What is LTV/CAC?
The LTV/CAC Ratio measures the relationship between the lifetime value of a customer and the cost incurred to acquire that customer.
The customer lifetime value (LTV) refers to the profit attributable to a particular customer, while the customer acquisition cost (CAC) is the expense incurred in convincing the customer to purchase the product (i.e., convert into a paying customer).
How to Calculate LTV/CAC Ratio
The LTV/CAC ratio stands for “Lifetime Value to Customer Acquisition Cost” and is perhaps the most important metric for evaluating software-as-a-service (SaaS) companies.
In practice, the LTV/CAC ratio is most often used to gauge a SaaS company’s cost efficiency in terms of its sales and marketing (S&M) spending, which ultimately determines its long-term feasibility of its current business model.
Simply put, the LTV to CAC ratio answers, “Are the current customer acquisition strategies of the SaaS business sustainable?”
The LTV/CAC ratio is computed by dividing the total sales (or gross margin) attributable to a customer over their entire lifetime (LTV) by the total cost incurred to initially convince that same customer or customer group to make their first purchase (CAC).
- Step 1 ➝ Estimate Customer Lifetime Value (LTV)
- Step 2 ➝ Calculate Customer Acquisition Cost (CAC)
- Step 3 ➝ Divide Customer Lifetime Value (LTV) by Customer Acquisition Cost (CAC)
LTV/CAC Ratio Formula
The formula to calculate the LTV/CAC ratio divides the customer lifetime value (LTV) by the customer acquisition cost (CAC).
LTV/CAC Ratio = Lifetime Value (LTV) ÷ Customer Acquisition Cost (CAC)
Where:
- Customer Lifetime Value (CLV) = ( ARPA × Gross Margin) ÷ Churn Rate
- Customer Acquisition Cost (CAC) = Σ Sales and Marketing (S&M) Expenses ÷ Number of New Customers Acquired
What is Good LTV:CAC Ratio in the SaaS Industry?
For early-stage SaaS companies, the general guidelines for a “good” LTV/CAC ratio are as follows.
| LTV:CAC Ratio | Interpretation |
|---|---|
| LTV/CAC ➝ ~3.0x | - Often cited as the ideal target range for the majority of software companies as the pace is sustainable (and reasonably profitable) - Intuitively, an LTV/CAC of 3.0x means the company receives $3.00 per $1.00 spent to acquire the customer |
| LTV/CAC ➝ <1.0x | - Considered unsustainable and implies the company is facing difficulty monetizing its newly acquired customers - Either the wrong strategies are being used or the customer base is too difficult to monetize (i.e., no spending power, unwillingness to pay) |
| LTV/CAC ➝ >5.0x | - The value received on a per-dollar basis might be high, yet the context of the situation makes the ratio not ideal (i.e., for an early-stage company, revenue/user growth is more important than cost reduction) - For instance, an early-stage company attempting to disrupt an industry is facing (or soon will) face pushback from incumbents and other competitors - Therefore, management likely needs to spend more on new customer acquisitions as it may be missing out on growth opportunities - Or, the conservative spending may be due to diminished growth opportunities |
How to Improve LTV to CAC Ratio
A sign of progress in the right direction is reflected in the LTV/CAC ratio converging towards 3.0x – which represents a more normalized, sustainable rate.
What Factors Cause Low LTV-CAC Ratio (<1.0x)?
An LTV/CAC ratio of 1.0x means the company is right at the break-even point – but note, CAC excludes expenses unrelated to acquiring customers.