Deconstructing The LTV:CAC Ratio
Updated: Nov 2, 2020
LTV:CAC is a wonderful metric, but there’s a lot to unpack here so let’s break it down. In this blog, we will discuss what it is, how to calculate it and what it can tell you.
In its most simple terms, this is the ratio of your company’s Customer Acquisition Cost to the Lifetime Value of that Customer. If you calculate this metric properly and analyze it, you’ll be able to tell if your SaaS business has a chance to become profitable… or where to focus your attention to make that profit more likely to happen. All too often, companies don’t remain customers indefinitely for a variety of reasons. During that lifetime, you need to make enough gross margin to cover the cost of landing that customer, plus some extra for more R&D, your general overhead, and eventually, your profit. In some cases, it may make sense to delay profit while you are growing fast and have access to capital, but someday, turning a profit may be a good idea for your stakeholders and employees.
The Merits of Lifetime Value (LTV)
There are a few components to this portion of the ratio; namely, your gross margin and your number of periods you expect to maintain having your customers.
The value part is the gross margin –– your revenue generated, less the cost of providing that revenue in a given period of time.
Calculating revenue for a recurring revenue company is actually very complicated and recent changes to accounting rules (ASC 606) made it even more so. a CPA might cringe at this simple explanation, but under the new rules, you need a contract with your customer, know what service(s) you are providing, what you’re charging for that service, then actually provide the service, and allocate what you charged over the period you are providing that service.
Since contracts typically include multiple elements, and since humans can be creative when negotiating the details of a contract, the revenue recognition often gets complicated.
A Simple Lifetime Value Calculation
To keep it simple, let’s say that your clients sign up for a monthly service that they can cancel at any time and you charge them only $70 per month. You don’t even bother to charge set-up fees or provide them with one-time services. So your revenue is $70 per month per customer.
The next step is to determine the cost of providing your service. The major costs of revenue for a SaaS company are for servers, hosting, bandwidth, your whole customer service / success department (if not sales related) and, if you capitalized the cost of the software you developed, you also would include the amortized cost of that software. Now, a lot of these costs may vary with the number of customers you have, remain fixed, or even increase in steps like when you hire a new customer service rep. But if your total monthly cost or revenue is $33K and you have 2,200 customers, it would be $15 per customer per month. The gross margin is $55 per customer ($70 - $15 = $55).
If your customers pay you by credit card, I don’t include that merchant fee of around 3% to be part of revenue. I consider that as the cost of collecting payment for the revenue and not the cost of providing that revenue. If a customer paid with a check and you paid a bookkeeper to deposit that check, you’d probably put that expense in your general and administrative department. I treat these as the same.
The LTV is the final component to this metric and it’s basically a function of churn.
Every month, you start out with a bunch of customers, but some of them aren’t around at the end of the month. Why? They churned. If you had 100 customers to start the month and five of them discontinued your service, then your churn rate for that period is 5%. Assuming that trend continued, your customers would last for about 20 months.
The customer lifetime value then is $1,100 or 20 times $55 of gross margin.
The Details About Customer Acquisition Cost (CAC)
Pronounced “kack” by some, the acronym for Customer Acquisition Cost is the per unit cost of acquiring a customer. How is it calculated?
Just add up all the expenses incurred when acquiring customers during a given period
and divide the number of customers acquired during that same period.
These expenses include marketing salaries, advertising spend, trade shows, salesperson compensation, commissions, the overhead associated with sales and marketing personnel, CRM software, etc.
Here's an example:
A Few More Details. You should also include your sales and marketing departments’ share of overhead, but I don’t believe that is absolutely a must in the early years of any company’s life. I think it is more important to capture the expenses that are direct to those departments and to be consistent from month to month.
If you’re ever in doubt about an expense, I would include it because there is no point in fooling yourself. That said, I think it makes sense to carve out a portion of someone’s compensation if they did product marketing, which you could consider more like research and development.
So if you signed up 290 customers during that period, your CAC per customer is $500 ($145,000 / 290). But, $500 may be a great number or an awful one depending of the other half of the ratio.
Using our examples, your LTV:CAC is 2.2:1.
($1,100:$500). Is that good? Not terrible, but the best SaaS companies are north of 3:1, though there is a lot more to this metric, so don’t get discouraged.
A Few Tips to Improve Your Ratio
For one thing, don’t automatically assume that everyone is doing their accounting correctly, so your friend’s great LTV:CAC may be based on garbage numbers. (Unless my firm does their accounting in which case, you’ll know that they’re accurate.)
Instead, I would focus on fixing the components of this metric that are keeping this ratio low. Can you lower your Cost Of Goods Sold? Use AI tools to answer basic customer service inquiries? Why is there that much churn? Buggy product? Key features missing? Is the cost of marketing to qualified leads too high? Are sales commissions excessive? Find the biggest issues and address them now.
Is it too soon to calculate this metric? Maybe so, but ask yourself these questions to make sure you’re on track:
Is the CEO / founder making a lot of sales instead of a sales team?
Are the gross margins not indicative of what they will be at scale?
Do you have a few extra people in your customer service or success department?
All of these may distort the ratio in either a good or a bad way. But track it anyway. Start to build data and then keep working towards a great ratio.
If you need help with SaaS focused accounting, financial due diligence, financial projections and more,