LTV:CAC - The Metric That Determines Business Viability

For recurring revenue businesses, one metric reigns supreme in determining long-term viability and growth potential - the ratio of Customer Lifetime Value (LTV) to Customer Acquisition Cost (CAC). This ratio shows the relationship between the revenue a customer will generate over their lifetime and the cost involved in acquiring that customer.

Customer Lifetime Value (LTV)

LTV represents the total revenue a customer will generate before they churn, including any upsells and renewals. There are various ways to calculate LTV, but a simple formula is:

LTV = Average Revenue Per Account (ARPA) / Revenue Churn Rate

For example, if your ARPA is $5,000 and your annual revenue churn rate is 10%, your LTV would be: $5,000 / 0.1 = $50,000

This means the average customer lifetime value is $50,000 based on a 10% annual churn rate.

Customer Acquisition Cost (CAC)

CAC represents the total sales and marketing costs involved in acquiring a new customer. This includes things like sales compensation, marketing program spend, and any tools/software required.

To calculate CAC:

Total Sales and Marketing Costs in Period / Number of New Customers in Period

For example, if you spent $500,000 on sales and marketing last quarter and acquired 200 new customers, your CAC would be $2,500.

LTV:CAC Ratio

By dividing LTV by CAC, you get the LTV:CAC ratio which shows how much lifetime value a customer will generate compared to their acquisition cost.

Using the examples above:

LTV of $50,000 / CAC of $2,500 = LTV:CAC of 20

Generally, an LTV:CAC ratio higher than 3 is considered viable and healthy. A ratio of 5 or higher is excellent and will allow for efficient growth and reinvestment.

If your LTV:CAC is below 1, it means you are spending more to acquire customers than you'll make from them over their lifetime - an unsustainable situation.

Improving LTV:CAC comes down to reducing churn to increase LTV, optimizing your sales/marketing efficiency to lower CAC, and continually delivering more value to increase ARPA through upsells and expansions.

For subscription businesses, this metric determines your ability to affordably acquire new customers and grow. In the next post, we'll cover cohort analysis, which provides deeper insights into customer behavior.