Having a poor LTV/CAC ratio tells you one of three things:
- Your current business model is the wrong way to win new customers.
- Your average customer isn’t making enough money to support a positive gross margin.
- You’re running the numbers wrong.
All scenarios are bad news for your company; however, we can make sure the third option isn’t happening by the end of this article.
The value of the LTV/CAC ratio rests in its ability to show how much you’ll get from every penny you’re investing in marketing expenses.
Get it right and you’ll know exactly where to invest when it comes time to build your next budget.
What is the LTV/CAC Ratio?
The Customer Lifetime Value (LTV) to Customer Acquisition Cost (CAC) ratio is how much you spend to acquire a customer versus how much total revenue you generate from those customers.
If you spend $500 to get a customer and the customer only spends $400 in two years, that customer is not profitable. Whether you’re in e-commerce, SaaS, or any other business, that doesn’t fly. However, if the customer spends $1,200 in those two years instead, they’re a profit driver for your business by a factor of $700; you were able to recoup your marketing costs and make some money to spare.
You’re able to calculate the LTV/CAC ratio for either a single customer or a number of new customers in your customer base.
Why the LTV/CAC Ratio is Important to Track
Knowing your LTV/CAC helps you to value your growth tactics accurately. The benefits are enormous, but enabling your sales and marketing teams to adjust their customer acquisition strategies is a major one. It gives them the data they need to know what's working and gives them the ability to defend their need for relevant executive support.
This is merely one of a number of KPIs that are critical to track. Others include annual recurring revenue (ARR), monthly recurring revenue (MRR), and customer lifetime value (CLV or LTV).
HubSpot Tracked Their LTV/CAC Ratio to a $25 Billion Valuation
HubSpot stands tall among the SaaS companies that have found a way to leverage the LTV/CAC ratio over the years.
In this 2012 data, HubSpot’s LTV/CAC progressed gradually from 1.7:1 in the first quarter of 2011 to 4.7:1 by the second quarter of 2012.
The SaaS company had built a valuable product and was making a little over 50% of each customer. They needed to make at least 300% in gross marginal product to be profitable.
They were able to combine public relations and viral marketing to attract customers and retain existing ones over a longer period. Their ideal customers wanted inbound marketing, sales, and customer relationship management.
Their ability to leverage its LTV/CAC ratio has contributed to its growth from $52 million in 2012 to $25 billion in 2023.
How to Calculate the LTV/CAC Ratio
The equation itself is simple: divide your customer lifetime value (LTV) by your customer acquisition cost (CAC) to get your LTV/CAC ratio. The trick is ensuring that you have all of the preliminary figures ready, before calculating LTV and CAC.
- To get your LTV, divide your average revenue per user (ARPU) by your churn rate.
- To get your ARPU, divide revenue by the number of subscriptions in a single period.
Similarly, the CAC calculation requires you to divide the total cost of acquiring customers by the total number of customers acquired in a given period.
Be careful not to leave out aspects of the customer acquisition cost, including:
- Cost of using marketing tools
- Expenses from marketing (and advertising) platforms
- Sales and marketing team salary
- Cost of creating marketing materials and ad creatives
Let’s say you spend $20,000 to acquire 200 new customers in 12 months.
Your CAC will be:
$20,000 / 200 = $100
If your customer's LTV is $350, your LTV/CAC ratio is 3.5:1.
What’s a Good LTV/CAC Ratio?
The SaaS industry benchmark for a good LTV/CAC ratio is 3:1. It's not hard to see why. You’re generating enough revenue from your customer to cover the cost of acquiring them, have a buffer for other business expenses, and hopefully enough to turn a profit.
For example, HubSpot aims for an LTV/CAC ratio of 3:1, which means they want the revenue they generate from each customer to be at least three times more than the resources it costs to acquire them.
However, most early-stage startups are too young to have an LTV/CAC of 3. HubSpot maintained an LTV/CAC ratio of less than 2 for many years before they got it above 3.
If your LTV/CAC is too high while your business is in its early stages, it might indicate that you aren’t maximizing your sales and marketing efforts. If what you’re doing is working and you want the business to expand, why not invest more in gaining additional market share?
What’s a Bad LTV/CAC Ratio?
A ratio of 1:1 or lower means that you’re spending more to acquire customers than they’re spending on your product. As my old accounting professor used to constantly remind us, you can’t scale your way out of negative margins.
You’ll need to adjust your SaaS pricing strategy (to make more money from your customers), reduce your marketing spend, adjust your ideal customer profile, or optimize your customer retention strategy to get buyers to stay with your firm for longer.
Common Challenges of Using the LTV/CAC Ratio
It’s one thing to have a good LTV/CAC ratio. It’s another to leverage it to make positive decisions for your business.
Here are common challenges SaaS businesses face when trying to use their LTV/CAC ratio to drive business goals. Some of them are problems with the ratio and others are operational challenges that keep SaaS businesses from maximizing the ratio.
1. Incorrect Calculations
The CAC ratio can get a bit overwhelming to calculate at times. Between collecting data from all relevant sources (like customer data from your CRM software and advertising data from your ad vendor), your team could mix things up, which might result in an error that affects the final CAC figure.
