If you work at a fast-growing SaaS organization, you might have heard your CEO talk about customer lifetime value (LTV) and customer acquisition cost (CAC) at your last town hall meeting. While traditionally thought of as sales and marketing metrics, both LTV and CAC are financial metrics that are a focus for finance teams too as SaaS firms start to adopt a holistic approach to measuring their performance.
The intensifying focus on LTV, CAC and the unique relationship between them might have you thinking—what exactly are these metrics and why should our finance team be tracking them?
Every SaaS company will have their own approach to LTV and CAC based on their market, business model and growth stage. But some key principles ring true for all SaaS finance leaders who are looking to leverage their data to drive strategic decision making—and that's what this article is all about.
But first, let's start by defining LTV, CAC and the LTV to CAC ratio.
What Is The LTV:CAC Ratio?
LTV:CAC is the ratio that compares the lifetime value of customers to the costs associated with acquiring them.
LTV:CAC ratio is calculated by dividing your LTV by CAC.
This is an important metric for gauging your company's long-term profitability.
What Is The LTV:CAC Ratio Formula?
LTV:CAC Ratio = LTV / CAC
What Is Customer Lifetime Value? (LTV)
LTV is the average revenue earned from customers spanning from the moment a customer signs to the moment they churn.
Actively measuring LTV allows you to answer two crucial questions:
- How much revenue are we getting from clients over the course of their time with us?
- How much revenue can I expect to generate from new customers?
To calculate LTV accurately, you need to account for key inputs like average revenue per customer, gross profit margin and average customer lifespan. For B2C SaaS companies, you also need to consider the average purchase value and average purchase frequency when measuring LTV.
Let's say, for example, that your SaaS firm has an average ARR of $30,000 per customer. If gross profit margin is 70% with an average customer lifespan of four years, then LTV could be calculated using the following formula:
LTV = (average revenue per customer) x (gross profit margin) x (average customer lifespan)
= ($30,000) x (0.70) x 4
= $84,000
What Is Customer Acquisition Cost? (CAC)
CAC is the average amount of money that a company spends to acquire a new customer.
This metric is a little more straightforward than LTV, in the sense that SaaS businesses across industries generally require the same high-level inputs to determine their CAC.
To accurately calculate CAC for a specific time period (usually per year or per quarter), you need to account for total sales expenses, total marketing expenses and total number of new customers acquired during that time.
Keep in mind that effectively measuring sales and marketing costs includes advertising spend and employee payroll for all revenue-generating roles.
A company's CAC can be calculated using this formula:
CAC = (total sales expenses + total marketing expenses) / (total number of new customers)
What is a Good LTV to CAC ratio? (LTV:CAC)
Generally speaking, the benchmark for a strong LTV:CAC is 3:1—which means the value of your customer relationships should be about three times the cost of bringing those customers on board.
Even though what's considered to be a "normal" LTV:CAC will vary slightly between industries, you should look at the 3:1 benchmark as a pretty reliable indicator of whether or not your SaaS business is well-positioned for success.
Another way to assess your sales efficiency is through what's known as the "SaaS magic number," which looks at your company's change in revenue quarter over quarter in relation to what it spent on marketing and sales activities.
How Churn Impacts LTV:CAC Ratio
Churn rate is the measure of customers who leave a service over a given period.
When churn rate increases, the average retention time for a typical customer decreases, directly affecting the Lifetime Value (LTV).
A lower LTV means that the revenue generated from a customer over their relationship with the company is reduced.
At the same time, the Customer Acquisition Cost (CAC) remains constant or may even rise, as businesses may need to invest more in marketing to replace lost customers. A high churn rate can lead to a lower LTV:CAC ratio, indicating a potential inefficiency in customer acquisition and retention strategies.
Understanding and minimizing churn is therefore crucial for maintaining a healthy LTV:CAC ratio, ensuring that the value derived from customers aligns with the cost of acquiring them.
Importance Of Tracking The LTV To CAC Ratio
As more and more SaaS companies start to dominate the digital economy, more conversations about LTV and CAC will start happening in boardrooms around the world. For finance leaders and CFOs—who are continuing to evolve from number crunchers into strategic, data-driven decision makers—this represents an incredible opportunity to start leveraging LTV and CAC data to help determine the path forward for your SaaS business.
So, if you haven't started already, here's why your finance team should start paying attention to LTV and CAC and actively share those insights with the rest of your organization.
1. Provides Efficiency Insights
2023 is the year of financial efficiency. Efficiency is one of the top strategic initiatives financial leaders are prioritizing.
A high ratio indicates efficient use of resources, while a low ratio may signal overspending on acquisition. The ratio provides a good indication into how effectively a company is converting its marketing and sales spending into long-term customers
2. It Helps Influence Key Business Decisions
Forbes Council Member and Fattmerchant Co-founder Sal Rehmetullah said, "CAC and LTV are the two most crucial metrics for CFOs to track because they dictate your sales strategies." While this is certainly true, the sales department isn't the only area where LTV and CAC insights can deliver value.
Your finance team should also rely on LTV and CAC to identify strategic investment opportunities in marketing, operations and customer service. Let's say, for example, that your company's LTV:CAC starts to dip below that 3:1 benchmark. If you look at the reasons why, you might find that LTV is getting dragged down by an increase in churn rate. That level of insight would help your leadership team figure out what they need to prioritize—such as investing in product updates or expanding customer retention programs.
