SaaS Unit Economics - Part 2 - Scaling Efficiently
This post is Part 2 of my analysis and discussion around SaaS unit economics, and if you haven’t read Part 1, it would be helpful because it covers the assumptions on revenue, customer growth and retention. For Part 2, I will cover gross margin and the following metrics: CAC, CAC Payback Period, and sales efficiency.
On average, SaaS companies tend to have a blended gross margin around 70%, which includes the cost of revenue for both subscription and professional services. Top SaaS companies can have recurring gross margins above 80%, which shows why the business model is attractive.
The total cost of revenue includes both the direct costs of delivering their product and the customer success employee salaries and benefits. (Customer success personnel provide the onboarding and ongoing support of the customer). For this example company, direct costs will include Amazon Web Services (AWS) hosting costs and other costs for software used in the product. Here is a quarterly view of the gross margin calculation: Total Revenue - Total Cost of Revenue:
With the chart, it is easier to see the positive trend, which could be due to a number of reasons, such as: (1) purchasing (ie. pre-buying) Amazon EC2 reserved instances vs. on-demand pricing; (2) product may become more self-serve, which would decrease need to hire more customer success managers.
CAC, CAC Payback Period and Sales Efficiency
CAC is the measure of how much it costs for the company to acquire a new customer. It is calculated by summing the total sales and marketing expenses for the period and dividing that number by the # of new customers added in that same period. It is helpful to look at the number on a monthly, quarterly and annual basis because with monthly/quarterly data, it is easy to see the trends/seasonality while annual figures provide a more consistent view. For my calculations, I did not assume a long sales cycle and all calculations are “in period.” Below is a detailed view of the numbers and calculations:
The size of the CAC here implies a mid-market to SMB focus given the relatively low absolute size. CAC payback period ranges between 15 months and 20 months, but more importantly, it is within the typical range of 12 to 24 months, which means it requires a relatively short time period to become profitable.
This company’s sales and marketing efficiency stays above 1, which means a higher probability of getting to cashflow breakeven. In general, a result less than 0.5 is a company still trying to figure out its sales model, and between 0.5 and 1 implies a relatively capital inefficient way to generate more revenue.
LTV to CAC Ratio
LTV to CAC is an important ratio to calculate ONLY if you have enough data and history as a SaaS company. Otherwise, there can be significant fluctuations if using shorter time periods due to the metric’s sensitivity to churn rates. Frequently, a 3x ratio is stated as an acceptable benchmark. If the company has an LTV to CAC higher than 3x, then there will be less capital required to grow revenues. In other words, this calculation tells us whether the company can scale efficiently and profitably. For the company in this example, the numbers tell a positive story that there is strong demand in the market for its product and the company is able to ramp the growing sales team to full productivity quickly.
Further underscoring this company’s ability to effectively scale is the fact that as it has invested heavily in sales and marketing to support its growth, CAC has remained relatively flat to slightly improving over the 2 year time period.