How to calculate CAC Payback Period (the right way)

A deep dive on customer acquisition cost and payback period (with a template)

Apr 16, 2024

*Support for Mostly metrics comes from Mercury, the fintech startups use for banking and all their financial workflows.*

CAC Payback Period is one of the most referenced, yet miscalculated, metrics in the tech world. Today we’ll cover the following:

I. The Art - What it is

II. The Science - Two preferred ways to calculate it

III. The Components - The data inputs

IV. A template for you to use in your own calcs

V. What does “good” look like? - Benchmarking real companies

VI. Can CAC Payback be too low? - With advice from Alex Clayton of Meritech

VII. Anything else to watch out for? - Red flags to beware of

The Art

Customer Acquisition Cost is what you spend in sales and marketing costs to go out and get a net new customer.

CAC Payback Period is a derivative of Customer Acquisition Cost, and spits out the number of months it takes to breakeven on that new customer.

CAC Payback Period also incorporates the customer support and maintenance costs associated with getting the customer to stick around (COGS, or Cost of Revenue).

CAC Payback Period is important because it shows how efficient your GTM machine is. Investors care about it because you can’t trade a buck for eighty-five cents forever, and this indicates if you’ve built a model that can get to sustainable unit economics.

The Science

Below are the two most common ways to calculate CAC Payback.

Neither is inherently better - I’m providing options because you won’t always have all the components you need, and might need to be flexible.

Whether you use COGS as a dollar figure, or as a % of revenue, either way, you need to make sure you gross margin adjust your CAC Payback Period.

The Components

Sales and Marketing Expenses: S&M should be lagged according to the average sales cycle of the sales engine you’re measuring. The goal is to align the dollars you spent in the past to generate the sales you are finally seeing today. This is especially important if you are hiring GTM people really quickly. You don’t want the costs of new hires who haven’t sold anything yet (deadbeats!) to show up in the CAC Payback for today’s additions. Examples of lagging by segment:
- Enterprise sales cycle of 180 days = 2 quarter S&M lag
- Mid-Market sales cycle of 90 days = 1 quarter S&M lag
- SMB sales cycle of 30 days = 0 quarter S&M lag
Cost of Goods Sold (COGS): This includes hosting costs, customer support, and customer success. It’s basically the ongoing costs you incur to keep your install base around. It’s taken from the period you are measuring, with no lag.
- Not to beat a dead horse - but you DO NOT lag your COGS (or gross margin)
New Revenue Additions: These are the in-period additions to your topline, preferably measured in ARR.
- It is NOT your ~~total~~ Revenue, MRR or ARR - just net new, and expansion if you have a land and expand or usage based model.
- Ideally it is not your ~~GAAP revenue~~, which is an accounting based measurement of topline (but can be used in a pinch… more on that below).

Generally, all of these figures are best measured on an aggregated trailing twelve month basis to smooth for seasonality. Most companies add more ARR in their fourth quarter than the rest of the year. This means your S&M will technically go back 5 quarters (or 15 months) if you are lagging by one quarter. Otherwise, looking at it monthly can result in a graph that looks like a heart EKG.

A template for calculating CAC Payback Period

CAC Payback Template

What’s “good” look like?

The median CAC payback period for private software companies is somewhere under 18 months, depending on scale. Generally speaking, the smaller you are, the faster you need the money back, hence the need for a shorter CAC payback cycle.

Kyle Poyar of Growth Unhinged did an excellent job of breaking CAC payback period into Annual Recurring Revenue (ARR) cohorts below. You can think of this as your Seed through Series D-ish benchmark.

It’s important to note that “good” varies significantly for larger, public companies who tend to focus their resources more heavily on a prolonged Enterprise sales cycle and have better access to capital.

I ran CAC Payback Period for public companies growing 30% to 50% year over year using Meritech’s Benchmarking tool.

Klaviyo is leading the way at under a year, followed by Crowdstrike and Samsara, who are under 1.5 years. The median for this cohort is 24.3 months, or just over 2 years. But you can see there are a couple companies taking ~3 years to recoup costs.

Can CAC Payback be too low?

Yes. It might indicate you are leaving money on the table and under investing in your go to market engine. The Mendoza Line for small private software companies is ~6 months and ~10 months for public software companies.

At these points you start to blur the line between highly effective, and not spending enough to grab the market.

You can also triangulate based on Net Dollar Retention rate.

