The CAC Ratio Revisited

While the Customer Acquisition Cost (CAC) Ratio has been around for years, and many best practices have been published around this critical SaaS metric, in recent conversations with SaaS-company CEOs about benchmarking, we found a lot of companies still aren’t tracking it. We think you should, but you should also be aware of its deficiencies.

Why it’s useful:

The defense of the CAC ratio (lifetime value of a customer/the cost to acquire the customer) is that it is the most fundamental economic underpinning of your SaaS company. As the HubSpot CEO likes to describe, “We put $10,000 into our SaaS machine, and we take $35,000 out.” It is that simple, and it cuts through much of the noise generated by GAAP accounting.

If a SaaS business’s CAC ratio is not fundamentally solid, then its unit economics are not good, and it will fail. If the CAC ratio is solid, it is a good business, and it will thrive given the right funding and management. This is why investors love this ratio (VCs invented it).

It is a unit economic view (regardless of time) on the business as opposed to the temporal view on the business in the P&L. GAAP lines up revenue earned and expenses incurred in the same period. The CAC ratio lines up revenue earned and expenses incurred by customer acquisition over time. In the early years of a business, and in periods of rapid growth, the P&L of a sustainable business can look almost identical to the one of a doomed business, and the addition of the CAC ratio will expose the difference.

The CAC ratio also focuses the business on important processes needed to scale: retention, gross margin, and sales efficiency. Improvements in all these areas will benefit the business and make it more capital efficient and, ultimately, more profitable.

The drawbacks:

1. Unlike most other metrics, the CAC ratio is not directional; a higher CAC ratio is not always better or worse than a lower CAC ratio and vice versa, and it is therefore not something you necessarily want to use as an operating target. Firing sales people and spending less on marketing, for example, will almost always improve your CAC, and hiring will do the opposite. It can be helpful in assessing the business in steady state, however. For a given investment in sales and marketing, a higher/improving CAC ratio is always better. Similarly, a modest decrease, as opposed to a large drop, in the CAC ratio in light of increased investment in sales and marketing is good feedback assuming revenue grows.
2. In theory, any CAC ratio above 1 adds value to the business as the costs imbedded in the calculation are incremental. In practice, however, that is not correct. There are real overhead costs that are incurred by the business as the customer count grows, and the calculation does not include a capital charge. The capital part is really important. It takes “tons” more money to scale a low CAC ratio business over a high CAC ratio business.

To the point concerning capital: most of our portfolio companies track a “payback” calculation of some sort. “How long does it take for the company to recoup its customer acquisition costs?”  This metric is better at isolating the capital required to grow the business: the faster the payback, the faster profits can be recycled back into acquiring new customers. This metric, unlike CAC, can be meaningfully influenced by payment terms, and should be calculated on a cash basis if possible. As capital becomes more expensive and scarce, this is an increasingly important metric to track.
This metric is not as good an indicator of overall company performance as the CAC ratio, however, because it does not take into account how long the customer stays around, which is the largest single determinant of long-term health and profitability.

Conclusion:

SaaS companies should track their CAC ratio and revisit it periodically. They should attempt to improve it given a steady state sales and marketing effort, and they should recognize its implications on the amount of capital needed for growth.

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