SaaS Metrics 3 – Why LTV/CAC Ratio Is Important To SaaS Entrepreneurs
The LTV/CAC Ratio or – Customer Lifetime Value/Customer Acquisition Cost Ratio – brings into clear focus the future prospects of your business. If you have a healthy LTV/CAC Ratio, you have a better chance of success in the longer term. If it’s not so healthy, then you might have some work to do to keep your SaaS company in business.
The LTV/CAC Ratio summarises a lot of great information for a SaaS business. It collapses the anticipated average lifetime revenue of a customer, customer churn, and sales and marketing costs into one number that can answer the fundamental question: On average, do we earn more revenue per customer than to spend to acquire them?
Simply, the LTV/CAC will highlight if your business model can support its growth and be profitable over the longer term. If the ratio is trending up it might be a sign you have some serious issues in retaining customers or your sales and marketing is weak and costing too much to acquire a lead and turn it into a customer.
How to calculate the LTV/CAC Ratio
In order to calculate the LTV/CAC Ratio first you have to calculate your Customer Lifetime Value (LTV) and then your Customer Acquisition Cost (CAC).
First, the LTV measures dollar value over the entire lifetime of a customer or the total amount of revenue, on average, you expect to earn per customer. It is calculated as follows:
LTV = Average Revenue Per Account (ARPC) x Average Customer Lifetime.
Customer Acquisition Cost (CAC) is the investment you make in sales, marketing and other expenses geared towards acquiring and converting new customers. It is calculated as follows:
CAC = Total Sales and Marketing expense/ number of new customers
The LTV Ratio is then simply calculated as follows:
LTV/CAC Ratio = Customer Lifetime Value (LTV) / Customer Acquisition Cost (CAC).
For example: suppose it costs your business $2500 dollars for marketing to identify a target company, generate a lead, engage them with your sales organisation and move them through all stages of the buying cycle to become a customer. Sales secure sign off on a 12-month contract worth $6,000. Happy days!
But wait – there’s more. In most businesses, the initial cost of acquisition usually attracts a multiplier of between 3-5x. This represents the Cost of Goods Sold – overheads associated with having won that business beyond sales and marketing. This might include support, communications, billings and finance, facilities and so on.
So what might look like a profitable deal is in the red from the get go:
|Initial Cost of Sale||
Therefore, that customer needs to be renewed for a second year in order to cover your cost of sale and make a profit. Options to address this kind of first year CAC gap may include a change in pricing strategy, longer minimum contract terms or a well planned upsell/cross-sell approach that is likely to increase the value of the initial contract inside the first year.
Why is it important to entrepreneurs?
The LTV/CAC Ratio is a simple way to evaluate the future prospects of your SaaS company. A higher 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. Conversely a lower LTV/CAC Ratio can mean you are spending more on acquiring new customers than they are worth to your bottom line. It’s possible you will need more capital to drive revenue growth.
So what’s an acceptable LTV/CAC Ratio for a SaaS business? As always, there are many exceptions to the rule of thumb, but generally you should aim for a LTV/CAC Ratio of at least 3:1. If its early on in development of your SaaS company, your LTV is likely to be quite low relative to your CAC. This is fine as long as your LTV is trending up, relative to your CAC, over time.
An LTV/CAC Ratio of 3:1 means the value of a customer should be three times more than the cost of acquiring them. This should give you a good buffer to deal with short term negative corrections in either your customer acquisition or churn. (The next article in this series will dig into the question of how to address Customer Churn, so keep an eye out!)
If the ratio is closer to 1:1 – you are spending too much and are very likely to struggle to be profitable. It might be time to reassess how you are spending your sales and marketing budget or look more closely at product/market fit.
If your LTV/CAC Ratio is closer 5:1, you might be spending too little and are probably missing out on business. It’s time to rev up your sales and marketing effort and drive for stronger customer and revenue growth.
There’s variation on the way the LTV/CAC Ratio and its components should be calculated – so it’s worth doing more research to find the approach that best suits your business. Always ask how any metric makes sense for your business and what does it tell you about your current versus future position.
Controlling your CAC
So how can you manage your overall cost of customer acquisition and strike the right balance with lifetime value, without pricing yourself out of the market?
There is a lot of advice out there but here are four areas where it makes sense to get focused:
- Smooth sales and sign-up. If you are a B2C provider, it is possible to utilise smart automation in the marketing and sales process that will reduce the level of direct sales touch needed to attract a new customer. However, if you are a B2B offering, that touch level may be higher and you’ll need to tool your sales team to reduce the number of steps that have to be processed and administered to get a deal approved. Many businesses design their signup processes around internal requirements from finance, legal, operations and management. Instead, work backward from the customer experience with a view to making it easy, seamless and smooth as possible for them. If your sales model involves a contract sign-on with the client, consider how you can ensure there is no delay at the moment of truth.
- Well considered marketing. Decide early if you are sales or marketing led. Both are valid but if the sales team are calling the shots, you’ll need to hire marketing-savvy sales leadership and immerse your marketing resources in your sales teams rather than building a stand alone unit. This can make it harder to scale your marketing efforts as the business grows, but can provide the organic foundations for a highly collaborative, sales-aligned marketing culture, long-term. If you are in a heavily contested space, have aggressive competitors or a narrow window of opportunity to leverage first mover advantage, it makes more sense to build a crack marketing unit to drive the business from the get-go. A properly tooled and budgeted marketing-led business can more rapidly build out the strategies, programs, channels, partnerships and sales enablement models needed to identify, attract, convert and retain the right kind of buyers. Either way, ad-hoc is the enemy of planned growth. A marketing team pulled in too many different directions can not be effective, or optimise the budgets made available to them.
- Transparent pricing. Many incumbent providers are hamstrung when trying to replatform their offerings to fit a SaaS model. Their internal processes and remuneration structures, legal constraints and global presence can actually make it hard for them to set clear pricing offers on their public website environments. This flies in the face of what it means to be a SaaS or subscription based service, where the ability to research, validate, price, justify and procure should be very easy for the buyer. This is where emerging providers have a genuine competitive advantage. The more upfront you are with your pricing models, the more transparent you can be about inclusions, exclusions, upgrade paths, free trials and promotional offers that give first time buyers a specific benefit, the more quickly you can create strong reasons for a prospect to believe that signing up for your service is a good idea.
- Constant innovation. It’s table stakes for a SaaS company to be in constant development on their offerings to design, test and iterate new features, functionalities and in-app awesomeness, but it’s also important to be equally innovative with the tools, channels, tactics, content and data that you use to connect with your audience and learn about their preferences, behaviours and needs. As a SaaS entrepreneur, drinking your own industry Kool Aid should be part of your DNA, so embrace your ability to identify, pilot and build your business processes and functions around other SaaS offerings. Fly the flag for SaaS providers in all your lines of business from sales and marketing, to finance and operations, HR and everything in between. Not only can this be a great way to build a community of like minded folks around your business, it’s also a smart way to keep your CAC and COGs under control.