Lifetime Value to Customer Acquisition Cost (LTV/CAC)
Lower is better
How is Lifetime Value to Customer Acquisition Cost (LTV/CAC) calculated?
What is Lifetime Value to Customer Acquisition Cost (LTV/CAC)?
The LTV/CAC ratio is one of the most important metrics for SaaS companies as it provides insight into the long-term profitability of your business. The general idea is that you want a customer to pay you more throughout their relationship with you than it cost you to acquire them in the first place.
It's widely accepted that having an LTV/CAC ratio of 3.0 or higher signifies that your business model is profitable and scalable for a SaaS company. This means that you're spending 30% or less of your customer's lifetime value to acquire them. Businesses that have a high LTV/CAC ratio are more to have exponential revenue growth. Because of this, almost every venture capital firm will ask for this metric when looking to invest.
Eventually, your customer should be paying you more than it cost you to acquire them. The total time that takes, or the length of the red triangle, is your The diagram above represents the lifecycle of a customer. At a high level, you'll want the red triangle to be as small as possible and the green triangle to be as large as possible. Since there is often an upfront cost associated with acquiring customers, you may not see a return on your investment for a few months after becoming a customer. The time spent recouping those upfront costs is highlighted in red.
You want your business to be like a magical machine where you get $1 in; you get $3 back out. Your LTV/CAC ratio, along with other SaaS metrics, lets you know if you're on track to do just that.
An LTV/CAC ratio above 3.0 means that you deliver enough value to your customers that they stick around and want even more value from your product or service. It also means that you're profitable in the long term time to break even. After that, it's your job to make the green triangle as big as possible. You can increase the length of the triangle by continuously delivering value to reduce your churn rate. You can also increase the triangle's height by increasing prices or increasing your expansion revenue (selling add-ons or upgrades to your existing customer base).
An LTV/CAC ratio below 3.0 indicates that you're spending too much on marketing and sales efforts, not spending enough to decrease churn, or that your pricing may be too low. And an LTV/CAC below 1.0 means that you're basically just setting money on fire.
A higher ratio above 4 for LTV/CAC may indicate a missed opportunity and that you may want to funnel more resources into marketing and sales expenses to acquire customers.
There are a few different ways you can do this. One way is by decreasing the cost of acquiring new customers. Another way is by increasing customer lifetime value. You can also reduce customer acquisition costs by reducing sales and marketing costs. Your ROI must be high enough to justify your marketing spend.
In terms of LTV/CAC, churn rate is the percentage of customers that stop using your product or service within a given period of time. It's not good to have high monthly churn because then it means that you're paying more money for new customers than existing customers are worth. A few retention strategies to reduce monthly churn rates are providing more value to customers, providing a high-quality onboarding experience with a customer success team, and consistently communicating the value, you're delivering with new features.
Another way to increase your LTV/CAC ratio is by increasing your expansion revenue. You can do this by identifying and upselling additional products or services complementary to the primary product. Cross-sells are when you offer existing customers an additional product or service that goes along with their original purchase but requires no further investment from them (e.g., "Would you like fries with that?").
By increasing your prices, you're able to increase the height of your green triangle. Of course, it's important to avoid price increases in the short term so that customers can adjust and not feel like they're getting ripped off. However, in the long term, you should be able to increase your price multiple times without negatively impacting customer acquisition efforts.
You can increase your average lifetime value by encouraging customers to make longer commitments with you. This can be achieved through longer contracts or paying for an annual subscription upfront instead of per month. With annual commitments, you'll be able to realize otherwise future revenue sooner. For early-stage companies, this is especially important since you'll be able to allocate that revenue towards the cost of acquiring new customers.
Why is Lifetime Value to Customer Acquisition Cost (LTV/CAC) important?
LTV/CAC is a crucial metric for any business that has recurring revenue. It is an excellent indicator of where to invest your resources. If you calculate your LTV/CAC ratio for different cohorts of users, you can also analyze the effectiveness of various sales and marketing campaigns.
Start tracking your Lifetime Value to Customer Acquisition Cost (LTV/CAC)
Create a KPI for Lifetime Value to Customer Acquisition Cost (LTV/CAC) to monitor it over time and an OKR to track your impact against it in Commonality.
Customer Acquisition Cost (CAC)
Ensure you're staying lean and scaling efficiently by measuring how much it costs to acquire a single customer.
Customer Churn Rate
Measure the number of subscribers that unsubscribed or stopped paying in a given period of time.
Lifetime Value (LTV)
Ensure that you're delivering value that customers are willing to pay for by measuring the average revenue that a customer will generate throughout their lifespan as a customer.
Time to Break Even
Make informed decisions about operating your business by measuring the time it takes for your revenues to match your operating expenses for a customer or product.