Metric Stack - Customer Lifetime Value vs Customer Acquisition Cost and more!
Sixth edition: why should LTV be three times more than CAC?
Spoiler alert: the benchmark for LTV to CAC Ratio is 3:1. Try Googling it right now and you’ll see pages and pages of “3:1” or 3x. Why does everyone say Customer Lifetime Value should be 3 times Customer Acquisition Cost, and does it hold true?
I’m Priyaanka Arora, your personal metric assistant and Content Researcher & Writer at Klipfolio. In week 6 of Metric Stack, we’ll explore how to interpret this magical ratio customized to your business.
Tackle Customer Acquisition Cost, the startup killer
We saw the dangers of high Customer Acquisition Cost (CAC) in the previous edition of Metric Stack. In short, you want to make more money than you spend on acquiring new customers. If you don’t, you can run out of cash, but you may also be looking at the symptoms of poor product-market fit or intrinsic value.
As a recap, CAC is the cost of acquiring new customers and can be calculated by dividing the sum of sales and marketing costs by the total number of new customers. Commonly referred to as the startup killer, CAC can be 5 times more expensive than retention. It’s important to optimize CAC by focusing on product value, following processes, and strengthening organic content acquisition.
How do you overcome a startup killer? Start with the understanding that no metric is inherently bad. When managed well, CAC can attract investors and even line your bank account! Armed with key metrics like LTV/CAC Ratio, you can act as soon as you see the early signs of disarray in your viability. It’s this ratio, often touted as the “lifeblood of SaaS businesses”, that we’ll look at today.
What is Lifetime Value to Customer Acquisition Cost Ratio?
LTV/CAC Ratio measures the return on investment in customer acquisition by calculating the ratio between theoretical lifetime revenue and sales and marketing spend. Here’s the formula:
LTV/CAC Ratio = Lifetime Value / Customer Acquisition Cost
Customer Lifetime Value (LTV) is the total amount of revenue brought in by a single customer over their entire period of existence as a paying customer. Dividing this value by acquisition cost gives you revenue generated for each sales and marketing dollar spent.
What is a good Lifetime Value to Customer Acquisition Cost benchmark?
As I mentioned earlier, the rule of thumb is that the average new customer should bring in three times more money than the cost of acquiring that customer. Here are some guidelines on what to infer from your LTV/CAC Ratio.
Less than one: you are losing money on each dollar spent on acquisition
1:1 denotes you are breaking even and not generating any profits from your customers
2:1 LTV/CAC can indicate inefficient and excess acquisition costs
3:1 is the “magic ratio” which balances LTV and CAC perfectly, indicating your Sales and Marketing strategy execution is bringing fast growth
4:1 LTV/CAC is a compliment to your Sales and Marketing team, but can mean other departments cost you too much, especially if your profits are down
5:1 can mean you have much more potential and can benefit from increased Sales and Marketing spending.
Bear in mind that these guidelines are good as a rule of thumb but may not be applicable to your business at all.
Does a 3:1 LTV/CAC Ratio guarantee profitability?
Nope. There are too many other factors that influence LTV/CAC. I’ll highlight three of the most important factors to consider when evaluating your performance against benchmarks.
There are many, many other metrics to consider along with LTV/CAC. At the very least, track the impact of churn, revenue expansion, cost per lead, and lead to win rate to have a 360 degree understanding of LTV/CAC.
Your overall operating expense matters. Say your CAC is $10k and over a period of time, this generates an LTV of $30k. You’d have an LTV/CAC of 3:1 which you’d think is perfect, but the proportion of your operating expenses consisting of Sales and Marketing spend matters. If Sales and Marketing is 70% of your operating expense, you’re potentially compromising other areas of business like employee compensation or research and development. While you may see short term growth with this equation, you would end up lowering your product quality or employee retention.
One size doesn’t fit all. What you do with benchmark data is really up to you, so customize your analysis to your business. For example, early stage startups may have high research and development expenditure, leaving little budget for sales or marketing which would skew LTV/CAC. However, R&D will lead to better product-market fit, boosting profitability and growth in the long run.
What’s new on MetricHQ
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Stay tuned for the next edition of Metric Stack Newsletter to get the latest scoop on all things metrics! Send feedback, comments, questions here: parora@klipfolio.com