CAC (Customer Acquisition Cost) Formula is Overly Simplistic

One common SaaS KPI that investors like to tout is CAC (Customer Acquisition Cost). It’s almost always a question in diligence on any transaction.  

CAC is traditionally defined as how much do you need to spend on sales and marketing to acquire new customers.   The conventional formula is as follows:

                 Sales & Marketing Cost

CAC =       ——————————–

                 # of New Customers 

Most people consider it a a measure of how efficiently and effectively you can drive growth. I will argue this is simply not true there are many other drivers to growth.

The CAC formula works better if you are purely driving leads from sales outreach or marketing efforts.   However, that is a very limited set of SaaS businesses. It also assumes your product or service has no influence on your CAC.  As the saying goes, if a customer is happy with your product they tell six other potential customers, if they are unhappy they tell ten!

Most SaaS companies are a combination of leads from S&M and referrals.  In fact many established SaaS companies get a majority of their new customer demand from referrals based on the reputation of their product and customer service not their sales & marketing.  If you invest less in your product or customer service,  your CAC could become less efficient.  If you spend more on your product and service,  your sales desk will convert inbound demand more twice as efficiently and your CAC will improve.  The mistake people make is they think they can scale a business on “CAC” alone. This is not true.

Running a business well means being smart about allocating capital.   What are the most effective investments to drive growth over the short, medium and longer term; Product, Sales, Marketing, Customer Success/Support and HR?   You want to be measuring increased revenue growth against increased operating investment. Perhaps we call is Revenue Return on Invested Capital or RROIC:

                   Incremental Operating Spend

RROIC =    ————————————–

                  Increase in Recurring Revenue

If you can return $1 in recurring customer revenue to $1 in incremental operating spend per year, you can grow break-even with no further capital. This assumes you are already running cash break-even –  if not you would need to reduce your operating spend.    Over time you may become more efficient as customer referrals become a larger part of your new customer demand and can add $2 in revenue per $1 in spend.  Then you graduate to ROIC – where operating investment returns operating profits. Here you have even more discretionary capital to either invest in the business, or return to shareholders.  SaaS companies go from operating losses, to break even to 30-50% profit margins as they mature. PE funds like Vista Equity Partners and Thoma Bravo will take established SaaS companies that are still breaking even, and transform them into profit engines to drive shareholder return.

Many operating investments support growth indirectly or over different time horizons.  You can also look at prior year operating investment over current year results to understand the correlation.    While RROIC is a broad calculation, it was a simple way to explain to shareholders the value of our operating investments.