Payback Period: Why It’s Important And How Long It Should Be
Payback period is defined as the time it takes gross profits to repay Customer Acquisition Cost. Having one that’s considerably shorter than the Customer Lifetime, is a fundamental sign that you have sound unit economics.
This metric can drastically vary from one company to another. Two equally successful businesses could have payback periods of 3 months and 3 years respectively. It all depends on how long your typical customer stays with your company.
For banking services – both traditional and digital – it is measured in years. For example, it is estimated that challenger bank N26 has a payback period of at least 6 years. SaaS companies that aim for a lean and flexible business model, but often struggle with customer loyalty tend to measure payback period in months. Slack’s payback period, for example, is estimated to be around 6 months.
Even though each business model poses hard limits on how short a payback period can get, there is no doubt that trying to make it the shortest possible would result in a healthier company.
There is a negative correlation between payback period and growth rate, and that all boils down to liquidity. As explained by Tomasz Tunguz in one of his blogs, the longer the payback period, the more working capital is tied up in customer acquisition and therefore cannot be spent on growth.
But what is the “standard” benchmark for a software company in 2020? Well, Tunguz looked at a sample of 54 public software companies to find out.
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There is a huge variance in the sample: top performer Zoom scores a record 3 months, while cloud computing company Appian takes about 4 years to pay back its CAC. This is a reflection of different business models and approaches. Four out of the top five companies, notes Tunguz, employed a bottom-up approach starting with a target of smaller companies and freelancers before landing enterprise clients.
The median payback period for this sample is 22 months – almost two years – with companies in the top quartile managing to pay back their CACs in under 15 months.
It must be noted, however, that since these are public companies they will naturally perform better than their early-stage counterpart on this metric. This is because the Customer Acquisition Costs tends to decrease while a company grows together with brand awareness and economies of scale.