No matter the size of your business, acquiring new customers is something to celebrate! This is particularly true for early-stage companies looking to acquire their first 10, 100, and 1000 customers.
However, it's just as important to understand the Customer Acquisition Costs (CAC) and how long it will take to recover those costs in the form of customer revenue. That is CAC payback. It's the real milestone that deserves celebration because once a customer has stayed with your businesses through the CAC Payback Period, you're closer to making a profit on a unit economics basis.
Want to know more about the CAC Payback Period? Then keep reading to get an in-depth understanding of how it can help your business and how you can benchmark your SaaS CAC Payback Period.
What is the CAC Payback Period?
The payback period is a long-used concept that comes in handy to studying and analyzing traditional businesses. Investors are keen to know precisely when the capital invested will recoup before they embark on any ventures. The shorter the payback period, the more opportunity they see in the business and vice versa.
Imagine you plan to buy an apartment complex and will make upfront payments to purchase it. And you intend to collect revenues from that building in terms of rental payments. So, you must be curious to learn when exactly the payments you make will be recovered before you make a profit. The payback period determines that for you.
Now, let's come back to subscription-based businesses or SaaS companies. If we draw an analogy, that upfront payment made in traditional business is Customer Acquisition Cost (CAC) in our particular case. Note that this is just an analogy. There are obviously different metrics and analytics for SaaS companies.
For a quick review, customer acquisition cost or CAC is the total amount of money spent on acquiring customers. More specifically, CAC is the costs spent on acquiring new customers divided by the number of new customers acquired. Examples of CAC are marketing and sales costs. To know how to calculate customer acquisition cost and improve customer acquisition cost, check out our Glossary Article on CAC.
CAC Payback Period is a measure of how many months it takes a company to generate enough revenue to break even on the cost of acquiring a customer. SaaS companies use it to work out how much cash a company needs to grow.
This is the metric that SaaS companies and entrepreneurs keep an eye on to spot flaws in their marketing and sales strategies. The calculation of the CAC payback period is equally important for both startups and successful companies.
But this begs the question of how exactly to calculate the CAC payback period. How many ways could there be, and what do we need to know before calculating it?
How to calculate CAC Payback Period?
The formula to calculate the CAC Payback period is as follows:
Where CAC is Customer Acquisition cost and ACS is Average Cost of Service.
Before we get candid, let's reconsider that apartment complex example. To determine the payback period of that building, we will divide the capital investment by the estimated annual revenue to be collected in terms of rental payments. Easy.
Suppose the amount to purchase that building is $500,000. And you estimate to collect a revenue of $100,000 per year. The payback period, in this case, is 500000/100000. Hence the payback period will be 5 years. Note that we just calculated the timeframe in years, not months.
For SaaS companies, things are pretty much the same. Customer acquisition cost (CAC) is our investment per unit. And the MRR per user is our estimated monthly revenue collected per unit. To calculate the CAC payback period, we will divide the CAC by MRR per user.
Let's assume some numbers. We spend $500,000 on our marketing and sales to acquire 1000 new customers. CAC would be $500 in this case. Based on our subscription costs, we calculate MRR per user to be $100. CAC payback period, in this case, 500/100.
That is 5 months. It means that investments made on a user will be recouped if they stick to us for 5 months.
But wait. We just completely overlooked the fact that we need to provide customer service to our new customers. Customer service could cost us heavily and gnaw on our revenues. There could be additional costs, too, to keep your business up and running. Now you may have started to get the idea of the Average Cost of Service.
Average Cost of Service is the cost incurred per customer to provide them with customer service or other hosting services. You can calculate it by dividing the total customer service cost/customer success costs by the total number of customers. Without calculating it, you may miss the picture in its wider essence.
Revisiting our example, the CAC Payback period may become longer when we put the ACS in the equation. CAC is $500, and MRR per user is $100. And now we calculate ACS to be $20.
Plugging those numbers back into our equation, the CAC payback period will be 500/(100-20). We now have a CAC payback period of 6.25 months.
There could be another way to calculate CAC Payback Period. The formula for that will be:
Where CAC is Customer Acquisition Cost, and GM% is Gross Margin Percentage.
Do note that some financial experts, while calculating the CAC payback period, use Average Revenue per User (ARPU). It is almost the same thing as MRR per user for startups. However, established SaaS companies that could calculate Customer Lifetime and Customer Lifetime Value are better positioned to determine ARPU.
What's a good CAC Payback Period for a SaaS company?
