Customers and the revenue they bring are the lifeblood of your company. They’re the assets that help corporations sustain their competitiveness in the cutthroat SaaS market. That said, the CAC (customer acquisition costs) associated with these customers eat away at potential profits. This is simply why the LTV or lifetime value of each customer needs to be greater than the CAC.
A high LTV to CAC ratio implies that you’ve unlocked the right strategies for gaining and retaining customers, as well as strategies for growing without relying on external investments. Below, we look at how both of these metrics are calculated, what they mean, and the steps you can take to optimize them.
Lifetime Value or Customer Lifetime Value is the estimated revenue one customer can generate for your business over the course of their relationship with you.
Customer Acquisition Cost is the average amount spent on gaining a single customer for your business.
For startups and early entrants in business, the ration between LTV and CAC helps determine how much you should spend to gain a customer. Estimating this number will enable you to learn whether you are spending enough on customer acquisition or if you’re missing opportunities of gaining customers.
How to Calculate LTV:CAC Ratio
You can calculate LTV in a couple of ways. For SaaS entities:
Average Monthly Revenue Per Customer x Customer Lifetime = LTV
Average Monthly Revenue Per Customer / Monthly Churn = LTV
For calculating CAC you can use this formula:
Total Marketing and Sales Expenses / Newly Acquired Customers = CAC
Calculating LTV:CAC ratio is easy with the following formula:
LTV / CAC = LTV to (1) CAC Ratio
What is an Ideal LTV:CAC Ratio?
For a growing SaaS business, the ratio should be 3:1 or higher because a higher ratio means higher sales and marketing return on investment (ROI). Investors are easily attracted to companies with high LTV:CAC ratios because it means that the SaaS company can grow with little outside investment. However, if your ratio is too high, you are most likely underspending and halting your growth.
A low LTV:CAC ratio means that your business is inefficient at acquiring customers. In this case, your company needs more capital from outside to gain customers and stay afloat. Companies with low ratios are not attractive to investors and aren’t regarded as stable.
How and When to Use the LTV:CAC Ratio
Calculating the LTV:CAC ratio will not be beneficial to a SaaS business when you have just started. It will show its true colors when your business is growing and scalable. Just like any business metric, use the LTV:CAC ration for making the following decisions:
- Which types of customers are easy to acquire?
- How much can the business spend to acquire X type of customer?
- Do I need 1 or more sales representatives, based on the ratio?
Similarly, you can use this business metric to pitch to investors and demonstrate your understanding of how the business works. It also proves your planning for future growth with scalability in mind.
The LTV:CAC ratio is more important than just a determinant of customer acquisition costs. On a large scale, it also reflects the health of your startup and its agility compared to others in the market. It also predicts your incoming revenue and any possible spikes your business can achieve with a boost in investment. You can make strategic improvements to your business model with the help of this ratio. Moreover, you can gain the most value from this metric if you track it over time. Periodic analysis will show you the result of adjustments made and their implication on business growth.