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When he's a 3 but, his LTV to CAC's a 9
Dissecting the art and science of LTV to CAC
Customer Lifetime Value (LTV) estimates the total amount of money you’ll get from a customer before they churn out. It effectively tells you:
“If I add up all the deals I do with a customer every year, on average I’ll squeeze a total of [$x] out of them before they bounce”
Let’s look at each component:
Average Annual Revenue per Account: Pretty self explanatory. Note that this is easiest to estimate for subscription businesses, since they’ll pay a consistent amount each period. You can still calculate LTV for non subscription businesses (like Starbucks in the tweet above); it’s just harder to estimate the average annual revenue for a series of less predictable, one-time sales. But fortune favors the bold!
Average Account Churn Rate: This is the inverse of your average account retention rate. Note that it’s measured on an account, not dollar denominated, basis. This is important because you might have a much better dollar denominated churn (or retention) rate, as higher paying customers subsidize the pots and pans who churn out more often. This is also easier to predict for subscription businesses because churn is pretty black and white - you know when they leave.
Gross Margin: This is what’s left over after paying for your cost of goods sold. For tech companies this is typically hosting costs, customer support, and customer success. It’s basically what you have to pay to keep the customer’s accounts on and running. And if you’re one of those rare companies that actually makes something you can touch, your cost of goods sold are the raw materials and inputs to create your product (Starbucks has a lot of coffee beans in their COGS).
Generally all of these figures are best measured on a trailing twelve month basis to smooth for seasonality. I can’t stress this enough. If you have one bad retention quarter it may cause your LTV to drop precipitously (shout out spell check). Save your heart rate and your quarterly graphs the EKG-like spikes.
Comparing LTV to CAC
Now that you have a grip on LTV, you’ll want to compare it to your Customer Acquisition Cost (CAC). Knowing your LTV is great, but it’s not very useful in a vacuum.
In other words, LTV and CAC go hand in hand. You don’t really know what good LTV is without knowing your CAC.
Here’s how you calculate Customer Acquisition Cost:
You’ll notice that we are lagging our Sales and Marketing costs by one quarter. The assumption here is that what you spent in the prior period generated the pipeline to close the deals in the current period. This allows us to match the cost to the result (aka the sale).
To figure out your LTV to CAC, simply put one over the other. The result is a multiple of how many times over you make up your CAC over the course of a customer’s lifetime. In this example you get +5x from a customer compared to what you initially spend to land them.
What’s “good” look like?
Anything under 1x means you are literally burning money, or destroying value.
As a rule of thumb, you want your LTV to CAC to be minimally greater than 3x. I think this is a low-ish bar for software. Anything over 5x, in my mind, is good. And anything above that is phenomenal.
Can LTV to CAC Be too High?
“TOO MUCH VALUE?!” you say! Bear with me!
It could indicate you’re actually leaving growth on the table by not investing more in your sales and marketing machine to go out and acquire more customers. Since valuation is often tied to growth, you may be restraining shareholder value. And from a competitive standpoint, you might be making life too easy for your competitors by not more aggressively chasing net new customers. As a rule of thumb, if your LTV to CAC sky rockets to double digits, you may want to think about cranking up the investments in your go to market engine.
Are there differences in LTV to CAC by Industry?
Absolutely. Most people only think of software, due to it’s contractually recurring nature, but other businesses can and should estimate LTV to CAC as well.
Once again you’ll want to start by figuring out your LTV, and ideally over a 12 month period. Here’s a funky example: most HVAC companies have a customer LTV of $47K, with customers starting off with smaller jobs and ramping up as shit breaks over their average two to three year lifetime. It’s also a lumpy one to calculate due to seasonality (people’s AC’s go out in the summer and heat breaks in the winter). You can find a couple of other fascinating examples here. Funeral homes have a notoriously low LTV to CAC, because, well, you only die once.
Anything else to watch out for?
You’ll want to look at LTV to CAC by segment, or sales engine. Enterprise customers usually have a higher cost to acquire than SMB customers, but larger life time values by way of larger deal sizes and lower churn.
You may also discover cases where customers are less valuable up front, but they consistently expand over time and cost little to nothing to maintain.
And much like CAC, there’s a nearly 100% chance that whatever LTV a company self-reports understates churn as well as cost. Churn is often understated by excluding accounts tied to “sunsetted” products. On the cost side, expenses may not be fully burdened for overhead (rent, office expenses, IT) and share based comp (often a massive non-cash charge for startups) across Sales, Marketing and Customer Support. Beware of that Hollywood Accounting!
Potentially Reliable Stuff I Read at 2AM (Sources)
What I’ve Been Reading
I’d like to throw my hat in the ring to compete for the title of ‘King of Abandoned Online Shopping Carts’. I researched and (almost) bought 11 different pairs of sunglasses last month. I obsessed over the nuances of each pair and how they’d perform while I’m running vs at the beach with my kid vs walking my dog. I wrapped myself in the minutiae, comparing the wrap around style, frame colors and relative price differential for polarized lenses.
This convoluted process pushed me to think about why we buy things. Sometimes it’s driven by social signaling. Sometimes it’s driven by pure utility. Sometimes it’s because we popped open the Amazon window at 2AM after nine Miller Lites. Either way, there’s a lot of psychology behind our purchasing patterns. And unbeknownst to us, the way we get o a product or service may be following a predetermined cookie crumble trail that was methodically laid out for us.
It’s rounded out how I think about the marketing team’s work in positioning a product for consumers - whether they be people or businesses. And it’s made me realize we are all marketing, in some capacity, in our daily lives.
Quote I’ve Been Pondering
You can’t interrupt authenticity.
-Lewis Howes, NYT Best Selling Author, Entrepreneur