LTV/CAC - Friend or Foe?

2 June, 2022

There’s a cult of LTV/CAC devotees. But unfortunately, unlike maths, when you put garbage in the numerator and garbage in the denominator, it doesn’t cancel out.

It’s therefore crucial to know when LTV/CAC is useful versus when it’s not.

The LTV formula is a good tactical tool for analysing marketing channels. However, it’s often bastardised as a compass for corporate strategy. Its assumptions are confused for reality, and its ambit is expanded beyond its tactical significance.

LTV dogmatists start to argue that as long as LTV is higher than CAC, you should aggressively spend on marketing. This is when things go awry.

I’ll explore:

  1. What is LTV/CAC
  2. Three categories of problems with LTV/CAC
  3. A few solutions

What is LTV/CAC?

LTV stands for customer lifetime value. It’s the gross profits a customer brings to a business over their lifetime, discounted to the present. Prudent conservatives also subtract CAC, which is the cost of acquiring a customer… but we’ll see CAC is a nightmare to measure.

  1. ARPU = annual average revenue per user
  2. Costs = annual costs to support the user
  3. n = average customer lifetime, which is the inverse of churn
  4. WACC = discount rate (cost of capital)
  5. CAC = customer acquisition costs

Problems with LTV/CAC

1/ The future does not resemble the past

At best, the LTV is a “good guess” at how the future will unfold.

First, average revenue per user far into the future is near impossible to know. It depends on long-run market competition, which is challenging to forecast. Just because a business is creating value in the present, doesn’t mean it will capture value far into the future.

Second, churn changes over time. It’s just noise in early years. Tail assumptions about retention and ARPU are guesses at best. Whilst LTV has profits skewed towards the back half of a customer journey, CAC is upfront. For cash-strapped startups, this can create a problematic cash-flow cycle and increase dependence on external capital.

Third, averages obscure reality. The marginal consumer often costs more to acquire than early adopters. They also spend less. Thus, the average LTV/CAC should not be used to justify marginal spend on customer acquisition. Read that again.

Fourth, wildly profitable acquisition channels rarely endure. Arbitrage and competitive market dynamics result in CAC blowing up until breakeven is reached.

Fifth, customer lifetime typically exceeds an early startup’s runway. The startup won’t receive LTV if it goes broke first. And there’s no faster way to go broke than S&M-driven operating losses justified by positive LTV/CAC.

2/ Calculation problems

Ask 10 startups how they calculate LTV and you’ll get 15 different answers.

First, LTV practitioners rarely discount their LTV estimates. Discounting is important to account for:

  1. Risk — earlier cashflows are more certain
  2. Time — earlier cashflows have a compounding effect, particularly if the company has a high ROIC

Second, marketers miscalculate CAC. They often divide S&M by total customers to calculate CAC. But only purchased customers should be included, not organic customers. This is because purchased customers underperform organic on almost every metric. Organic users typically have a higher revenue contribution, higher conversion rate, lower churn, and higher NPS.

Third, many people discount “revenues” rather than gross profits. However, it is critical to consider all future variable costs of supporting the customer.

3/ The formula is misleading since the variables are not independent

When you try to optimise one variable in the LTV formula, you often impact others.

Raising ARPU (price) will increase churn.

Growing faster through marketing will increase CAC (assuming finite customer demand). Increased direct marketing spend has diminishing returns to scale. But then we get the question of how to attribute brand marketing.

Aggressive marketing might also increase churn by capturing lower quality customers. If you improve customer service to reduce churn, you increase costs and deteriorate cash flow contribution.

Problematically, many forecasts show all metrics improving in the future. Reality says differently.

What’s the solution?

Solutions for startups

First, know when LTV/CAC is useful versus when it’s not. It’s a useful tactical tool to compare and contrast marketing channels — at least when implemented with candor and rigour (that is, all CAC math must be granular to the channel).

However, a blended average LTV/CAC is not a strategic tool to justify marketing spend. It doesn’t show what happens in the margin. An LTV/CAC of 4x doesn’t mean that marketing is profitable. Nor does it mean that marketing is better than product-led growth which actually benefits customers.

As Jeff Bezos said:

“More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.”

Solutions for investors

As an investor, use payback period instead. It’s more grounded in fact. Payback period only requires near-term actuals versus the hand-wavy, infinite time horizons projections for LTV.

To calculate CAC payback, you can use:

(MRR * gross margin)/(previous month’s S&M)

Similarly, the SaaS magic number is a helpful measure of sales efficiency. It measures “for every dollar of S&M, how much ARR do you create”. For Q2, this looks like:

(Q2 rev - Q1 rev) * 4 / (Q1 S&M).

Whether you use months or quarters depends on the business. For B2B SaaS, months is typically best. For marketplaces, go with quarters.

In summary, the LTV/CAC destiny is usually a mirage. The formula has an important place in tactical marketing, but be wary of its limitations in corporate strategy and venture investing.

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