Simple guide to SaaS unit economics

Venture capital funding in software-as-a-service (SaaS) crossed $119 billion in 2023, indicating a growing demand for cloud and subscription-based software solutions. 

Why do venture capitalists (VCs) bet on these companies to do well? 

Some factors are growth potential, founding team, product-market fit, and revenue model.

However, a startup's unit economics plays an important role in determining its operational efficiency and scalability. But, what does SaaS unit economics mean, and how do you calculate it?

Stay tuned and find out!

What are unit economics in SaaS?

Unit economics in SaaS refers to the amount of money won or lost by a SaaS company when they sign up a new customer. The term “unit” primarily refers to customers and not products. Therefore, it is safe to say that unit economics in the SaaS industry is one of the key indicators of whether a business’s customer acquisition and retention efforts are sustainable. 

It is also worth noting that if a business is earning a profit per unit, it is likely to be profitable overall. 

Why is this important to investors? Simple, it helps them assess the business’s financial and operational health, clearing the path for sound investment decision-making. 

Key unit economic metrics for SaaS businesses

As mentioned earlier, unit economics aren't straightforward, with many moving parts that make them tricky to analyze.

Hence, it becomes crucial to track the most relevant and useful metrics to ensure your SaaS business is profitable and the current operational model is scalable.

Here are some important unit economics metrics for SaaS businesses: 

1. Customer Acquisition Costs (CAC)

Customer Acquisition Costs indicate the amount of money spent to acquire a new customer. The expenses include the cost of sales and marketing activities, commissions, salaries, and other overhead expenses

The lower the CAC, the higher the return on investment (ROI) and profitability. 

Formula: 

CAC = total amount spent on sales and marketing in a stipulated time frame/total number of new customers acquired in that period

2. Average Revenue Per Account (ARPA)

A pretty self-explanatory metric, isn’t it? The average revenue per account is the amount of money every customer pays for your SaaS product. 

For example, if you have 1000 customers and a total revenue of $100,000, your ARPA is $100. 

3. Gross Retention Rate (GRR)

The gross retention rate is the total percentage of repeat revenue generated from existing customers during the specified time frame.

Formula:

GRR = (Current Period Revenue - Previous Period Revenue) / Previous Period Revenue x 100

4. Gross profit

One of the most straightforward metrics out there, gross profit indicates the difference between the revenue generated and the total cost of goods sold (COGS). 

Formula:

Gross profit = revenue - COGS

5. Gross margin

The percentage of revenue in your kitty after COGS are deducted is the gross margin of your SaaS company. 

Formula:

Gross margin = [(Total Revenue - COGS) / Total Revenue ] 

6. Customer Lifetime Value (CLTV)

As the name suggests, lifetime value is the average revenue a business can generate per customer throughout the customer’s lifecycle with the company. 

Formula:

CLTV = (ARPA x gross margin)/ (1- gross retention rate)

It is worth noting that the CLTV predominantly depends on the gross profit generated from customers.

7. Churn rate

The churn rate is the total number of users who have stopped using your product or canceled their subscription in a defined timeframe. 

Formula: 

Churn Rate = (Number of Customers Lost / Total Number of Customers at the Beginning of the Period) * 100

8. Total revenue

Total revenue is the amount of money your SaaS business can generate in a predefined period. 

Formula: 

Total Revenue = Average Revenue Per User (ARPU) * Total Number of Users

9. Average Customer Lifetime (ACL)

The average customer lifetime provides a clear understanding of the total amount of time a customer has subscribed to your SaaS product. 

Formula:

Customer lifetime = 1/churn rate

For example, if the churn rate of a SaaS company is 7%, the average customer life will be 14.28 months (1/0.07) 

How to calculate the unit economics of a SaaS business

The unit economics of a SaaS business is primarily determined by the CLTV: CAC ratio predominantly built on all the important metrics mentioned in the previous section. 

