Minimizing the Customer Acquisition Cost (CAC) Ratio

Recently, I’ve had a few conversations with people regarding my version of the Customer Acquisition Cost (CAC) ratio. As a reminder, my version of the CAC ratio is: [($Total Sales + $Total Marketing)/$First Year Contract Value]. The objective is to make the CAC ratio less than 1 which implies a customer acquisition payback of a year or less. This is the ratio I recommend companies use to measure their sales/marketing effectiveness. I discussed this a year or so ago in this blog in a post titled The Capital Needed to Create a SaaS Company”.

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Will Price when he was with Hummer Winblad and Phillipe Botteri at Bessemer Ventures suggest slightly different approaches and put the Sales and Marketing costs in the denominator with FCV on top of the equation. This makes sense if you’re looking at a company from an investor’s view but I come at things more from an operational perspective and developed my approach in 2004 when I was running Siebel’s CRMOnDemand division. I found that my approach allowed me to easily determine whether or not my Sales and Marketing teams were paying back our customer acquisition costs within 1 year and to track the trend. With the other mathematical approaches, in my opinion, it’s a little harder for the operational executive to determine what’s going on. All approaches are mathematically sound; it’s just a matter of preference.

One of the common issues I’ve been debating is why not use Total Contract Value v only First Year Contract Value so that Sales and Marketing get complete credit for multi-year deals.

Here is how I like to think about the issue.

With early stage companies that use a SaaS business model, companies should be primarily concerned with the preservation of cash not necessarily revenue.  The CAC ratio as I have proposed it focuses on actual Sales and Marketing expenses – which takes real cash – and the First Year Contract Value which represents actual first year cash inflows.

For early stage companies, I feel this is the most appropriate way to look at the CAC ratio because it measures ‘real’ cash inflows v ‘potential’ cash inflows. As the company matures and revenue becomes increasingly more important and cash less so you may want to adjust this ratio to give at least partial credit for multi-year deals.

I want to also comment a little further on the “$Total Marketing” in the CAC ratio. To really maximize effectiveness here, companies must hold the marketing function accountable for accurately creating and predicting future revenue for the company. Rather than just being responsible for managing corporate brand, marketing must be transformed and own the lead generation function and held accountable for accurately predicting out of period, future revenue.

Asking the sales organization to predict future revenue is like asking a sprinter to run a marathon. Sales is incented to predict and close in period revenue. They are terrible at predicting out of period revenue – just take a look at the garbage your CRM system contains in terms of future pipeline coverage. And, many companies make guidance statements based upon this highly subjective data – no wonder so many companies miss their forecasts.

As the former head of marketing for a multi-billion dollar software company, I am all too familiar with the pressure of delivering leads and generating statistically relevant data for Wall Street predictions. Consequently, I firmly believe the marketing function as we have known it must be transformed. Instead of just a brand organization, Marketing must become accountable for accurately predicting  Q+1…Q+N revenue by building a lead generation and lead nurturing function that monitors, tracks and predicts lead conversions and conversion rates.

That’s why I am a big believer and an investor in Marketo. They are building applications for Marketing and Sales that enable those groups to minimize CAC costs and accurately predict and maximize future revenue. And, whether you choose to use Marketo or another similar application, your company must transform its marketing function and hold it accountable for creating and accurately predicting future revenue: only then can you expect to truly minimize your CAC ratio.

  • http://www.HubSpot.com Dharmesh Shah

    I could not agree more.

    One of the surest signs of a successful SaaS business today is the degree to which marketing is measurable and where the economics of CAC vs. LTV make sense.

    Great companies like Salesforce.com, ConstantContact, Omniture and others all had this as a significant factor.

  • http://www.justinpirie.com Justin Pirie

    Spot on Bruce- I think companies will run a lot more healthily if they’re run on first year rather than lifetime when calculating their CAC ratios.

    Marketing automation is where SaaS players need to focus their efforts in 2010 and marketing needs to become more accountable to revenue. Marketo looks to be positioned healthily to take advantage of it.

    I think marketing automation will be the focus of “This Week in SaaS” this week. Last week’s here if you’re interested: http://bit.ly/55dCpk

  • http://www.saasmarketingstrategy.com Peter Cohen, SaaS Marketing Strategy Advisors

    Bruce, I agree with your approach, especially the need to measure CAC relative to annual revenues and the role of marketing in generating leads and future revenue. (I like the “sprinter vs. marathoner” analogy.)

    The goal of customer acquisition payback of a year or less is a good one, though it’s useful to point that it’s very difficult to achieve in a company’s early years. Salesforce.com and Concur, now very successful, didn’t realize annual revenues in excess of customer acquisition costs until year 3. (See “How Much Capital is Required for SaaS Marketing: http://saasmarketingstrategy.blogspot.com/2009/11/how-much-capital-is-required-for-saas.html)

    But by aiming toward that goal and using marketing automation tools or techniques to carefully manage CAC, SaaS companies should be able to build an efficient marketing machine that will yield a positive CAC ratio over time.

    Peter Cohen
    SaaS Marketing Strategy Advisors
    http://www.saasmarketingstrategy.com

  • http://www.cosential.com Dan Cornish

    I recently attended a roadshow by Marketo. One of the presenters (co-founder of Marketo) whose name escapes me, said that the main reason why they are the fastest growing SaaS company is because they spend $0.90 of every $1.00 in sales on marketing. so, their CAC ratio is close to 1. Our ratio right now is about .3 so this is telling me that I need to spend more, but raising our marketing spend will negatively impact our cash position. How do you manage cash as you grow?

  • http://www.interwest.com/software-as-a-service/ Bruce Cleveland

    Dan: As you’ve alluded, cash is one of the more challenging parts of the SaaS model, assuming your ASPs are similar to Salesforce.com’s. You can be caught in a Catch-22 where you know you need to invest more to acquire customers but if you do, you burn a lot of cash.
    Before I invested heavily in marketing (assuming your sales reps aren’t overwhelmed with leads) and jeopardized the profitability of my company (your website says you are profitable – great job), I would first test whether an incremental investment in marketing generates an incremental increase in sales. If it does in a linear fashion, I might consider looking for external capital in order to finance customer acquisition.

    If venture capital isn’t an option, perhaps taking on a small debt line used specifically for marketing programs – similar to how working capital is used by other companies – might be an option.
    If for every $ of marketing you invest, you can generate incremental revenue that is paid back within 1 year and you have to pay the loan back over several years – even at a reasonable interest rate – that may be a practical solution to managing cash and growth concurrently.

    Regardless of any route you take, I would also look for lower cost customer acquisition strategies that are now available. For example, you sell project management CRM into architecture, construction, and engineering firms. Those industries respond well to reference-based selling. I would make sure I had a strong reference program in place and content produced by industry that linked back to my site.

    Without knowing more, those are my initial thoughts

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