Written by Sean Newman, Strategic Finance mentor at The Commons.
In the past decade, there has been no shortage of mega fundraising rounds financed by behemoth investors such as Softbank and Tiger. The right product can change the world, and those savvy enough to recognize the next big thing will reap enormous rewards for years to come. That being said, as Bob Dylan once said, the times they are a-changin’.
The VC gravy train is slowing down. Growth at all costs is no longer an option. Promising young startups are being told to grow up. And growing up means discovering a viable pathway to profitability.
Don’t panic! The winners… and there are many of them, will still emerge victorious, but this will rely on more than product-market fit. Strategic Finance has never been more important for ensuring the future success of a company. And we have one weapon in our arsenal that is more valuable than all the rest: LTV/CAC.
A well managed LTV/CAC can attract generous investors and determine a company's growth strategy, but I’m getting ahead of myself. First, let’s start at the beginning and look at what LTV/CAC is, how it’s calculated, and what it does for a company.
What is LTV/CAC?
LTV stands for Lifetime Value. This is the total dollars brought in by an average customer over a lifetime. This may look very different depending on the industry. On one hand you have SaaS companies such as Hulu. The goal is to upsell users to premium subscriptions while avoiding churn at all costs. On the other hand there are marketplaces such as DoorDash. In a given period there can be one, several, or many transactions per user.
Let’s further break down “Lifetime Value”.
Lifetime… this is typically not a user’s literal lifetime. Should it be 12 months? Or 10 years? More time results in a higher LTV, but also sacrifices believability. If you’re an early investor in Tinder for example, a 20 year curve may arouse suspicion. When in doubt, most companies can expect a lifetime curve of 3-5 years for their products to be believably applied to LTV calculations.
Value… this could mean revenue, but I recommend building your case around gross profit. Ensuring that each user has positive overall Gross Profit is a crucial step towards one day achieving profitability. Remember– now more than ever this is a critical piece of due diligence for investors. Gross profit is revenue less the costs associated with making and selling a product. It is calculated as Revenue - Cost of Goods Sold.
CAC stands for Customer Acquisition Cost. Typically a customer is acquired through one of four categories.
- Sales Programs
- Marketing Programs
- Organic (this one technically has a CAC of $0, but it’s very rare for a company to rely solely on organic acquisition for rapid growth)
In addition to the direct costs associated with the above programs, it’s up to you as the finance expert to think through the salaries, overhead costs, and support that ought to be interwoven into each program. For example, let’s say a five person team launches subway ads in NYC. If each person spends roughly 20% of their time on this campaign over 6 months then costs should include 5 x Fully Loaded Headcount x 50% (for 6 months) x 20% (time spent). The cost associated with buying the space should also be included.
How is LTV/CAC Calculated?
- Average Value of Sale can be subscription price, basket size, or medication cost. What’s important is that it’s distilled down to one single transaction
- Number of Transactions can vary. Typically in SaaS there is one per period. This is your monthly HBO subscription or your yearly Microsoft Suite fee, for example. In marketplaces there can be far more transactions per period. For example, an Uber customer may take Ubers 6 times a month
- Retention Period follows a retention curve from Month 0 where 100% of customers are retained, to Month XYZ. Again, 3-5 years is typically a believable curve.
Let’s take Lyft for example. The following (made up) inputs can provide us with an LTV:
- Transaction cost per booking = $10
- Avg. users take 2.5 trips per month
- Retention = 100% in Month 0, 80% in Month 1, and 70% in Month 2
$10 x 2.5 = $25.
100% x $25 + 80% x $25 + 70% x $25 = $62.5 LTV
This of course only takes 3 periods into account and is therefore not a complete LTV. As mentioned earlier, a good curve for LTV is 3-5 years. So instead of M0 to M2, your curve would go from M0 to M59.
CAC can be interpreted in many ways depending on how your company is run. Oftentimes, similarly sized companies and even competitors have differing growth models. One telemedicine company may invest in their “brand” while the other builds a mighty salesforce. Only time (and LTV/CAC ratio) will tell which strategy plays out best.
Sales Program CAC = Salary + Commission + Travel & Entertainment + Taxes. Other potential additions may be sales director salaries, sales ops salaries, or support team salaries.
Marketing Program CAC = overhead, paid ads, etc. This is usually very straightforward to find. The challenge is determining which customers were acquired through the program.
Partnership CAC = costs of the program. Do you pay your partner a fee? How much time did it take those involved to manufacture the partnership? This is about mapping investment in the program using what feels fair.
What is a Good LTV/CAC Ratio?
By definition, a ratio below 1.0 loses more money as it grows, so it’s fair to say that is at the bare minimum the floor. Typically 3.0 to 5.0 is considered the sweet spot that investors want to see from a healthy business. If a ratio goes much higher than 5.0, it may be leaving too much growth on the table, and profits should be reinvested in sales people or marketing.
Why is LTV/CAC So Important?
LTV/CAC is the middle ground between growth at all costs and the fabled EBITDA profitability. It shows that a company makes money on each transaction instead of losing money. In theory, all other costs can be diluted through economies of scale. Typically LTV/CAC has most value for two types of audiences:
Investors. During a fundraising round it is always a good idea to sell your company to VCs through favorable LTV/CAC ratios.
Company Leaders. It’s in the best interest of your Founder, CEO, and StratFin Director to explore the brutally honest facts of your current ratio. What follows is a discussion on levers and ultimately plans for product and biz ops related decision making. Perhaps retention is uniquely low for one type of customer and a change in the app experience will improve this. Or CAC is more favorable in a specific line of business. It makes sense to grow your salesforce there. This can be reviewed quarterly and steer the decision making of the company.
If your company is not taking a look at LTV/CAC, perhaps you should be the person to change that. The strategic insights it offers are game-changing. We here at The Commons are big fans of LTV/CAC. In fact, we discuss it quite a bit in our Strategic Finance Sprint.
Interested in learning more? Let’s get in touch! I don’t just write for The Commons, I also teach! My favorite part of our community is being able to see people pivot into tech jobs or level up in their current position. Spots are limited so don’t waste a minute. See you in class!