Why the best SaaS companies have a payback period of 0 months!
As a VC we are assessing companies and their financials on a daily basis.
Like most investors, we get particularly excited about capital-efficient businesses. These companies need less cash to scale, which means less dilution for all stakeholders in follow-on rounds.
One of the main metrics to assess capital efficiency is the payback period.
The payback period or earn back period refers to the number of months that it takes to recover the costs of acquiring a customer (the CAC). It is calculated by dividing the CAC per newly acquired customer by the average monthly recurring revenue per customer multiplied by the gross margin (see below):
A low payback period is crucial to capital-efficient growth. Simply put, if you quickly earn back your acquisition costs, you can re-invest your precious dollars in the business and less working capital is required.
Benchmarks of SaaS companies show that a payback time of >18 months is considered sub-par, between 12–18 months is acceptable and a payback period of 6–12 months is considered attractive.
This method of calculating the payback period is indeed correct for companies that invoice every month (whereby cash-flow = P&L) but overstates the payback period for companies that receive annual pre-payments (where pre-payments are activated on the balance sheet and recognized monthly).
A SaaS business — let’s call her SaaS1 — spends EUR 800 (CAC) to close a contract with an ACV of EUR 1,200, paid upfront in month 1. The prepayment is classified as deferred revenue and only EUR 100 is recognized as revenue in the P&L of SaaS1 every month. Assuming a margin of 80%, the payback period according to the formula is 10 months (CAC EUR 800 / (EUR 100 MRR * 80%). However, SaaS1 has received the full CAC back in month1, so the payback time is essentially not 10 but 0 months!
This also means that when a SaaS company receives an annual prepayment, it doesn’t make a difference whether the payback period is 3 or 11 months. One could argue the same for a payback period of 13 or 23 months. Let me explain: with a payback time of 13 months, a company receives 12/13th upfront and has to wait until month 13 to receive the last month. Also with a payback period of 23 months, the company will recover the CAC in full in month 13 (of course, in the example of 13 and 23 months, the company in the first year would have to pre-finance 1 month vs. 11 months, even though the payback time is the same).
In short, assuming the LTV: CAC equation is healthy, I see the following takeaways:
- Companies with annual pre-payments may consider boosting growth with a slightly higher payback period (e.g. from 13 to 23 months).
- Companies with a monthly invoicing schedule may consider providing a discounted rate for annual prepayment. This can reduce the need for an expensive equity investment because there is less working capital required for pre-financing customer acquisition costs.
Curious to hear your thoughts!