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NO SOFT LANDING… so is a recession coming?
Before I dived into the world of Revenue Operations I worked in FP&A. I’ve always had a fascination for macroeconomics. That and world history. BUT! Oopf, the recent inflation headlines that came out this week lead me to believe we are in for more pain. SaaS Revenue Operators we better get our asses in gear but this year is not going to be one of respite, but a year of more headwinds.
Let’s talk about unit economics. The theory goes that if you can rightsize your economics into positive territory that you’ll be able to bring in some serious positive operating cash flow given you have sufficient volume. Sure you already know this but let’s define Customer Acquisition Cost (CAC) and Lifetime Value (LTV) quickly. Then I’ll go into a few ideas we can use to improve the picture.
Getting CAC in the black
Customer acquisition cost (CAC) is defined as the total costs associated with acquiring a new customer. This includes all the expenses incurred in marketing, sales, and other activities to attract and convert a prospect into a paying customer.
The formula for calculating CAC is:
CAC = Total Sales and Marketing Expenses / Number of New Customers Acquired
The total sales and marketing expenses include all the costs associated with generating leads, such as advertising, content creation, website optimization, sales salaries and commissions, events, tech spend and any other expenses directly related to acquiring new customers.
To calculate the CAC accurately, SaaS companies should track all their sales and marketing expenses and also keep an accurate count of the number of new customers they acquire. By doing so, they can monitor the effectiveness of their customer acquisition strategies, identify areas for improvement, and optimize their marketing and sales efforts to reduce CAC and improve their profitability.
In this week’s newsletter I included a CAC worksheet for Paid Subscribers for you to adopt and adapt.
But what if Revenue Operations reports outside of Sales?
Over the last couple of years there have been debates where RevOps / SalesOps / MarketingOps / GTMOps should report to.
A decentralized organization structure would have Marketing Ops reporting into Marketing and Sales Ops reporting into Sales. This is a solid reporting structure for businesses focused on speed and less focused on alignment. Businesses in growth (Series A to Series B) make sense here.
A centralized organization structure can take many forms but the one key tenet is that all of the functional operations sit under one roof, Revenue Operations. RevOps may sit under the CRO but sometimes it does not. It could report to Finance. It could report to Business Operations. The goal in the latter two reporting structures is to maximize for unbiased Go To Market support. Hard to disagree with a marketing or sales leader when they are also responsible for your promotion and bonus.
I bring this up because what if the GTM Ops costs do not report nice and neatly into your sales and marketing cost centers in your general ledger (GL)? Does your team put in the effort to allocate costs on a prorata? Or do they take the easy way out an exclude them altogether? Or take a halfway measure and put together a fractional multiplier?
So when calculating your cost metrics it makes sense to set a standard that leans towards the truth over expediency. Get the data right. Don’t cut corners.
Some have argued that Burn Multiple is better to use than CAC
So is it better to look at Burn Multiple? It’s much easier to calculate. It also includes EVERYTHING including product, engineering, CS, HR, office spend, etc. EVERYTHING like I said!
In venture capital, "burn multiple" refers to the ratio of a company's cash burn rate to its revenue or gross profit. The cash burn rate is the amount of cash a company spends each month to operate and grow its business, while revenue or gross profit is the income generated by the company's sales. In the middle of 2022 most VCs were telling their PortCos (portfolio companies) to cut their spending. Cut your burn. Get it down to 2x or less.
For example, if a company has a monthly cash burn rate of $100,000 and its monthly revenue is $50,000, its burn multiple would be 2.0x ($100,000 divided by $50,000). A burn multiple of less than 1x is generally seen as favorable, as it indicates that a company is generating more revenue than it is spending on operating expenses.
Image illustrated by Kriti B Vichare.
Investors may look at a company's burn multiple to assess its financial health and determine if it is a worthwhile investment. A high burn multiple can be a red flag, indicating that a company is spending too much money relative to its revenue and may not be sustainable in the long run.
The reason I like burn rate in a recessionary environment for startups is that if you run out of the cash… the game is over. Your business is dead. Better to live and fight for another day. This is why startups have had to cut much deeper in percentage terms relative to overall headcount than public companies.
When public companies cut, they boost operating margin. This is supposedly good for stock prices.
Facebook 11,000 jobs - 13%
Google 12,000 jobs - 6%
Microsoft 10,000 - 5%
When startups cut (see www.layoffs.fyi) they’re cutting more than 20%. Why? Because they need the cash to extend their runway. See the Vichare cartoon above.