While the CLTV: CAC ratio appears to be a straightforward formula, the LTV in SaaS can make it a bit tricky. Calculating the CLTV: CAC ratio is easy once you calculate the CTLV and CAC, determining the long-term feasibility of the existing business model. 

A SaaS company must maximize the LTV while minimizing CAC to optimize the LTV: CAC ratio. 

Calculate the CLTV: CAC ratio in three simple steps. 

1. Determine the CLTV
2. Calculate the CAC
3. Divide the CLTV by CAC

Let’s look at an example:

If your company spends $10,000 on sales and marketing and gains 100 new customers in a period, the CAC in that period will be $10,000/100 = $100. 

It is easy to calculate the CLTV: CAC ratio once you have calculated these metrics individually.  

For the sake of understanding, let’s assume that the CLTV is $500 and the CAC is $100. 

CLTV/CAC in this case would be $500/$100 = 5

A CLTV: CAC ratio of 3:1 or more is generally considered healthy in the SaaS sector. 

Here’s a quick rundown of a healthy CLTV: CAC ratio across different sectors.

Wish to scale your business? Learn more about revenue-based financing for SaaS. 

Understanding the shortcomings of the CLTV: CAC Ratio

Although the CLTV: CAC ratio is considered a gold standard technique for calculating the SaaS unit economics, there are a few notable drawbacks. 

1. CLTV: CAC is a multi-faceted metric

It is very important to note that CLTV: CAC is a compound metric and it is easy to overlook some of the intricate details of a SaaS business that directly impact its bottom line.

As we have seen earlier, the CLTV: CAC ratio involves several metrics, and calculating it for different industries and customer segments can produce different results. 

Therefore, it is key to ensure your metrics align with the context of your SaaS business and aren’t generic. 

2. CLTV: CAC relies on historical performances

Although CLTV: CAC heavily relies on past results, it often overlooks dynamic market conditions and shifts in go-to-market strategies. 

In the fast-paced world of SaaS, where pricing plans, customer personas, and staffing models are constantly evolving, relying solely on this ratio may lead to inaccurate assessments. 

Therefore, it is best to reassess the important metrics according to your company’s current objectives, requirements, and market landscape. 

It is also crucial to understand that the unit economics for startups may vary from established SaaS companies, as they navigate different hurdles and opportunities, particularly in the growth phase.

Despite these shortcomings, the CLTV: CAC ratio is an effective litmus test to determine the growth potential and financial health of your SaaS business. 

How to optimize Your SaaS business for long-term success

While the unit economics of a SaaS business impacts investor decisions, there isn’t an incessant need to track them daily. 

As a founder, you can improve your startup’s unit economics by concentrating on other moving components including COGS, gross retention, enhancing ARPA, and CLTV. 

You should aim to improve the gross profit and margin while lowering the COGS. 

If you are clear about how to calculate, you can redirect your focus on improving the overall operational efficiency of your SaaS business by:

• Harnessing the power of artificial intelligence (AI) to improve efficiency
• Minimizing friction and other barriers while onboarding new customers
• Tracking and optimizing cloud hosting costs

SaaS businesses can also optimize unit economics by generating relevant and high-intent leads, deleting or skipping ineffective go-to-market strategies, and consistently tracking their performance marketing tactics. 

Fuel your SaaS business’ long-term growth

While keeping a check on the SaaS unit economics can get challenging, it isn’t something you can’t figure out in your SaaS startup journey. 

The key is to ensure all the relevant stakeholders from different departments of the company including customer success, marketing, sales, product, and support are aligned with the short-term and long-term objectives. 

Additionally, it is always a good idea to constantly monitor the moving parts and crucial components including gross retention, marketing costs, revenue per account, and other metrics that are beyond the CLTV: CAC ratio. 

As you determine the unit economics of your SaaS company and brainstorm the next steps for sustainable growth, we recommend exploring financing options, especially non-dilutive funding. 

We offer one of the easiest and fastest ways to fund your business: our revenue-based financing solution empowers SaaS companies to secure instant capital for long-term and sustainable growth.