For SaaS companies moving beyond their product development and early growth stage, efficient resource allocation and high customer retention are important drivers of growth. If the wrong customers are being targeted or retention rates are volatile, SaaS companies are missing key growth opportunities.
How does a SaaS executive evaluate the efficiency of their customer acquisition model?
LTV:CAC ratio is one of the most critical indicators of future success and a key calculation used by investors to determine valuation. Simply, the LTV:CAC ratio is the relationship between a customer’s lifetime value, or LTV, and the cost to acquire that customer, known as CAC or customer acquisition cost.
For typical high performing SaaS businesses, the gross profit generated by each customer must be meaningfully higher than the customer’s cost of acquisition. For investors, the LTV:CAC ratio is an indication of both customer profitability and marketing effectiveness.
Below we work through the calculations for LTV and CAC:
Customer Lifetime Value (LTV)
LTV is the gross profit a single customer is predicted to generate over their engagement with the company.
A customer’s gross profit is the revenue a customer generates net of the company’s cost to fulfill that revenue. Calculating a customer’s gross profit requires an understanding of the company’s gross margin, a percentage that represents the revenue retained net of cost of goods sold (see our previous blog on What Every Software Executive Should Know About COGS). Calculating customer lifetime value also requires an understanding of how long a customer remains engaged with the company, known as the average customer lifetime. As a proxy for customer lifetime, one can use the retention rate, the percentage of customers or ARR retained annually, the average annual recurring revenue (ARR), and gross profit margin. In this example, we use the average ARR, which typically consists of the expected annual recurring revenue stream from subscriptions or maintenance.
LTV = (Average ARR X Gross Profit Margin) / Churn Rate*
Consider three similar SaaS companies and their respective LTV calculations:
|Average ARR||Gross Profit Margin||Churn Rate||Lifetime Value|
Although both Company A and B have the same 13% churn rate, Company B has a higher average ARR than Company A, leading to a greater LTV, even though Company A has a higher gross margin.
Now comparing Company B and C, they have the same average ARR of $50,000 and the same 80% gross margin but Company B has a churn rate of 13% vs. Company C’s 5% churn rate, which means Company B is retaining significantly fewer customers or ARR than Company C, resulting in Company B having a lower LTV relative to Company C.
In short, a company with a relatively higher customer LTV could be benefitting from one or a combination of the following:
- greater average ARR
- higher gross margin
- lower churn
Customer Acquisition Cost (CAC)
CAC is the cost to acquire one customer. This is calculated by ascertaining the sales and marketing expense on potential new customers by the actual number of new customers obtained. This number can be calculated using a monthly or annual timeframe. In general, the lower the CAC, the better for the company.
CAC = S&M for New Customers / Number of New Customers
Compare Companies A, B, and C below. As Company A is spending less while acquiring the same number of customers as Company B, their CAC is lower, reflecting more effective sales and marketing spend. Though Company B and C spend the same amount on sales and marketing, Company B’s efforts are attracting double the new customers, reflecting a more effective sales and marketing effort.
|Annual Sales and Marketing Expense||Number of New Customers||Customer Acquisition Cost|
Now let’s consider LTV:CAC among all three companies to assess which is the most valuable per this metric.
The LTV:CAC ratio can be calculated as follows:
In this scenario, Company C would be valued more highly by investors. Despite a higher CAC, it’s customer LTV is significantly higher, resulting in a more attractive LTV:CAC ratio than Company B or C’s.
What does LTV:CAC ratio mean from an investor’s perspective?
LTV:CAC is one of the most critical metrics used to value SaaS companies. From an investor’s perspective, a high LTV:CAC ratio, considered 6x or higher, indicates good growth potential with limited marketing investment while a low ratio means that the capital required to acquire new customers is not being effectively utilized and the company may need a future influx of capital to generate ARR growth. An extremely high LTV:CAC such as 13x for Company C in the example above may even indicate that the company is underinvesting in sales and marketing.
LTV:CAC remains one of the most critical indicators of a SaaS company’s health and potential for growth and capital infusion. Beyond providing insights into resource allocation, customer success, and marketing efficiency, it is one of the key calculations used by investors to determine valuation. SaaS executives should make LTV:CAC ratio a focal point for their company.
If you have any questions about calculating LTV:CAC ratio, please don’t hesitate to reach out.
*Churn Rate = 1 – Retention Rate