Or perhaps the issue is with prior incorrect ratios. An LTV/CAC ratio from an incorrect churn rate, for example, will paint the wrong picture of the company's strengths, weaknesses, and opportunities, which can lead to harmful strategic decisions.
2. Lack of Strategic Alignment in Decision Making
Making informed decisions (like identifying the ideal customer for your product) with the LTV/CAC ratio requires all relevant departments to work together and share information. Such collaboration will help your company acquire and serve customers better, improving your retention and getting a better customer LTV.
Your organization lacks alignment if:
- Relevant departments are not given sufficient time to meet project deliverables.
- Team members are oblivious to changes happening in other departments.
To address this challenge;
- Make it easy for your sales, marketing, finance, and customer service teams to collaborate and exchange ideas (to prevent an information silo).
- Unite the goals of the different departments within your organization to encourage the flow of information and idea sharing across all departments.
3. Balancing Long-term Goals with Short-term Business Needs
The LTV/CAC ratio gives data to assist with long-term decisions, but SaaS businesses are not in short supply of urgent business goals. Addressing these short-term financial needs may cause you to sacrifice the longer-term goals that LTV/CAC ratio represents.
You need to organize regular meetings where your team checks in to review your short and long-term goals to find ways to use the LTV/CAC ratio to your long-term strategic advantage.
4. Lack of Historical Data
Knowing your customers’ lifetime value is critical to calculating your LTV/CAC ratio. Because most early-stage businesses do not have the relevant historical data to measure their metrics, they’ll struggle to get a true picture of their business.
For example, knowing your LTV depends on your churn rate; it could take you 2+ years to get this data to be able to compare LTV with your CAC.
If you have proven product-market fit and some idea of how you’ll be monetizing customers over the long term, you might have to use forecasts for your customer LTV in the near term. You could observe competitors’ LTVs or use adjusted industry standards, based on your total addressable market (TAM), serviceable addressable market (SAM), and serviceable obtainable market (SOM).
5. Inadequate Measurement
The lifetime value of customers ebbs and flows as your products mature and you add features and improve functionality over time. Any changes to your products, good or bad, will affect improve churn or retention rate and the resulting LTV/CAC ratio.
However, in order to notice this, you need to be tracking your metrics regularly. Where necessary, invest in tools that enable you to monitor and optimize your SaaS metrics (like the LTV/CAC) so that you can make decisions that make your brand more profitable.
Why You Have a Low LTV/CAC Ratio
Ultimately, poor sales and marketing campaigns will cause your business to spend more to acquire customers than the value it gets from the customer. This could be caused by:
1. Lack of Product-Market Fit
Product-market fit measures your target customer’s willingness to pay for your product. Achieving this fit requires not only building a product that meets customer needs, but the ease with which the product meets those needs.
Not even the best marketing, sales, or pricing strategy will help if your product fails this test. Even if they succeed initially, customer churn will be high, which will hurt your LTV/CAC ratio.
These steps can help you ensure product-market fit in your SaaS Business:
- Identify your ideal customers (and create buyer personas).
- Understand their underserved needs.
- Define how your product will meet the needs of the buyer personas (especially in ways that no other product currently does).
- Create a minimum viable product to test market demand, including the preferred pricing strategy—flat-rate pricing, tiered pricing, or value-based pricing.
- Offer it to the public, gather feedback, and adjust as needed.
2. Missed Upselling Opportunities
The less you understand your customers’ reason for buying, the higher the likelihood of your customers leaving for competitor products. Imagine if you sold a product that measured grass length in backyards; most customers would also want something that can cut the grass. If your tool remains a measurement device forever, you’ll start losing customers to the lawnmowers that have measurement tools built right in.
Let’s look at HubSpot again: they could have limited their offering to a customer relationship management (CRM) product, which would allow them to do fine. But they have broadened their offering over the years to include complementary services within the business growth value chain.
This has enabled them to offer more of the services their potential customers need, reducing the need to go to other brands for those services and by extension, the likelihood of leaving your company for your competitors with more options.
Social listening, customer survey, and competition analysis can help you understand the solutions that will complement what you currently offer, so you can keep your customers buying from your firm for much longer.
That way, your LTV will increase exponentially while your CAC remains virtually the same. This is the benefit of upselling.
Be shrewd about building though; with every new feature that you add, conduct proper market research to ensure you’re actually solving a customer need. No one likes an overengineered product.
3. Marketing to the Wrong Audience
Unlike the product-market fit problem, you have a valuable product but your marketing strategy and messaging are targeting the wrong people.
Marketing to the wrong audience is caused primarily by your marketing team’s lack of understanding of:
- Your product, and
- The people that use it or make the buying decisions.
To avoid this, your marketing team needs to know your ideal customer profile like the back of their hand, so they can speak to (and convert) them in the most efficient way.
Track the Metrics that Matter
Tracking the LTV/CAC ratio (and other SaaS metrics) is critical to your success as a CFO. I write about the most important metrics for SaaS CFOs to track and bring experts in to give their takes on critical issues in the world of finance.
Plus, I share the best content in The CFO Club’s newsletter. Keep it in the black (and be sure to come back).