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Trusting Payback Period In An Era of CLTV

As SaaS companies continue to enter the marketplace, continually evaluating and monitoring performance has become essential. Metrics play a crucial role in assessing the financial health and growth potential of a SaaS company and one of the most loved and used is Customer Lifetime Value (CLTV or CLV). CLTV is overrated and over relied upon, particularly by small and medium independent software vendors (ISV’s) that sell annual contracts and do not have years of historic data.

The little loved metric, Payback Period is a superior measure of sales and marketing effectiveness and should be a cornerstone KPI.

Don’t believe me? Let’s dig in.

Understanding SaaS Customer Lifetime Value (CLTV)

Customer Lifetime Value (CLTV) is a cornerstone SaaS KPI. SaaS is all about the long-term and recurring revenue and this metric attempts to measure the net profit a company can expect to earn from a customer throughout their entire relationship. CLTV takes into account:

Average revenue per user (ARPU)
Average customer lifespan via net revenue churn rate
Customer Gross margin

While CLTV provides insights into the long-term value of customers, the limitations are found in the word average. The assumptions can be particularly misleading for companies:

that lack history and reliable historic customer data
with changes in product lines
seeing a sudden shift in trends
with customers that with greater account value dispersion, churn variability, and expansion/contraction potential

By virtue of size, smaller or emerging SaaS companies have greater sensitivity towards changes in the independent variable of the calculation. If the organization has an unrepresentative period, deal, and customer, they risk of overstating or understating their customer value and marketing effectiveness. See below for some example calculations to illustrate the point.

Organizations can mitigate potential data distortions in results by performing in-depth customer, industry, and cohort analysis, but not all companies have those resources.

The Limitations of SaaS CLTV

Time Horizon: The market is growing and evolving quickly. The past, often doesn’t represent the present, let alone the future. CLTV calculations typically require data spanning several years to accurately estimate the customer’s lifetime value. However, this long-term focus can hinder decision-making in the short term and whether today’s efforts are working. If the dynamics of your product, market or customers are changing, your past may not be representative of your present or future.

Cash Flow: CLTV doesn’t consider the timing of revenue generation. It fails to account for the time it takes for a company to recover its initial customer acquisition costs, which can impact cash flow and profitability. This is particularly crucial for SaaS companies that heavily invest in customer acquisition and need to demonstrate quick returns on their investments. If your company is bootstrapped or has limited funds, beware of relying on CLTV!

The Benefits of Payback Period

Focus on Short-Term ROI: Payback Period measures the time it takes for a SaaS company to recoup its customer acquisition costs. By providing a clear timeline for cost recovery, it helps prioritize investments and evaluate the profitability of different customer segments or acquisition channels. This focus on short-term return on investment (ROI) is crucial for SaaS companies operating in a rapidly changing market environment, particularly for newer organizations and companies with new customers being unrepresentative of historic customers.

Agility and Adaptability: SaaS companies need to stay agile to respond to market shifts and customer demands effectively. The Payback Period enables quick evaluation of customer acquisition strategies and channels. By understanding how long it takes to recoup costs, companies can make data-driven decisions to optimize their resources and adapt their approach accordingly. This is particularly important for companies with limited cash.

Cash Flow Management: Payback Period allows SaaS companies to closely manage their cash flow. By identifying how quickly they can recover customer acquisition costs, companies can better plan their budgets, investments, and expenses. This metric provides a clear picture of when the company will start generating positive cash flow from new customers, ensuring financial stability and sustainability. In essence, Payback Period works a little like a P&L for the sales and marketing functions.

Scalability Assessment: SaaS companies thrive on scalability. Payback Period provides valuable insights into a company’s ability to grow and expand its customer base efficiently. By reducing the Payback Period, companies can accelerate growth and reinvest profits sooner, driving further expansion.

Conclusion on Payback Period vs CLTV

Customer Lifetime Value (CLTV) is an important metric for SaaS companies, but beware of its limitations. It relies on longer-term time horizons and may use unrepresentative assumptions that make it less suitable for agile and rapidly growing SaaS companies.

In contrast, the Payback Period offers significant advantages by focusing on short-term ROI, cash flow management, agility, and scalability assessment. By incorporating the Payback Period into their SaaS metrics, companies can make informed decisions. They can better assess the effectiveness of sales and marketing efforts, optimize their resources, and achieve sustainable growth.

While there is no “right” answer on which metric to use (why not use both?), we think Payback Period is a more useful metric for smaller, dynamic, resource limited, or fast growing SaaS companies.

If you don’t know where to start, Sanitas Accounting can help. Reach out and we’d be happy to help with strategy and implementation on improving your cash flow.

Example SaaS CLTV Calculations & Sensitives

Uneven distribution of customers or outsized changes to the assumptions might impact your CLTV value and should be monitored closely. To illustrate the impact, let’s see how changes in assumptions can impact CLTV.

Average Revenue per User (ARPU): $50 per month
Churn Rate: 10% per month
Gross Margin: 80%

To calculate the customer lifespan from the churn rate, we can use the formula:

Using this customer lifespan, we can calculate the CLTV as follows:

CLTV = ARPU * Customer Lifespan * Gross Margin

Substituting the values, we get:

CLTV = $50 * 10 * 0.80 = $400

Outsized Customer Joins

Suppose the company lands an outsized customer who joins at triples the average revenue:

CLTV (with outsized customer joining) = ($50 + $100) * 10 * 0.80 = $1,600

The inclusion of the outsized customer significantly increases the CLTV to $1,600 (4x increase!), demonstrating the impact of high-value customers on overall customer lifetime value.

Outsized Customer Churns

Let’s assume an outsized customer churns, resulting in a loss of their revenue and a 20% reduction in ARPU:

CLTV (with outsized customer churning) = ($50 * 0.8) * 10 * 0.80 = $320

In this case, the CLTV decreases to $320 due to the loss of the higher revenue from the churned customer.

These examples highlight how the addition or loss of an outsized customer can have a significant impact on CLTV calculations. It illustrates the importance of identifying and managing high-value customers within the customer base.

These sensitivity calculations demonstrate how changes in assumptions impact CLTV. Adjusting the ARPU, churn rate, or gross margin can have varying effects on CLTV, emphasizing the importance of accurate inputs and monitoring metrics closely. SaaS companies can use these sensitivity analyses to identify areas for improvement and make informed decisions to optimize customer lifetime value.

For those curious, we recommend performing similar sensitivity analyses for changes in the churn rate and gross margin.

SaaS Metrics: Companies Needs to Ditch CLTV & Use Payback Period