remains complex to compute 

The Customer Lifetime Value (also known as CLV) is another metric you may know. It informs you on how much your business expects to earn from the average customer over the course of the relationship you’ll have with them. 

For SaaS companies, the preferred LTV calculation is the following: Average Revenue Per Customer/Churn Rate.

By definition, the LTV needs to account for churn: it’s based on the complete duration of a relationship, from beginning to end… Which means that until a customer churns, you can’t actually measure it!

This makes the LTV virtually impossible to define for young companies – but also for bigger companies with a small number of accounts or launching new products – since they do not have enough perspective to measure their churn rate accurately.

Let’s take a look at an example, shall we? 

Let’s imagine you are a company targeting a new customer segment. During the first year of operation, you will know the price people are currently paying – but you won’t be able to know the LTV of this new type of customer, as it's too soon to know how long they'll stay, or how fast they will churn.

Assessing the profitability of a product or business at this stage with this method is straight impossible.

The ARR:CAC ratio is easier to calculate

OK, here’s a third metric that you’ve most likely heard of. It’s ARR, which stands for Annual Recurring Revenue. It provides you with the recurring revenue components of your business.

The best thing about ARR is that you can start calculating it as soon as the first subscription is sold. It’s also a great tool to compare your company to its competitors.

That’s not all: ARR is also easy to target and monitor. Basically, if you track your ARR:CAC ratio over the first few months of your company's existence, or the first few months of a new campaign, you’ll have a great profitability-oriented metric to track your progress.

This is vital because it enables you to benchmark your company – against the world as well as against an older product/campaign you have data on.

Let’s get down to numbers:

• ARR:CAC < 1: ouch! Your acquisition of new customers is very expensive. At this rate, your gross margin won't be high enough to make your company profitable… there may be a glitch in your strategy!
• 1 < ARR:CAC < 3: this is like the Goldilocks zone of this ratio. Pretty good, but you can do better!
• ARR:CAC > 3: great job, you’re on track to making substantial profits!

Let’s take an example:
Imagine you priced your recurring product at a subscription of $1000/year. You want to be in the green zone and are therefore targeting an ARR:CAC ratio of 3. This means that you should target a CAC of 1000:3 = 333$.

Maybe you’ll have to factor in other budget layers, more costs, some taxes, etc. But the bottom line is that tracking this ratio will enable you to keep your business afloat, it’s as simple as that. And the higher this ratio, the better for you, your team and your business!

Finally, a word of warning. Tracking ARR:CAC shouldn’t exempt you from monitoring your churn as well (which will appear later). The best thing to do is set a churn metric for your entire customer base or for the new cohort you’ve just acquired.

Conclusion 

At Husprey, we are well aware that there are biases to ARR:CAC. But the focus here is more on how easy it is to compute and follow over time on different customer cohorts, rather than at just one point in time. This enables you to identify trends and assess your actions’ profitability.

The next step is as easy as pie: use data storytelling to make your insights more engaging, persuasive and memorable while reporting to your board! 

For further reading on data storytelling, see Using Data Storytelling to Bring Impact to Your Analysis.