LTV: CAC is a sales and marketing efficiency metric and can help you measure customer profitability.
Measuring your LTV:CAC ratio will allow you to see how viable your SaaS business model really is. By comparing how much you spend to acquire a customer to how much revenue they produce, LTV:CAC is able to show how much profit your customers bring in.
By understanding this ratio, you’ll be able to analyze your sales and marketing channels and their effectiveness in acquiring ideal customers (AKA customers that are profitable) and decide how to allocate funds into which channels accordingly.
Investors love this metric. If your customers are not generating additional revenue than what it costs to acquire them, then this is a huge red flag that your SaaS company is not sustainable. The LTV:CAC ratio shows whether or not your customers are worth more than what it costs to acquire them, so it’s important to keep track of this metric.
To fully understand this metric, let’s break it down into its two components: LTV and CAC.
Definition: The revenue a customer will generate over the course of their relationship with your company.
There are multiple ways to calculate LTV, but in its simplest form here’s what we recommend:
Formula: Average customer lifespan = 1 / churn rate
Formula: LTV = (ARR per customer) x (average customer lifespan)
Definition: The amount of money spent on sales and marketing to attract a new customer.
Formula: CAC = (sales spend + marketing spend)/ number of new clients
*Make sure you include ALL of your sales and marketing spend. Buying a potential lead a cup of coffee, team salaries, and automation tools are often forgotten about, but should be included in CAC. For more read our CAC deep dive. (Also another reason why it’s so important to have a functional Chart of Accounts!)
Once you have your LTV and CAC metrics calculated, all you have to do is divide LTV by CAC.
Formula: LTV:CAC ratio = LTV / CAC
The SaaS rule of thumb is to have an LTV:CAC ratio of 3:1 meaning the value of a customer is three times more than what it costs to acquire them.
If your ratio is less than 3:1, you’re treading on dangerous waters. If it ever gets below 1:1, that means the amount of value customers bring in their lifespan is not even paying off what it costs to acquire them in the first place. Long story short, your business plan is not viable and will drive investors away.
This ratio is not too high or too low – it’s just right. 3:1 provides enough cushion for any off seasons or black swans and will keep investors happy. At this point, your customer lifespan and customer acquisition strategies are top notch and you can start focusing on growing other aspects of your business: product development, hyper-growth, etc.
Logically, you’d think a ratio of 8:1 would be better than 3:1, however in this case, it’s actually a sign of missed opportunities. Sure, your acquisition is efficient. However, if you put so few resources into sales and marketing, think about how many more audiences and engagements you’re not reaching. This is a good problem to have since now you can invest more in your sales and marketing and bring in new customers.
The best way to improve your ratio is to improve the individual components:
Segmenting – Getting a ratio that incorporates all of your customer base is not an accurate number; customer profiles can range. Instead, segment your customers by size (SMBs and enterprises) since ARR per customer amounts will differ and you’ll be able to evaluate your sales and marketing efforts for each type of customer.
If you want to go one step further, segmenting by specific sales and marketing channels will give you better insight on the efficiency of each individual channel. As useful as this is, it also can be tricky. Make sure you accurately track how much is spent on each channel and which customers fit each segment.
Tracking the correct data and knowing where to use it can be time consuming and confusing, but that’s why KPI Sense is here! Learn how we can help your company here.
Freemium users should not be included– They aren’t paying customers yet! Only consider paying customers in your CAC formulas as acquired wins. However, any costs associated with serving the freemium customer should be included in your sales and marketing spend. Also, don’t include the duration of freemium users into LTV. Customer lifespan only begins when they upgrade as paying customers (once they start bringing value to the company).
Don’t focus on LTV:CAC as an early stage startup – There is such a thing as too soon. As David Skok says, “LTV:CAC will only really be meaningful and reliable when you have found a repeatable and scalable growth process.” This metric is important, but it only becomes insightful once your company is matured and has an established sales process and marketing channels.
Include a 6 months average of your CAC calculations - This will create an overall depiction of your CAC since the efficiency of sales and marketing can go through ups and downs from month to month. Each month continue calculating your CAC and then after 6 months, take the average and divide LTV by this new CAC.
The LTV:CAC ratio tells you whether or not your business model is viable by measuring whether or not your customers are worth more than what it costs to acquire them. By comparing customer lifespan to acquisition costs, this ratio shows just how much profit one customer is bringing in. To learn how to calculate and more, make sure to scroll back to the top!