LTV/CAC ratio : The metric that matters

LTV/CAC ratio
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Here’s a piece of advice up front. Be optimistic, but don’t let it cloud reality with calculating your LTV/CAC Ratio.

Particularly speaking, new SaaS entrepreneurs, tend to be a bit too confident when it comes to the demand of their product.

The passion often leads to higher expectations of the software’s ability to acquire and retain customers. One also tends to overestimate the fact that their software will be helpful to customers for improbable stretches of time with little to no advancement in the product.

These assumptions, while well-intentioned, lead to inverse efficiency. To avoid this, it’s important to calculate the customer acquisition cost accurately — and slot it against the revenue that those clients will eventually bring in.

Calculating your CAC

You invest it all in your SaaS startup – the capital, hours of hustle, tons of brain space. All of it to acquire customers. Many entrepreneurs assume their acquisition costs are mostly composed of the cost spent acquiring leads, such as with online ads. It’s time to widen that spectrum.

It costs a lot more than ad spends.

Employee Cost:

Employee Cost especially marketing employees along with costs of consultants and agencies. You also need to calculate the overhead costs associated with them. Don’t forget to include sales commissions and bonuses that are paid throughout the acquisition process.

Failure Rate:

Failure Rate because some of your sales hires will never reach their full productivity and make a good return on your investment. Add to that, some of your customers might churn during the sales and CS handoff – what we call the “onboarding black hole.” These costs need to be accounted for.

Marketing Tools Costs:

Marketing Tools Costs of software that helps you accomplish marketing and sales tasks directly related to customer acquisition (think scheduling social media posts, marketing emails or CRM software), these costs need to be included as well.

Get a clear picture of how much it costs to acquire a customer so that you can get an understanding of what it will take for your company to stay profitable.

Calculating your LTV

The idea with calculating LTV is to figure out how much revenue you can reasonably expect each new customer to bring in over their entire relationship with your business.

The Advanced Method to Calculate Customer Lifetime Value

This advanced method has several variables but it also gives you a more precise LTV. Here are the variables involved:

Gross Margin:

Your gross margin is the total revenue the company generated minus the cost of goods, which in the case of a SaaS company can include the cost of operations and support services.

Gross Margin = Total Revenue – Cost of Goods

Net Revenue Churn Rate:

The net revenue churn rate is the percentage of revenue that you have lost from existing customers in a specific period of time.

Net Revenue Churn Rate = (Revenue lost in a specific period – upsells in that specific period) / Revenue at the beginning of the period

Monthly Recurring Revenue (MRR):

It is the recurring revenue that your SaaS company makes in a month. It helps to average out your pricing plans and billing periods into a single consistent metric that you can track over time.

MRR = Number of Customers x Average Billed Amount Per Customer

Average Revenue Per Account (ARPA):

It is the revenue generated per account. In most businesses, a single customer can have several accounts and that’s how ARPA is different from MRR. Calculate ARPA at the recurring period interval that your SaaS business works at.

ARPA = MRR/ Total number of accounts

In a situation where ARPA is roughly the same for all customers and there isn’t any expansion revenue expected over the customer lifetime, LTV can be calculated as:

LTV = ARPA x Customer Lifetime 
LTV = ARPA/ Customer Churn Rate

It is important to note that if ARPA in the equation is monthly, then the churn rate and customer lifetime should be monthly as well. However, if the ARPA differs across the customer base, then the gross margin needs to be taken into account in order to get a more accurate LTV:

LTV = (ARPA x Gross margin %) / Revenue Churn Rate 

Find the Balance

Maintaining this balance is the Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV). Also called the LTV/CAC Ratio. If it consistently costs more to acquire customers than those customers are likely to bring in over their customer lifetime, you’ll quickly run out of cash.

Clearly, your LTV should be greater than your CAC. But, how much greater?

The ideal LTV:CAC is 3:1

The ratio will fluctuate over time, but a good rule is to aim for an LTV that’s at least 3 times greater than the CAC. If the ratio falls consistently below 3x, it’s time to make some serious changes to reduce CAC or boost LTV.

As your company crosses LTV/CAC -> 3 target, then you should strive towards attaining a ratio of 5. This is majorly due to economies of scale, where you will spend less in getting additional customers and thus LTV/CAC should increase.

Tip: Reduce churn to increase your LTV

When customers are unhappy, they stop doing business with you. It’s that simple. The more customers that leave, the less you grow. If you want to keep your customers, then you need to address customer churn. Understand their needs, target them correctly, engage with them constantly and keep adding value to reduce your churn.

The Ratio of Success

The LTV/CAC Ratio is a simple way to evaluate the future prospects of your SaaS company. The right LTV/CAC Ratio means you have the potential to grow faster and require less capital to do so. This is often attractive to equity investors and can mean a higher valuation for the business.

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