Summary:
- LTV, or Lifetime Value of a Customer, is the average total revenue one customer generates for your business over their lifetime.
- CAC, or Customer Acquisition Cost, is simply the average expense to gain one new customer.
- SaaS startups should aim for an LTV:CAC ratio of at least 3:1
Lifetime Value of a Customer (LTV) and Customer Acquisition Cost (CAC) are two important metrics for SaaS startups, and the ratio between them should be watched closely. This article looks at both metrics and answers the question: what is a good LTV:CAC ratio for a SaaS Startup?
Maintaining a healthy LTV:CAC ratio helps prevent you from cutting into profitability by spending too much per customer or limiting growth by not spending enough.
What is LTV?
LTV, or Lifetime Value of a Customer, is the average total revenue one customer generates for your business over their lifetime.
The simplest way to calculate LTV is:
Average monthly revenue per customer X (# months) customer lifetime = LTV
or
Average monthly revenue per customer / monthly churn = LTV
However, LTV should really be gross margin adjusted, so a much better calculation is:
Average MRR per customer X (1/monthly churn) X gross margin (%) = LTV
If you really want to know how profitable your customers are, you need to measure how much money you make after subtracting the service/product delivery cost. You can’t tell if you’re building a sustainable business otherwise. If you generate $3 from a new customer after spending $1 to acquire them it looks like you have a 3:1 ratio – but you really don’t if it costs you $2 to deliver the product/service to the customer. That’s 1:1 ratio ($3 revenue – $2 cost = $1 profit) and is not nearly as attractive. Now, suppose you increase your spend up to $3 to buy a new customer because you think that’s your customer value? Now you’re spending $3 to earn $1 of profit. Bad idea.
Factoring for Churn
Churn can be a tricky thing to calculate, especially for early-stage startups. The simplest LTV method uses 1/churn, but that depends on your ability to get sufficient, reliable data. Industry benchmarks can be helpful here to put guard rails on the upper and lower bounds of your numbers. You don’t want to end up in a situation where you end up overstating your LTV by understating churn. The most important thing depending on your stage, is to use accurate or reasonable numbers. And if you have to be conservative in the face of uncertainty, it’s probably better to do so. I suggest early-stage startups with newer products and newer customers use a cap on the lifetime of 24-36 months (2.78-4.17% churn/month) until they achieve maturity in their churn numbers.
I suggest early-stage startups with newer products and newer customers use a cap on the lifetime of 24-36 months (2.78-4.17% churn/month) until they achieve maturity in their churn numbers.
What is CAC?
CAC, or Customer Acquisition Cost, is simply the average expense to gain one new customer. To calculate your CAC, divide your total marketing and sales expenses over a given period by the number of new customers added during that same period.
($) Total sales and marketing expenses / (#) new customers acquired = ($) CAC
The basic calculation for CAC is simple. What’s not always so simple is determining what to include or exclude from your sales and marketing expenses. Include the obvious costs like sales and marketing salaries, paid advertising and content marketing costs, as well as less obvious expenses like sales and marketing software costs. Exclude branding, PR, and similar expenses not directly connected to customer acquisition. Also, exclude costs for servicing existing customers (e.g. account management, user gifts/guides/marketing/etc.).
What’s a Good LTV:CAC Ratio?
A good LTV:CAC ratio is 3:1 or higher. This is an ideal benchmark to aim for and improve over time. At a certain point, your ratio could become too high, to the point where you’re missing out on growth. (If your ratio is 6:1, you’re leaving potential revenue on the table.) An experienced SaaS startup CFO can help you track your LTV:CAC ratio and determine the best threshold for your current growth stage and future plans.
Segment Your LTV & CAC
Once you’ve got a handle on your overall LTV:CAC Ratio, don’t stop there. The next step is to segment these numbers.
For example, what’s your Customer Acquisition Cost between different sales and marketing channels? Do you spend more to acquire new customers from trade shows or PPC advertising?
Similarly, look at how Lifetime Customer Value varies between different user types. Is your LTV higher from Basic or Premium accounts? How about Business v. Personal users? New v. Returning customers? Segmenting your LTV and CAC will help you determine how much to invest in sales and marketing and where to invest your limited resources for the best return.
The more your business scales, the more important these numbers become. Your customer data should become richer, and your customer acquisition process should become increasingly repeatable and scalable. Tracking your LTV:CAC ratio closely along the way helps ensure you’re investing the right amount into sales and marketing in the best possible places.
For related topics, also be sure to check out SaaS Metrics Simplified Part 1 and Part 2.