SaaS Math :: Calculating a Tolkien Number; One Number to Rule them AllPosted by Seth on Oct 19, 2012 in Start-up Life, work | 1 comment
Lots has been written on SaaS math and how to manage it, what matters and what to watch. You can read excellent content from David Skok, Joel York and lots and lots of others. Without regurgitating their thinking what I really want to see is ONE NUMBER that tells us me exactly how a SaaS company is doing. A single number that takes the temperature of the business.
Step 1- Isolating what metrics matter. We are going to focus on 3 numbers to derive the fomula:
- LTV- Estimated Lifetime Value of a Customer [must know what a customer is worth]
- CAC- Custom Acquisition Cost (fully loaded defined) [must know what it costs to get a customer]
- NTM Revenue- Next Twelve Months of Revenue. [must know how fast you recover your cost]
Step 2- Ratios The two core ratios most often derived from the above are LTV/CAC and CAC/NTM Revenue. The first tells you the ratio of your customer value to your customer cost and the second tells you how fast you recover your acquisition costs. Rule of thumb you want to see LTV/CAC >3 and CAC/NTM <1 (meaning you make 3x your cost and recover your cost within the first year– which also has obvious cash flow implications).
Step 3- Metrics Mashup Let’s look at the ratio of the ratios in Step 2, that is how your fundamental value capture compares to how fast your recoop costs:
- Value/Recovery Speed
- (LTV/CAC) / (CAC/NTM)
- Which any good freshman in high school will tell you is the same as: (LTV*NTM)/CAC^2).
- One number to rule them all? let’s call it the “Tolkien Number”.
- You want your Tolkien Number to be at least 4 and ideally 5+
Really interestingly, this reinforces what the best SaaS marketers know is that managing and decreasing your Customer Acquisition Cost is the single biggest factor in increasing your Tolkien Number and value maximizing your marketing and growth. True, increasing your Lifetime Value or the speed you get paid back on the the acquisition costs will help your Tolkien Number a lot- but the denominator is the square of your Customer Acquisition Costs so the bigger you costs your exponentially hurt yourself. If your CAC goes up you pay the price (literally).
Step 4- Data validation & visualization
- The chart below shows Tolkien Numbers while assuming your Customer Acquisition Cost is constant at 2- look how the LTV and NTM numbers impact your number (note that your Next Twelve Months revenue cannot exceed your LTV):
- Now look at what happens to your Tolkien Number if you can’t charge people any more (LTV=fixed @ 6 and you can’t get paid any faster, say NTM=2) as CAC changes. It gets crushed.
So the “Tolkien Number” gives a quick metric capturing the value of your Revenue, Speed and Costs- controlling these is all that matters. Aim for at least 4 and crush it at 10.