The aim of a business is to grow and the way to do that is to gain more customers than you lose. The easiest way to do this is to use money to promote or incentivize people to use your product. The problem with this approach is that not all growth is good growth.
So what counts a bad growth? Well, any growth where the Customer Acquisition Cost (CAC) is more than the revenue from the new customer.
Customer Acquisition Cost (CAC)
In essence, the CAC is an estimate of the cost to gain a new customer.
$$CAC = {Sum\ of\ all\ sales\ \&\ marketing\ activity\ costs\over No\ of\ new\ customers\ added\ due\ to\ these\ activities}$$
These sales and marketing costs include online activities such as AdWords, Re-marketing, Blogs, Email Campaigns etc. It also includes offline activities such as field sales, brochures, posters, t-shirts, stickers. For a good introduction to all the different ways to advertise and promote your business I would recommend the excellent book Traction by Gabriel Weinberg.
You should also include any one off customer success work needed to get the customer up and running to give a more accurate customer acquisition cost.
For most SaaS businesses the initial cost of acquiring a new customer can be quite high. This is not really surprising as it often involves a lot of personal contact and hand holding to get the initial customers up and running. During this time the objective is to gain a perspective on how the customer sees your product and how to simplify the on-boarding process and to figure out which traction channel is the most cost effective..
As the Y-Combinator founder Paul Graham said, startups initially need to do things that don't scale. Therefore calculating the CAC only makes sense once the business has reached a certain maturity.
Customer Lifetime Value (LTV)
The CAC is really useful when it is considered in conjunction with another metric, the Customer Lifetime Value (LTV) of a customer. This is the economic value of a customer over its lifetime. The simple calculation for the LTV is:
$$LTV = {Average\ Monthly\ Revenue\ Per\ Customer\over Customer\ Churn}$$
In the easy days when you have very few paying customers your Customer Churn will be 0% (e.g. you haven't lost any customers yet). This case it is best to assume it is 16.67% to simulate an average life of a customer equal to 6 months.
There are more complicated ways to calculate the the LTV incorporating customer service costs, interest rates etc.
CAC to LTV Ratio
Many Venture Capitalists (VC's) keep a close eye on the LTV/CAC ratio.
$$LTV:CAC\ Ratio = {LTV\over CAC}$$
This ratio helps to understand the sustainability of a SaaS business. A ratio where the CAC/LTV > 3 indicates that the business is essentially self funding. Whereas a business where the CAC/LTV is less than 1 indicates that business is chewing through its cash reserves.
So, it acts as a barometer for determining how much or how little you should spend on marketing and/or sales to maximize your growth and stay ahead of the competition.
The LTV:CAC ratio is a useful indicator that’s great for predicting future growth, but it can be quite changable. For example, your LTV could drop if a new competitor enters the market driving up your churn. Or your LTV might increase if you make a really successful product change.
So, it's not perfect but it is certainly a leading metric to watch.
