http://techcrunch.com/2015/08/28/the-math-behind-saas-startup-valuation/?

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The Math Behind SaaS Startup Valuation

One of the most critical metrics for software companies but also one of the most difficult to
measure is the lifetime value of their customers (LTV). The lifetime value dictates how a
company should spend its marketing and sales dollars.
Unfortunately, many early stage startups struggle to measure LTV, because they havent been
around very long and, consequently, havent seen a large number of customers through their
lifespans with the product.
Most software companies calculate their LTV and a critical related metric, customer acquisition
cost (CAC), using the following formulas:

But rather than measure it in this way, an early startup must estimate its customer lifetime value.
So, whats the best way to do this?
One of the most innovative techniques Ive seen was created by a Redpoint portfolio company
founder, Vik Singh, CEO of Infer. Viks innovation is using a rolling sales and marketing period
to estimate both LTV and CAC. Ive asked Vik to explain his approach below.

Shortcomings Of Traditional LTV And CAC Calculations

If youre running a startup like me, there are three key problems with the standard formulas for
determining LTV and CAC:

Attributing sales and marketing spend to actual closed, won deals is very difficult in
general, and even more pronounced for emerging SaaS companies that typically do not
possess the marketing infrastructure for doing so.
You need years with a reasonably sized base of paying customers to truly understand
your LTV, and you have to assume that your product or service isnt changing much (for
your LTV to hold up over time). These factors pretty much dont exist for early SaaS
companies, and can easily break for even later-stage companies that are highly
innovative.
These are backwards-looking metrics. They tell you what your LTV or CAC was for a
prior time period, but not what its shaping up to be, which is key for actionability.

While its often helpful for investors to use the traditional calculations (for example, one year of
growth spend divided by the following years number of new customers) when generating comps
for industry benchmarking across portfolio and publicly traded companies, these kind of
generalizable formulas arent accurate or forward-looking enough to inform internal decision
making and run a business.
As a company executive, you have access to more detailed numbers, a la your CRM and
accounting systems so its possible to build more advanced forecasting models to derive these
metrics.
However, I would contend that you need rules of thumb that can be computed effortlessly. You
cant improve something if you cant measure it, right? If you consistently monitor these key
SaaS metrics, you can be more nimble about increasing LTV or decreasing CAC.

Calculating Expected CAC And LTV

So, heres what I came up with thats easy to compute, doesnt depend on much closed sales
data, is forwarding looking and better addresses the attribution gap. Lets go
The first thing you need is your cost per opportunity. Say you spent $10 million on sales and
marketing (fully loaded including salaries) in the month of June, and created 2,000
opportunities that month. Your cost per opportunity for June would be $5,000. This assumes a
short opportunity lag time, which is common in the SaaS world, but you also could use the prior
and following months to do the calculation if your sales cycle is longer.
Next, you want to determine your expected (as in probabilistic terms) CAC, using your
opportunity win rate and average deal size, which shouldnt fluctuate much. If, historically, your
win rate has been 20 percent, and your average annual contract value (ACV) is $30,000, then
your ECAC would work out as follows:
Expected # of New Customers = 0.2 (opportunity win rate) x 2K (opportunities) = 400
Expected CAC = $10 million (fully loaded growth spend) / 400 (expected new customers) = $25K

If you divide ECAC by your average ACV, you will derive the payback period (in months)
the time it will take for you to recoup your growth spend on acquiring that customer. In this case:
Expected Payback Period = $25K (ECAC) / $30K (first-year ACV) x 12 months = 10 months

The customer pays for itself two months before its up for renewal (assuming an annual
contract), which is not bad. Related to payback, you can compute the return on investment (ROI)
over a subscription period. For example:

Expected first-year ROI = $30K (first-year ACV) / $25K (ECAC) = 120 percent

And, if you know (or think) your ACV will appreciate 15 percent (so 115 percent of the first year
ACV, or 1.15 in decimal form) if the customer renews for another year, then your expected ROI
for two years of subscription works out as follows:
Expected second-year ACV = $30,000 * 1.15 (renewal increase) = $34,500
Expected two-year ROI = ( $30,000 (first-year ACV) + $34,500 (second-year ACV) ) / $25K (ECAC) = 258 percent

To compute LTV, you need to estimate how many years your typical customer will stay with
you. This can take several years to find out using actual sales data, so if you dont know, then be
conservative based on other companies in your space (ask your investors!).
Lets assume a three-year average lifetime then, based on the assumptions above and on
annual contracts (versus month-to-month service), you can forecast LTV as follows:
Expected LTV = ( $30K (average ACV) + $30K (average ACV) * 1.15 (renewal increase) * 1.15 (renewal increase) ^ (3-year lifetime 1) 1) /
(1.15 (renewal increase) 1) = $104,175

It will take more than two years to know your actual renewal increases if your renewals happen
annually and you probably wont press hard on renewal increases after just one year with your
earliest customers.
You can try analyzing industry comps to determine a good target, or just be conservative and
remove the appreciation assumption, which also reduces the complexity of the formula (it would
become $30K * 3 [estimated customer lifetime] = $90,000).
Finally, lets put it together divide ELTV by ECAC. Using the first ELTV value of $104,175,
and dividing that by the ECAC of $25K, we get 4.167. From a company health perspective and
what Andreessen Horowitz expects to see for a good SaaS business (3X or more), this is very
good.

Continually Predict Your Business

Ask most SaaS executives what their CAC is and theyre likely to cite a number from a previous
quarter or year. But because ECAC is based on the number of opportunities generated very
recently (whether closed or not yet closed), it provides guidance on your current sales pipeline.
Another great thing about this technique is that you can adjust any rate and see how it changes
the figures (i.e., decrease average deal size, increase the opportunity win rate and decrease
lifetime value to see what the impact of, say, lowering your pricing scheme might look like).

Of course, the attribution of opportunities to growth spend isnt perfect, but its much better than
the outdated CAC used by most SaaS companies with which Ive worked. This approach calls it
out, so youre forced to make an assumption, which is far better than the one-size-fits-all
formulas were given by the investor community.
With the methodology above, an SaaS entrepreneur can compute their key SaaS metrics at any
time. More frequent, useful guidance about a business will create a competitive edge by letting
you read, predict, monitor and take advantage of market dynamics faster than other startups that
might be crowding your space.