What metric do we use to calculate topline? Lifetime Value!
Lifetime value (LTV) is a metric used in marketing and business to estimate the total value that a customer will bring to a company over the course of their relationship. LTV takes into account the total revenue that a customer is likely to generate, minus the cost of acquiring and serving that customer.
Here’s a simple of calculating LTV:
Average Revenue Per Customer * (1 / Gross Churn Rate)
Why do we take the inverse of the gross churn rate? If your churn rate is 20% than if you apply a linear survivorship to it then your average lifetime will converge to 5 years. It’s not exactly right so here’s a more precise table. The underlying math is in this simple table.
If you wanted to calculate Payback Period you’ll want to include gross margin. Here’s the formula for Payback (In Months):
(Customer Acquisition Cost / Gross Margin Per Customer) * 12
So if your average ARR per customer is $100,000 and your gross margins are 80% then your Gross Margin Per Customer is $80,000. If your Customer Acquisition Cost is $110,000 then the payback period is 16.5 months.
LTV/CAC, or Lifetime Value to Customer Acquisition Cost ratio, is an important metric in business because it helps companies evaluate the long-term value of their customers relative to the cost of acquiring those customers.
Here are a few reasons why LTV/CAC is important:
It helps determine if your customer acquisition costs are reasonable: A high LTV/CAC ratio means that your customers are worth more to your business over their lifetime than the cost it took to acquire them. This is a good sign that your marketing and sales efforts are effective and that you're spending your money wisely.
It helps with forecasting revenue: By understanding the LTV/CAC ratio, businesses can better forecast revenue growth and determine how much they can afford to spend on customer acquisition in the future.
It highlights areas for improvement: A low LTV/CAC ratio could indicate that your sales and marketing strategies aren't working effectively or that you need to adjust your pricing. This information can help you identify areas where you can improve your business and increase profitability.
How do downgrades impact LTV?
Recently companies have been downgrading rather than churning. My initial formula above of using gross churn rate may not be accurate to truly capture LTV. Many companies went over their skis and have had to cut staff. In this situation I would readjust your average revenue per customer lower. Don’t use last year’s number. Use a realistic number. Personally I think we’ll see a path back to growth but for the next four to six quarters companies who have
Why you should segment your CAC and LTV
Segmenting LTV and CAC is important because it allows businesses to gain deeper insights into the profitability of different customer groups, channels, and marketing campaigns.
Identify profitable customer segments:
By segmenting LTV, businesses can identify which customer segments are the most valuable to their business. This information can be used to tailor marketing and sales efforts to these high-value segments and help increase revenue and profitability.
Optimize marketing spend
Segmenting CAC can help businesses identify which marketing channels and campaigns are the most effective at acquiring customers. This information can be used to optimize marketing spend and focus on channels and campaigns that have a lower CAC and higher ROI.
Improve customer retention
Segmenting LTV can help businesses identify which customer segments are the most loyal and profitable over time. By understanding the characteristics and behaviors of these segments, businesses can develop strategies to improve customer retention and increase LTV.
Better forecast revenue
Segmenting LTV and CAC can help businesses forecast revenue more accurately by taking into account the unique characteristics of different customer segments.
Some crazy ideas to adjust the unit economics
So let's talk about three BOLD ways you can impact LTV/CAC. These will apply more for startups then established companies. They were worth a discussion. Better to push the envelope than be silent and complicit in a business' demise.
Marketing idea: Slash unproductive marketing campaigns (top quartile spending groups but bottom quartile). Try not to scorch the earth by slashing spend completely. Be surgical. Be nuanced.
Sales and Customer idea. Raise your prices on your highest payback segments. This is going to suck and feel like a gut punch but you might be able to have an elasticity that outweighs the inevitable churn. Luckily you’ve done the math above and know exactly which customers are bleeding your balance sheet.
Customer Support idea. Refine your customer support tiers. If your smallest customers receive the same level of service as your largest customers then there's plenty of room to allocate resources better. We didn't cover Cost of Recurring Service in relation recurring revenue but reallocating wasted resources over to your highest paying customers will likely reduce your churn and reduce downgrades and thus better preserve your LTV
If you’ve read this far I’d love to hear some ideas of your own. Reply to the newsletter and drop an idea in the newsletter chat (via the Substack app).
In this week’s newsletter I included a CAC worksheet for Paid Subscribers for you to adopt and adapt.
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LTV / CAC worksheet (3 tabs: GTM Headcount, Marketing Blended Costs, Unit Economic Calculator). Link below 👇
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