Marketing Spend: How Much is Enough?

Workday, a software-as-a-service (SaaS) provider of HR and financial solutions, raised another $75 million last month to fund growth. This is in addition to $75 million raised in earlier rounds, bringing the total to $150 million in funding.

Workday will probably use some of the new funding to build out its application and its operations and support infrastructure, but I suspect a large portion will be spent on sales & marketing to acquire customers.

Is this amount too much? Too little? Just right?

A formula to assess the level of spending on customer acquisition could be helpful.

Average lifetime value of customer/average cost of customer acquisition

In this formula,

Avg. lifetime value of customer= avg. monthly recurring revenue * avg. length of subscription

and

Avg. cost of customer acquisition = sales & marketing expense/new customers

According to this formula, a calculation yielding "1" would indicate that the cost of acquiring a customer would be equal to the revenues derived from that customer over time. In other words, $1 in customer acquisition expense yields $1 in lifetime revenue.

A number greater than "1" would indicate that customers are contributing more than the costs of acquiring them, and the excess could be applied to fund development, support, operations, and other expenses, or even show a profit. That is, $1 spent on acquiring a customer would generate more than $1 in lifetime revenues from that customer.

A number less than "1" would indicate that the cost of acquiring customers exceeds the revenues they'll contribute over time. SaaS vendors may run at a rate of less than "1" for a period of time, funding the shortfall with debt or outside capital, but it's not sustainable over a long period.

(There are certainly more sophisticated formulas, using gross margin, cash flow analysis and other elements, which would provide indicators for profitability and capital requirements, but in this instance I've opted for simplicity in order to focus on sales & marketing spending. Bessemer Ventures and Joel York are excellent sources for more in-depth financial analysis.)

For illustration, let's run the formula using financial results reported by salesforce.com for the fiscal year ending January 31, 2009.

  • Revenues from subscriptions in FY 2009 = $985 million
  • Sales & Marketing costs in FY 2009= $534 million
  • New customers acquired during FY 2009 = 14,400
  • Total customers at Jan. 31, 2009 = 55,400
salesforce.com reports that the average length of a subscription contract is 12-24 months, though I suspect they renew most of these contracts, so the average length of a subscription is much longer. For the sake of this exercise, I'll estimate 5 years.

  • Avg. lifetime value of customer= ($985,000,000/55,400 customers) * 5 years =$88,899
  • Avg. cost of customer acquisition = $534,000,000/14,400 new customers = $37,083
  • Average lifetime value of customer/average cost of customer acquisition = 2.40

Based on these data and my assumptions, for each $1 spent on customer acquisition, salesforce.com generates $2.40 in lifetime customer revenues.



I've calculated the ratio for several publicly-held SaaS companies, using the same estimate of a 5-year customer lifespan.

At the high-end of the scale, athenahealth generates about $10 in lifetime customer revenues for every $1 in sales & marketing costs to acquire a customer.

RightNow, by contrast, generates 40 cents for every $1 spent acquiring a customer.

Use these numbers with caution. For one, they represent only a single year's worth of data and can be skewed by unusual events. Taleo's ratio, for example, is affected by its acquisition of Vurv and its entire customer base in 2008.


More data and deeper analysis would be required to assess the potential profitability, cash requirements or overall financial health of SaaS companies, but the formula does give useful guidance on marketing spending.

  • Extending the life of the customer's subscription is critical to success. Be certain to allocate resources to retain your current customers. Losing customers you've already paid for can be disastrous.
  • Carefully control spending to maximize effectiveness. To the extent possible, measure the impact of all sales & marketing activity on acquiring or retaining customers. Certainly, this is critical to on-premise vendors as well, but it's especially so for SaaS companies.
  • Carefully identify your target prospects and avoid deals that don't offer an adequate potential lifetime value. There's no point in spending $5 to acquire a customer who's maximum potential lifetime value is $3. That's spending money to lose money.
  • Ensure your pockets are deep enough to carry you while you wait for revenue. Though you're making the sales & marketing investment up front, the returns are spread over the lifetime of the customer. You need to have adequate funding to bridge this mismatch of immediate investment and long-term return.