LTV:CAC ratio - an introduction
How much is a customer worth over the lifetime of their relationship with your business? And how much did it cost to make them your customers in the first place? The ratio of these two numbers, the LTV:CAC ratio, helps you understand the relationship between how much it costs to acquire customers and how much you’ll make from them over time. It is a fundamental metric that investors focus on and so should management teams.
What is LTV:CAC ratio?
The LTV:CAC ratio is the relationship between what it costs to sign-up a new customer and the profits they will deliver over the time they are a customer.
CAC stands for “customer acquisition cost” and is the average expense of gaining a single customer.
LTV stands for “lifetime value” per customer and is the average earning a single customer is predicted to generate throughout the time they're a customer.
The LTV:CAC ratio compares the value of a customer over their lifetime to the cost of acquiring them.
Why is the LTV:CAC ratio important?
LTV:CAC ratio is a key metric for any business but particularly for SaaS or subscription businesses. It should be used as a key metric for management teams to run the business and will be high on the agenda of investors.
Looking at your CAC on its own is useful, but provides limited insight. Looking at it alongside LTV provides a much more comprehensive view of your business and the cost and value of your customer base.
For instance, a business with little repeat business and relatively small transaction sizes should be spending much less acquiring those customers compared to a business that signs customers up to high multi-year enterprise deals.
It's the relationship between the cost of closing a customer and the profits you generate from them that really demonstrates the strength (or otherwise) of the business model.
How can I improve my LTV:CAC ratio?
Management teams will have various leavers to pull to influence their LTV:CAC ratios, for example:
LTV:CAC ratio and pricing/promotions
A reduction in sale price or promotion will have an impact on earnings from any customer reducing the LTV, but if that promotion makes it easier to close customers, the CAC should also come down, resulting in a healthy LTV:CAC.
LTV:CAC ratio and contract lengths
For enterprise deals or longer-term commitments, finding the contract length sweet spot between encouraging sign ups and retaining a client’s business is key to a positive LTV:CAC. Signing a customer up to a multi-year contract should have a positive impact on the LTV with customers contractually bound for a longer period, but it's likely to come with a higher CAC as these deals are harder to close, requiring more investment.
What does good look like?
It's widely accepted across the business world that a strong LTV:CAC is three. This means that the lifetime value of a client is three times the cost to acquire them. The age of the business, scale and maturity of the market will all impact on the result.
While a result greater than three shows strong performance, too high an LTV:CAC may indicate you're not investing enough in sales and marketing and so not growing the customer base as quickly as you could be. In the fast-growth world, investors are focused on market share and scale, so it's important to get this balance right.
What does LTV:CAC look like?
How do you calculate LTV:CAC ratio?
The formula to calculate LTV:CAC ratio is:
LTV:CAC ratio = Customer lifetime value / Customer acquisition cost
LTV:CAC ratio worked example
If a company has a customer lifetime value of £150 and it costs £50 to acquire each customer, its LTV:CAC ratio would be 3:1, calculated like this:
LTV:CAC ratio = £150 / £50 = 3:1
Conclusion
LTV:CAC ratio is a key metric bringing together two important elements for any business (the ability to acquire and service customers efficiently) and therefore vital for management teams to have a mechanism for tracking and appraising it over time. For any Series A or larger fundraise, investors will expect to see this metric and showing the right results, so it’s important to be tracking it early and doing what you can to make sure the results tell the right story.
