Why is LTV/CAC Important?
Metrics, in isolation may provide us with a data point but they often lack context with which we can guide our actions.
If it cost you $25 to acquire a free trial you may think that is a good amount to pay for a free trial. The truth is that even though it may be interesting it tells us very little about if this is good or bad for the business.
However, if you know that 20% of those free trials convert into paying customers that pay you $10 per month and they stay customers for an average of 12 months.
We have created context by combining data points and things no longer look so rosy.
For every 100 free trials it costs us $2500, we close 20 of them into paying customer and recoup $2400 in revenue – we are losing money.
But while things no longer look so positive we can take action, assess the health of the business, and know what our next steps must be. A “Foot on the ball moment.”
Your LTV:CAC ratio is no different.
By understanding what the LTV/CAC ratio is and what it tells you, it is possible to manage your cash flow more effectively, understand how much you can spend to acquire new customers, and identify where improvements can be made in the business to drive greater growth.
Now we have explained the benefits of LTV/CAC, we should focus on what it is and how it is calculated.
We have provided examples of a good ratio at the end of this article. For now, we will break down the equation into its component parts and explain how you can calculate the ratio for yourself.
How is Customer LTV Calculated?
When discussing ‘Lifetime Value’ or LTV, it is important to clarify if you are talking about lifetime value or customer lifetime value. Often the two are interchanged but there are slight and distinct differences between the two metrics.
Before continuing we must define the two metrics and understand their differences.
LTV – Refers to the amount of money collected from a customer over their lifetime.
CLV – Refers to the profit margin made from that customer over their lifetime.
We can see this in the calculations for each metric.
LTV is calculated by taking the Average Transaction Amount multiplied by the Retention Time Period.
Whereas, the customer lifetime value is the LTV multiplied by the gross margin percentage.
We can demonstrate the difference with an example.
Let’s imagine a SaaS company that has a monthly cost of $50. The customers are retained for 15 months and there is a gross margin of 20%.
The lifetime value would be $50 (the transaction amount) multiplied by 15 (the retention period) giving us an LTV of $750.
Using the same example:
If we were to calculate the Customer Lifetime Value, we would take the LTV of $750 and multiple it by the gross margin of 20% giving us a CLV of $150.
You should bear in mind that most LTV:CAC calculations will use the simpler LTV calculation, not CLV but it is important to know the difference and be clear on what metric is being used to avoid confusion.
How is CAC Calculated?
Calculating your Customer Acquisition Cost or CAC is achieved by taking the sum of all marketing activities + the sum of all sales activities divided by the number of deals closed.
This calculation is very simple but problems can occur when you have a multi-month sales cycle and are in the early days of your business.
Multi-Month Sales Cycle:
Whenever you have a multi-month sales cycle you must adjust the cost of sales to accurately reflect the amount of time spent on each cohort of leads.
You do this by specifying the number of leads each sales rep is working and dividing their time by the total number of leads. This way you can accurately determine the amount of time and therefore money spent to close these leads.
If you passed 100 leads to a sales representative in January and you had a three-month sales cycle, you would not expect anyone from this cohort to begin closing until March or April, of the same year.
However, each month new leads will be passed to the same sales representative meaning only a fraction of their time is being spent on each group of leads.
In February, that same sales representative would be working to close leads that were given to them in January and in February as such we must divide that sales representatives time by the total number of leads they are managing so we can determine how much time was spent closing the leads given to them in January, February, March and beyond.
Early Stage Businesses:
A similar problem arises in early-stage businesses, as it is not uncommon for you to have several well-paid individuals on the team. Those individuals are there to help you build and scale beyond your current position and handle far more deals than you are currently closing. However, they can increase your CAC significantly due to the low number of deals closed when you get started.
To tackle this, it is recommended that you only assign a percentage of those individuals’ time to the CAC calculation. This will provide you with a more accurate representation of the CAC as time is spent on a wide range of tasks during the early stages of a business. Not just the sales and marketing activities that would be expected in a traditional CAC calculation.
How Do You Calculate LTV:CAC Ratio?
To calculate the LTV:CAC ratio you will need to divide your lifetime value by the customer acquisition cost.
It is important to regularly report on this metric to track improvements over time and link them to initiatives designed with this purpose in mind.
What Is A Good LTV:CAC Ratio?
Now that we have examined in detail how to calculate LTV, CAC, and the importance of the LTV:CAC ratio, there is a question remaining. What is a good LTV:CAC ratio?
As with many questions, the answer requires context. A good ratio in SaaS may not be equally positive in Ecommerce or consulting.
However, when discussing LTV and CAC, we are most often referring to SaaS businesses, and as such, this is where we will focus our attention.
What Is A Good LTV:CAC Ratio For SaaS?
For SaaS, there are two tried and tested rules when it comes to your LTV and CAC.
- Your LTV / CAC ratio should be a minimum of 3. For example, $100 to acquire and an LTV of $300.
- CAC should be recovered in 12 months or less.