Well, it depends. There can't be a straightforward answer to that. However, the earlier you recover your investment, the better it is.
In fact, you should focus on reducing the CAC payback period so that your acquisition costs are recovered at the earliest.
Average CAC Payback Period for Start-ups
Generally, startups must not look into ventures with a payback period of more than 12 months. You may find yourself strained with your creditors and investors if your payback period exceeds 18 months. Successful companies can surely deviate from this principle.
Average CAC Payback Period for Successful SaaS Companies
If you own a successful SaaS company whose CAC payback period is less than 12 months, you are well positioned to grow your business. You may invest, innovate and experiment with new technologies and algorithms.
And if your CAC payback period is anything above 18 months, you need to make efforts to reduce it.
Average CAC Payback Period for B2B SaaS Enterprises
The playing ground of B2B Enterprise SaaS companies always differs from startups and small to medium SaaS companies. They usually have payback periods longer than 2 years.
However, it does not mean that you don't need to track your payback periods for current customers. The importance of this metric can never be played down.
Why is CAC Payback Period Important?
The CAC Payback Period is critical because it helps SaaS businesses figure out how much time it will take to earn back the expenses incurred when acquiring a new customer. However, there are some downsides too. Let's discuss them systematically.
CAC Payback Period Pros
It helps you make better decisions
Most financial experts keep this metric as a thermometer for their business. They desire shorter payback periods and deride longer payback periods. This metric enables you to make the right decisions at the right time.
Investors are more likely to invest if you have a promising CAC payback
It is also necessary to show this metric when you seek investors for your SaaS company. What data would you present to the investor? An investor understands only the language of payback periods. A presentable study on the CAC payback period could help you grab the attention of creditors for your business.
Keep a keen eye on CAC payback periods. We advise startups to keep their analytics updated. And not think of reinvestment till your CAC payback period is less than 12 months. This way, you would play safe, and your business will be healthy.
CAC Payback Period Cons
While the CAC Payback Period is essential, it shouldn't be viewed in isolation. While lower CAC months are considered preferable, there are many examples of successful SaaS companies with high CAC months, like Xero and Quickbooks.
It would be unfair if we do not educate you on the risks involved in obsessing with CAC payback periods. There are some downsides too.
The CAC payback period does not consider the future profitability of the customers. It only considers the time frame until the customers break even on the costs incurred for acquisition. That's it. What if they churn after the period is over? And what if they start to spend more on you after that time period? The CAC payback period is silent on that.
Another factor is that the CAC payback period does not bother the time value of money. The time value of money is a concept that a specific amount of money is worth more than it will be after a few months or years. The CAC payback period takes the money as of constant value.
The combination of these factors means that the business requires a substantial amount of cash to grow its revenue in the short term but can consistently deliver positive unit economics in the long term.
How to reduce CAC Payback Period
You would certainly be interested in knowing about the ways you can reduce your CAC payback period. We tell you there is no blanket approach for that. Instead, you would have to adopt a very agile and proactive approach to reduce your CAC payback period.
Optimize your marketing costs
The first point is that you need to optimize your marketing and sales costs. You should not overspend on customer acquisition in the first place. Go and check your marketing and sales team. Eliminate any redundancy you find there. The lower the value of CAC is, the shorter will be the CAC payback period.
Increase your ARPU
To increase Average Revenue Per User (ARPU), you should create packages. There could be basic, standard, and advanced packages for the customers. Try to sell your standard package to the basic user and your advanced package to the standard customer. And monetize your free users!
For user problems, you can have add-ons. Sell the customer add-ons. Up-selling and cross-selling are the only ways to increase APRU. And it is a no-brainer.
Remember: a user buys something according to their needs and the value they get
Increase Your Conversion Rates
You have analyzed your customer acquisition cost and now identify where you get the most bang for your buck. Look at your sales expenses and double down on the most cost-effective strategy.
Review your marketing strategy
Review your marketing strategy. See where your prospective customer comes from. Optimize your marketing expenses and marketing efforts accordingly. Leave the marketing strategy that does not work for you.
Avoid Customer Churn
Customer churn will be detrimental or your company. You will never be able to break even on customer acquisition if the customers do not stick around long enough till you have recovered the costs incurred on them. Invest in customer relationship management to keep existing customers and discourage customer churn.
The CAC Payback period tells you after how many months a user will become profitable to you. It is an important metric that tells the companies when the investment will recoup, and they start making profits. The efficient study of the CAC payback period enables you to look into the health of your business and behave in accordance.