In fact, Metrics Guru and VC Alex Clayton of Meritech Capital spoke to this on the Run the Numbers podcast. He thinks companies with +140% Net Dollar Retention AND Less than 18 months of CAC Payback period should spend MORE on customer acquisition. Here’s why:

“If you think about the value of a software business it’s the net present value of future cash flows. So let’s think about those future cash flows and what’s comprised there.
If you have a business that’s had 130% to 140% net retention per year and that’s consistent, that means your base is growing 30% to 40% per year. Every single dollar that you acquire over time will continue to grow and compound.
And let’s say your gross margin is relatively stable at 80%.
Software companies incur the cost to acquire a business up front. So we spend a lot of money to acquire them, the cost to upsell them / expand them over time is relatively less, and our gross margin is stable.
What does that mean? It means that base of revenue will become extremely profitable over time…
-Alex Clayton on the RTN Podcast (Apple | Spotify | YouTube)

In other words, if you know your customer is going to stick around AND expand over time, it’s worth it to spend a little more now in order to let them compound year after year for minimal additional cost. Allowing the same customers to grow over time will drive shareholder value.

Are there differences in CAC Payback by Industry?

Absolutely. Wealth management and insurance companies might be willing to wait up to three years given their retention rates. Think about it - how often do you shop for car insurance or move your 401K? No that often.

On the other side of things you have mobile phone developers who know you’ll get frustrated playing Words with Friends once you lose to your grandmother for the fifth time, and therefore require something closer to 30 days to break even on their app.

And on the extreme side of the spectrum, if you are in ecommerce or direct to consumer, you need to have a negative CAC Payback Period - you need to be value accretive upon purchase, as there’s no guarantee your buyer comes back for a second silicon rubber wedding ring.

Anything else to watch out for?

Yes, there’s a nearly 100% chance that whatever CAC payback period a company self-reports is understated. Check to see if overhead (rent, office expenses, IT) and share based comp (often a massive non-cash charge for startups) are contemplated within S&M and COGS. Someone’s gotta foot the bill.

Also, we are leaving out R&D spend. Why do I point out the obvious? Well, PLG (product led growth) companies rely on their product to do a lot of the actual selling. It’s common for a product to be built in a manner where a customer can self serve with a credit card. This takes engineering efforts (and dollars) that are not contemplated, but are kinda-sorta a cost of sales. Just keep in mind that PLG companies, while known for the efficiency, may get a tad of extra credit when it comes to CAC Payback Period. While they are spending less on S&M, they may be spending a lot more on R&D to make that “low cost, low friction” distribution possible.

As Kyle puts it:

PLG companies invest in R&D as part of their customer acquisition mix (free sidecar products, freemium, growth teams, self-service purchasing, etc.). Atlassian, for instance, spends $2.43 on R&D for every $1 on sales and marketing. On the flip side, DocuSign has the inverse ratio, spending $2.15 on sales and marketing for every $1 on R&D.
But R&D investment usually isn’t factored into the CAC payback period calculation, blurring visibility into the health of the growth model.
If you’re investing in PLG, plan to stay below the “normal” CAC payback benchmarks.
-Kyle Poyar of Growth Unhinged

And a final note for public companies: If you are doing analysis on public companies and they haven’t disclosed their ARR Additions (which most do not) you will be forced to use change in total revenue year over year.

Just know that the CAC Payback period you calculate will be “correct” but punishing compared to private companies using ARR Adds, for two reasons:

You are using GAAP revenue, which is amortized over the contract length, and lags ARR (an exit value which immediately benefits from growth in any period)
You are using GAAP revenue, net of churn. In the formulas above we are using Gross ARR additions for the period that the sales teams were able to sign, and not yet factoring in any Churn or Shrink, which will eventually hit Total ARR

This could cause a 10% to 20% overburden from public to private, depending on Churn and ARR vs Gaap revenue growth in any period.

Whew!

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Run the Numbers

Available on Apple | Spotify | YouTube

Another week, another public company CFO! We’re on a tear!

This week my guest is Jeff Cooper, the CFO of Guidewire, a publicly traded vertical software company serving the insurance industry. On this episode we cover:

What it’s like to have enterprise deal cycles that can take YEARS to close
The benefits of owning the control point within a customer’s tech stack
How to balance burning through your market, when you are a vSaaS company
The pros and cons of having a non standard fiscal year
Guiding to ARR
And how to think about the value of professional services within your valuation, and if you should outsource it to partners or do it yourself