One of the biggest challenges in modern business is short-term thinking. Especially with the fast-pace of digital interactions, it’s easy for us to think our companies are growing sustainably when they actually aren’t. So how can startup founders get ahead of this bias when communicating with financing partners?
The answer is to calculate a lifetime value (LTV) to customer acquisition cost (CAC) ratio (LTV:CAC). As a sales efficiency metric, this number communicates a quick story about whether a startup is in a position to scale sustainably over the long term.
The LTV:CAC ratio is one of the most important metrics that founders will need to report upon to financing partners. This article will help you learn more about this metric, so you can be prepared to answer questions.
The LTV:CAC ratio is a combination of two separate metrics: lifetime value and customer acquisition cost. The best way to understand the meaning behind this ratio is to break it apart into its individual components.
LTV, also sometimes referred to as Customer Lifetime Value (CLTV), is a measure of how much revenue a business can expect to generate from a single customer. You can calculate LTV over different units of time, including quarterly, annually, and over multiple time horizons. With this analysis, companies can build projections into the future — around net profits, for instance. With a clear line of sight into projected future profits, companies can make more informed decisions with respect to budgeting.
LTV can be calculated using margins or net margins. There are a few different ways to calculate LTV and that ultimately, this metric is about valuing the cash flows produced by one customer. These individual-level cash flows add up into an aggregate-level financial story.
Because there are variations in LTV calculations, it’s a good idea to ask your financing partner about their preferred methodology. That way, you can be sure to bring accurate and up to date data to the discussion.
Winning over customers requires an investment in time, energy, and resources. In the majority of cases, your business will need to commit funds to growth. When working with financing partners, your CAC is a quick way to quantify this expense.
You can think of CAC as the cost for acquiring each individual customer. There are a few general steps to calculating a customer acquisition cost.
Similar to LTV, calculating your CAC will require some discretion as to what information to include in your formula. Some companies choose to exclude salaries, for instance. Regardless, it’s important to be as thorough as possible and to follow your financing partner’s methodology closely.
Once you’ve calculated your LTV and CAC separately, you can combine the metrics into a ratio to measure sales efficiency overall. Without this ratio, it’s not possible to determine whether your CAC is too high or your LTV is too low, as the two metrics are relative to one another. The ratio is what tells the story.
An LTV:CAC ratio of 1:1 (1) means that the cost of bringing on a new customer is equal to the revenue that they generate over the course of doing business with your company. With an LTV:CAC ratio of 1, your startup is likely taking a loss due to expenses outside of customer acquisition costs.
For this reason, the venture-backed SaaS community generally accepts a score of 3, meaning that companies earn $3 for every $1 spent to acquire a customer, to be ideal. With a score of 3, startups have enough wiggle room in their profit margins to cover other business expenses.
Some startups with highly efficient business models have scores higher than 3. But if a score is too high, it may be a sign that the business is not growing quickly enough. This discretion is subjective and will require healthy dialogue between founders, VCs, the advisory board, and potentially others involved in a startup’s financing equation.
Individual LTV:CAC scores will vary based on agreed-upon methodologies and shared objectives. If someone is asking you for your startup’s score, it’s a good idea to find alignment around your calculation steps.
LTV, CAC, and LTV:CAC ratios are actionable startup metrics — meaning that you can improve upon them continuously in your business. Here are a few suggestions for making optimizations for higher scores:
Your startup’s LTV:CAC score is a metric that will evolve over time, especially as market conditions change. What happens if a competitor introduces a better product, or instance? Or if there’s a regulatory change in your industry?
Things change. That’s why it’s important to know what your LTV:CAC score is communicating. With this perspective, you’ll always be able to adapt to your market quickly.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal, or tax advice.