On the other hand, if your company's LTV:CAC is well above that 3:1 benchmark, there might be an opportunity for further investment in marketing and demand-generation initiatives without sacrificing profitability. Your finance team needs to own that analysis during your budgeting, forecasting and planning cycles—because as the stewards of financial data, you're well-positioned to report on how changes to LTV:CAC might affect your SaaS company's long-term goals.
The challenge, however, is when financial and operational data is siloed in a bunch of different source systems. Executives will expect you to deliver LTV and CAC insights quickly—especially in fast-moving SaaS environments--which is a lot harder to do when you're wrangling data manually with spreadsheets.
3. It Encourages Transparency and Collaboration Between Departments
Tracking LTV and CAC requires data from across your business, which means you can foster cross-functional collaboration when it's time to act on your findings. As we mentioned earlier, LTV:CAC is an indicator of your SaaS company's profitability—and tracking it effectively ensures leaders from every department have proper visibility into how their teams are moving the needle.
Let's say, for example, that your CAC is unusually high for one quarter, perhaps due to a big bump in marketing spend that just didn't translate to new customers for some reason. That scenario would negatively impact your LTV:CAC—and it would be up to your finance team to engage with marketing executives to show them how their trends are affecting the bottom-line.
It's also important to remember that with more transparency around LTV:CAC, cross-functional leaders can hold their teams accountable by proactively analyzing how their departments are performing.
After all, transparency is a two-way street—if non-finance leaders can identify for themselves how to make positive changes to your LTV:CAC, they'll feel more comfortable working with your finance team (and other departments as well) to develop a solid game plan and improve the business altogether.
4. You Can Help Lead Your SaaS Company's Business Intelligence Revolution
In order to drive collaboration and make LTV and CAC easier to understand, data visualization with dashboards should be a prominent aspect of your business intelligence strategy.
Dashboards are really useful for simplifying metrics such as LTV:CAC and for empowering cross-functional leaders with past, present and future performance insights. When built properly, dashboards can also tell compelling stories with your data and make it easy for leaders to visualize how LTV and CAC affect each other.
According to this survey from the Association for Financial Professionals, data management and predictive analytics are the most important skills that FP&A teams need today. But the same survey also found that inadequate software systems are their biggest roadblock.
So, if you want to create effective dashboards for LTV and CAC—or any other complex metric for that matter—you'll need to take an honest look at the tools you have in place and evaluate whether or not you can actually perform the strategic analysis that's expected of you. This represents yet another opportunity to level-up your finance team by complementing your planning processes with data visualization.
How To Improve Your LTV/ CAC Ratio
You can optimize your LTV/CAC ratio. For LTVs higher than the CAC, investing more in sales and marketing can drive business growth.
For LTVs less than or equal to your CAC, you will need to increase your LTV and lower your CAC to optimize your LTV/CAC ratio.
1. Update Sales and Marketing Strategies
You can optimize your company's marketing strategy to reduce your customer acquisition costs effectively. For example, consider more sustainable marketing options if you use paid advertising. Paid advertising builds brand awareness to attract customers, but the costs add up quickly.
Consider a more cost-effective marketing strategy instead, such as implementing a referral program. Referral programs help you generate more leads without going over budget. Besides, customers referred to your business have a lower churn rate and a higher LTV compared to non-referred customers.
You can also calculate your LTV/CAC ratio for various customer segments to determine your organization's most valuable customers. This will help you decide which customers to focus your marketing efforts on.
2. Adjust Pricing Strategy
You can also adjust your pricing strategy to lower your CAC. For example, a "freemium" pricing model can assist in attracting new customers and lower your CAC. In practice, however, this model only works well if there is a strong strategy to turn free users into paying users.
Consider offering a free trial to a new user instead of using the freemium model and lowering their CAC. By granting new customers full product access for a limited time, you can motivate them to buy the product after the trial period expires.
For the best results, always collect credit or debit card information before allowing customers to sign up for their free trial. That may significantly increase your conversion rate and turn almost all users into paying customers after the free trial ends.
You can also adjust your pricing. Undercutting a product can reduce LTV. So, make sure your product pricing reflects the value you offer your customers.
3. Improve Retention Rates
You can increase your customer retention rates to improve your LTV, especially if your church rate is high. Consider the following tips to help boost your customer retention:
- Optimize your onboarding process to ensure customers don’t leave before purchasing
- Collect feedback from churned customers to understand why they left
- Improve your products and services regularly to ensure they meet customers’ expectations
- Offer competitive pricing
- Offer top-notch customer support
- Encourage current customers’ brand support by creating reward or loyalty programs
LTV and CAC Made Easy With a Complete Planning Solution Built for SaaS
The importance of actively measuring LTV and CAC cannot be overstated for finance teams in SaaS. Proactively analyzing these metrics leads to more strategic decision-making, meaningful collaboration between departments and easier, more data-driven planning processes
So, if you're ready to empower your finance team with the tools they need to succeed, check out our financial reporting solutions to see how Vena makes tracking your most important SaaS metrics simple—all without replacing Excel.
