Your two acronyms of the day are:
Lifetime Value (“LTV”): the net value of an average customer to your business over the estimated life of their relationship with your company.
Customer Acquisition Cost (“CAC”): the average amount of capital you need to spend on sales, marketing and related expenses to acquire a new customer.
Together they form a ratio aptly called LTV / CAC, which is considered to be the golden metric. This ratio has everything – it combines purchase frequency, average order value, and customer lifetime to figure what each customer is really worth to a brand. Plus it’s a 5-star recruit for basketball and football, while maintaining solid grades and still makes time for community service.
Calculating your LTV / CAC ratio is a great way to see if your company is positioned for sustainable growth. Like most metrics, your LTV / CAC is highly context specific, and a solid value will vary depending on your product, brand and industry. Therefore it is calculated in different ways.
SaaS companies measure LTV by:
Average Monthly Revenue per Customer ($) X Customer Lifetime (typically in months) X gross margin (%)
Or, you can take average monthly revenue per customer divided by monthly churn.
E-commerce companies calculate LTV by:
Average Order Value ($) X Repeat Sales X Average Months of Retention X Gross Margin (%)
The retention rate is perhaps the most critical component. The longer customers stick with you, the higher their LTV is, because you can expect to receive payments for a longer time. There’s a great blog post about it being cheaper to upsell a customer and keep them for longer, than it is to gain a new customer. This is why it is so important to build a product that customers want and like to use.
CAC is a standard calculation, where you take your total sales and marketing expenses divided by the number of new customers acquired. But, that doesn’t stop companies from stretching the truth and showing CAC in ways that are so, let’s use the word interesting, that they forget the metric they were talking about halfway through explaining it to you.
Do you ever wonder why some companies offer referral fees to test out their product? It is because they know their average CAC, and whatever they are giving both the referrer and referee, is still less than that number they are willing to spend to acquire a new user. When the New England Patriots pay referees before a big game, they know that it costs less than the value generated by another Super Bowl ring. I am prepared for, and accept, a few unsubscribes from Patriots fans. That was worth it.
Let’s look at an example. An e-Commerce company spends $10,000 on an ad campaign and acquires 1,000 new customers. The average revenue per customer is $50 and the direct costs of filling each order are $30. The company retains 75% of its customers per year.
That means the contribution margin per customer is $20. And the LTV is $80, which is $20 / (1 – 75%). The CAC is $10. So, your golden ratio is 8:1. Not a bad ad campaign for a made up e-Commerce company using an arbitrary pricing strategy.
An LTV / CAC Ratio of 1:1 means you lose money the more you sell. A good benchmark for an LTV / CAC ratio is 3:1. Let me know when we set the record for most times using "LTV / CAC" in a blog post. I think we’re close!
If you hit 4:1 or higher, you could be looking at a great business model. You’d think that if your ratio is 5:1 or higher that you would be sitting pretty, but that would be too easy and VCs wouldn’t have anything to critique. Experts believe at that ratio, you could be growing faster and are likely under-investing in marketing.
What can you do with this ratio? Some companies look at this number, analyze it and decide how much they want to spend to acquire the average user. Other Ubers, sorry, I mean other companies, spend well more than they can afford to acquire users. They maintain that spend by raising additional venture capital. But, raising capital can only take you so far, and those companies at some point need to either increase LTV or decrease CAC.
Companies use this ratio to determine if a customer is worth more than what it costs to sell to them. A healthy LTV / CAC ratio is what gets investors comfortable enough to invest in a SaaS company that is losing money, because it is clear how they plan to become profitable.
Understanding this ratio in detail helps companies understand when, where and how much to invest in sales and marketing. You can figure out how many sales people you can afford to hire and how to effectively manage spend. And, it allows you to figure out which customers and products are the most profitable.
The more work you do in terms of segmentation, by customer type and marketing channel, the more actionable the data will be. You may find out it makes more sense to target SMBs instead of enterprise customers. Or, that a brand loyalty campaign targeting millennials may not be the right move.
Peter Thiel shared that LTV / CAC ratios should be used to take data and make it actionable, but don't treat them as gospel. While an impressive ratio is, well, impressive, the best founders don’t use that number as a vanity metric. Rather, they use it as a tool to demonstrate their complete understanding of their company’s unit economics and how they are prepared for growth.
This ratio is definitely important, otherwise why would it be covered on the ComedySeller. But, be on the lookout for companies that are playing with the numbers and how it is calculated, and more importantly, companies that are not using that ratio to drive business decisions.
This ratio, if calculated correctly, is a true indicator of sustainability of a company. A 5:1 LTC / CAC ratio shows that if a company can predictably and repeatedly turn x into 5x, assuming no crazy fixed costs, then it is a viable business.
Quick explanation of the cartoon above: Pareto says that 20% of your input generates 80% of your results. Peter says that competent employees will continue to be promoted, but at some point will be promoted into positions for which they are incompetent. Taylor talks about inflation rates and Newton about physics.
The question is: do you even need to know about a rule in order to perform well with that rule? If you're still not with me. Anyone can put an LTV / CAC number in their pitch deck, and you don't have to know what it truly means for you to have one. But, it'd be a lot cooler if you did.
I am a 25 year-old venture capitalist and amateur stand-up comedian living in NYC.