Every founder is probably familiar with the Lifetime Value to Customer Acquisition Cost (LTV/CAC) ratio. It’s a key question that any VC expects you to answer. In short, it shows investors profitability of customers acquired today. The other party interested in the metric is an internal operations or marketing specialist. They use it to optimise the return on their advertising investments to improve the overall profit margin.
The tricky thing about analysing LTV/CAC is that it appears to be very simple but it’s an integral / decisional aspect (or point of discussion) for VC investors, which makes it a bit murky. Merely understanding it and feeling confident about how it’s been derived is key in deciding whether to invest in a founding/management team or not.
Here is a safe way to go about your calculations:
From your P&L sheet, add up all the marketing & sales overheads & personnel and divide by number of customers acquired in the same period. Acquisition costs include: Cost Per Click (CPC), Customer support personnel, Discounts and/or promotion for referrals, or any other cost that is strictly connected at the conversion of a customer. Partial or full acquisition costs include: offline marketing and other sales-oriented promotions and marketing personell (provided they’re work is directly tied to CPC or other types of conversion)
LTV Method 1
LTV = t (52*s*c*p)
t = Average Customer Lifespan
s = Spending per Visit
c = Visits per Week
p = Profit Margin (in %)
LTV Method 2
LTV = m * [r / (1 – i + r)]
m = Gross Margin (in $)
i = Discount Rate
r = Retention Rate
An ideal LTV/CAC ratio should be 3:1. One direct way to optimise (lower) your CAC is to continuously A/B test campaigns. And one clear way to improve to LTV is to enhance the core products with higher value. Companies should also be careful about acquiring ‘cheap’ customers only. While it seems attractive, ask yourself how likely these customers can jump to competitors or how likely they will stay on for long enough (thereby increasing your average LTV). Sometimes it pays to invest in ‘good customers’. Good customers might cost more to acquire, but they’ll likely be more profitable as well.
To conclude, make sure that your calculations are properly baked into your financial model and robust enough to reflect changes in sensitivity scenarios.