How effective is your sales and marketing? How much does it cost to bring in new customers — and how does that compare to what you expect to earn from customers over their lifetime?
Looking at your LTV to CAC Ratio can yield insights into how efficiently your company is spending its sales, marketing, and customer retention dollars and, in the long term, how valuable your startup is. It can also tell you whether or not you’re in a strong enough position to lure in equity investors.
Following is a simple overview on how to calculate the LTV to CAC Ratio for your SaaS business.
What is the LTV to CAC Ratio?
The LTV/CAC Ratio reveals the total average value you anticipate receiving from a new customer compared to the average cost to acquire a new customer.
LTV = Lifetime Value of a Customer
CAC = Customer Acquisition Cost
How to Calculate SaaS LTV/CAC Ratio
There are several ways to calculate customer lifetime value. One way is with this formula:
LTV = Average Revenue per Account (ARPA) / Customer Churn
Or you can calculate customer LTV using this formula:
LTV = Average Revenue per Account (ARPA) × Average Customer Lifetime
SaaSy Co. offers three different pricing options for its CRM software: basic, professional, and enterprise. SaaSy Co. has 100 basic customers, 250 professional customers, and 75 enterprise customers. Its average customer lifetime varies by pricing plan.
Average Customer Lifetime
With this data, we can calculate the LTV of the company’s average customer:
LTV = [($50 × 100 × 12) + ($100 × 250 × 18) + ($500 × 75 × 24)] / 425 = $3,318
This means that, on average, SaaSy Co. can expect to generate $3,318 in revenue per customer.
CAC is simply: Total Sales and Marketing expense / # of new customers
If SaaSy Co. spends $200k to acquire 160 new customers, their CAC would be $1,250 / customer.
So, putting it all together:
SaaSy Co.’s LTV/CAC ratio is $3,318 / $1,250 = 2.65
Note: Sometimes a gross margin adjustment is made to LTV in order to compare gross profit to customer acquisition cost, rather than comparing revenue to acquisition cost. For high margin businesses, this adjustment often isn't necessary.
Analyzing Your Startup's LTV to CAC Ratio
Looking at LTV and CAC in relation to each other provides a cost-benefit analysis of the methods you’re using to acquire and retain customers. The LTV/CAC ratio is one of the most important metrics you can look at to get a handle on how efficiently your company is using its resources. Over the long run, this metric can be a good indicator of the value of your startup.
What do high and low values mean?
A high LTV/CAC ratio shows that you have figured out efficient methods of attracting and retaining customers. As such, it indicates that your company can grow fast and needs relatively little outside investment to grow. Investors are more interested in companies with a high LTV to CAC ratio, as these companies tend to have higher valuations and more potential for fast growth.
A low LTV/CAC ratio shows that you are relatively inefficient at acquiring high-value customers. In that case, your company’s growth will need more injections of outside capital to grow quickly. Such companies tend to have lower valuations and aren’t as attractive to investors.
The exception to the rule that a low ratio indicates potential trouble is the early growth stage of a SaaS startup. Young startups have to spend a lot to acquire their earliest customers, as they haven’t yet built up a reputation that cultivates word-of-mouth adoption or expands business with existing customers. And, when your customers’ lifetime isn’t yet very long because you’re new, your LTV will be low by nature. A low ratio at this stage isn’t necessarily a problem if you have confidence that your LTV will grow over time.
What's a good LTV/CAC ratio for a SaaS startup?
The most fundamental rule of the LTV/CAC ratio is that you want it to be higher than one. If it’s greater than one, that means the lifetime value of each customer is higher than the cost it takes to procure them. If the number is one or lower, that means you’re spending as much or more to bring the customer in the door than you eventually recoup in revenue from their business. The latter is a losing proposition.
The question of how much more than one the ratio should be is a matter of debate and may depend on the nature of your business and your business plan.
The typical received wisdom is that a good SaaS LTV/CAC ratio is at least 3:1. This means that the amount of revenue a customer is likely to bring in over time should be at least three times as high as the cost it takes to procure that customer.
However, that number doesn’t fit all businesses or scenarios. For example, you could go lower if you have very predictable acquisition costs and lifetime values. A 3:1 ratio is high enough to provide a cushion for variance, so if those numbers go higher and lower than expected, respectively, you can likely still maintain a decent margin. Those who don’t need such a cushion can still thrive with a lower ratio.
There’s also the question of your business goals and trajectory. If you’re on the path toward a large equity raise and an impressive exit, you’ll want to keep your ratio on the higher end, since that will indicate high margins and impressive revenue growth. If you’re content to simply own your business and grow it organically over time, a ratio that keeps you in business is the baseline of what you need.
What other insights can you get from your LTV/CAC ratio?
The LTV/CAC ratio is good for more than just comparing acquisition and lifetime value costs. On an overarching level, it’s a quality indicator of your startup's health, which is what investors will look for. It can tell you and investors how fast, and how much, you can expect your company to grow — and how predictable your revenue tends to be. It can help you analyze how effectively you’re spending your resources, thereby enabling you to make strategic improvements to your business operations.
You’ll get the most value from this metric — as with most metrics — if you track it over time. Trend analysis will help you see which of the adjustments you’re making to your processes are helping. It’s important to be patient as you make changes; the shifts in CAC and LTV will show up gradually as you measure incrementally.
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