The LTV-CAC ratio helps you determine how much you should be spending on acquiring customers. If this ratio is low, you're pretty much burning money in the long run because if you are spending more to acquire your customers than their expected return on revenue throughout the customer’s lifetime, eventually you will run out of resources to acquire any more customers.
Now, before we get into the ratio as a whole, let's break down the components.
CAC is calculated as the total cost of acquiring customers, divided by the total customers acquired over a given period. The 'cost' is your total spend on sales and marketing costs.
For example, if you spend $1000 acquiring new customers in Q1 and acquire 500 customers, then your CAC is $2.
Lifetime value (LTV) is the average revenue a single customer will generate throughout their lifetime as a customer of the business.
Or, you could calculate it as LTV = ARPU * Gross Margin * Average Duration of Customer Contracts
We have a very detailed blog that tells you how to calculate lifetime value that comes with a ready-to-use template too!
Once you've found the CAC and LTV metrics individually, you can now calculate the LTV-CAC ratio. To do that, you simply divide the lifetime value by the customer acquisition cost.
Ideally, the LTV/CAC ratio should be 3:1, which means you should make 3x of what you would spend on acquiring a customer.
If your LTV/CAC is less than 3, it's your business sending out a smoke signal! This should be taken as an indicator to try to reduce your marketing expenses so you can sustain effective acquisition efforts in the long term.
An enterprise customer can have a high CAC, but they'll also have a higher LTV since they tend to churn less. It makes sense to look at these enterprise customers, yet the LTV-CAC can help you uncover valuable revenue. For example, in the case of HubSpot, they had two personas: Owner Ollie and Marketer Mary. The former was the owner of a small business and did their marketing, while the latter worked for a slightly bigger company and was in charge of marketing. At first, they concentrated their efforts on Marketer Mary, which had an LTV of $11,125. But later, they found that selling to Owner Ollie through a channel partner produced an even better LTV of $11,404.
As a subscription or SaaS business, you'll be spending significant fund on acquiring customers through sales and marketing. But how much do you spend? Knowing the ideal LTV/CAC ratio and working it backwards can inform how much you need to spend if you know LTV. For example, if the LTV of a customer you want is $100, and you're looking to hit an LTV/CAC ratio of 3:1, then you'll need to spend approximately $30 on an acquisition.
If your customers are worth three times the value of the acquisition, then investors are all ears. But the point here is not to parade this metric around, it’s to show the investors that "this company has a broad product-market fit and its strong LTV-CAC today is likely sustainable at similar levels over time."
Before you can optimize your spend, make sure you've calculated the CAC accurately. If everything is in place, here are a few pointers to help you out.
The channels that bring in the most customers aren't always necessarily the ones that work. If those customers churn out quickly, there's no point in allocating many funds to these groups and crying over spent costs, which is why you should invest in channels that facilitate inbound marketing. Since 81% of consumers conduct online research before buying, having a targeted and informed approach will attract leads who are more likely to be interested in your solutions over a long period of time. It gives you good quality customers while having less costs.
If you have a freemium business model, try experimenting with your pricing to figure out the factors that could convert more paying customers. It could be an increased pricing tier, a feature-based pricing model, seat-based pricing, etc. The more quickly you can convert freemium users to a paid plan, the lower your CAC would be. But don't compromise customer happiness, because soon you will have no customers to keep or new ones to attain.
An arduous sales process or a longer sales cycle will lead to a higher CAC. Keeping your prospects engaged with an effective hand-holding process and proper onboarding is critical in retaining those in the sales process. Ensure you invest in setting up a tight funnel and make each step easily navigable. Customer retention is key.
If you want to be a profitable business, you have to cut your cost of revenue and as a digital business, the majority of this will come from CAC. At the same time, you need quality customers who love your business and stick with you for long periods of time, enabling high lifetime value and a chance at expansion revenue.
A SaaS business (or subscription business) is no doubt a customer-centric business. You need to acquire customers at low costs and keep them happy for an extended period of time. The LTV-CAC Ratio serves as a guardrail for maintaining these conditions. So keep peeking over at these KPIs as a pulse check––it's also one of the critical SaaS metrics investors use for the valuation of companies.