BUS-217  ·  Week 5

Concept

CAC < LTV: One Equation to Rule Them All

CAC < LTV

Pay attention to the following pages because understanding this one equation will determine whether your startup venture flies or dies. Yes, I know you're just skimming this, but I guarantee you that if you don't take the time to understand this now, someday your venture will be going broke, and you'll be wondering why.

A business is an engine that attracts customers, delivers something of value to them, and then extracts that value in the form of profits. That's what a business is. It logically follows that the cost of attracting a new customer needs to be less than the value we can extract from that customer. If it costs fifteen dollars in advertising to get a customer, but we can only make seven dollars from that customer, then Houston, we have a problem.

Conversely, if it costs fifteen dollars to get them, and then once they are a customer, they make repeat purchases that yield seventy-five dollars in profit, then you are happy. Ultimately, every venture of every kind has to have a Customer Acquisition Cost (CAC) that is less than the Lifetime Value (LTV) of a customer. It's a simple, self-evident concept, yet failure to accurately project LTV:CAC remains a leading cause of startup death.

Customer Acquisition Cost (CAC) is a very simple concept — it's the amount of money we spend on customer acquisition activities during a given period, divided by the number of new customers acquired during that period. So if we spend $10,000 during the quarter on sales and marketing and we got 1,000 new customers during that period, then our CAC was $10. Easy peasy.

The Lifetime Value (LTV) of a customer is similarly simple in concept. Let's say we sell widgets for $20, and we make $8 in gross profit on each one we sell. Now let's say that the customer buys a widget from us, and then ends up coming back and buying an average of five more widgets from us before they disappear. This means that the average new customer buys a total of six widgets from which we make $8 each in gross profit, so our LTV on that customer is $48. Because math.

Given this example, our widget business is a pretty good one! We are able to get customers for $10, and make $48 from them, which gives us an LTV:CAC ratio of 4.8!

The fact is, a high percentage of startups die because their cost of getting customers turns out to be higher than they can make from them. This is partly just because we're all optimists — we all think our startup is so awesome that people will flock to become customers and will remain customers forever. Eventually, that optimism fades as we realize marketing is expensive and no customer stays forever.

To paraphrase Ernest Hemingway, startups go broke two ways: gradually, and then suddenly.

Investors tend to obsess over LTV:CAC.

Investors care a lot about your LTV:CAC ratio because it's the essence of a successful business. It's also a proxy for their potential ROI. If you have proof that you can spend one dollar on customer acquisition activities and get five dollars in value back (an LTV:CAC ratio of 5.0), investors will want to shovel as much money as possible into that engine. Having a business with an LTV:CAC ratio over 5.0 looks like a just-add-money opportunity to investors.

It's a blunt tool that is better when sharpened.

Let's say that during one quarter, you spent ten thousand dollars on sales and marketing and got one thousand new customers for a CAC of ten dollars. Some of those customers probably came through word of mouth, some as referrals, some from your PR efforts, and some from paid advertising. You had a blended CAC of ten dollars, but that doesn't tell you anything about the relative effectiveness of each of your different customer acquisition efforts.

Not all customers are created equal.

With every business I've ever run, I've realized at some point that eighty percent of our profits were coming from twenty percent of our customers. It's incredible how this tends to be true with almost all businesses. If you look at the LTV of your entire universe of customers, you'll probably see that twenty percent of them have a much higher individual LTV than the rest. Wouldn't you want to focus your CAC efforts on getting more of the high-LTV customers? Yes, you would.

Therefore, cohorts matter.

The two points above would suggest that you really want to track your LTV:CAC ratio by customer cohort. For example, what's the ratio for customers acquired through Facebook advertising versus those acquired through Google advertising? Knowing that would tell you a lot about allocating advertising dollars. What's the LTV:CAC ratio for customers acquired through our referral program? Knowing that would tell you how much you can afford to offer in a referral fee. Your company's blended LTV:CAC indicates the health of the overall engine, but it doesn't tell you how to optimize the engine's performance for the next quarter. Tracking customer cohorts tells you that.

Also, velocity matters.

One afternoon, I sat in the backyard of longtime Silicon Valley venture capitalist Tim Connors as he drew graphs for me on his whiteboard (only VCs have whiteboards in their backyards). He explained that he doesn't care about the LTV:CAC ratio, per se; what he cares about is the velocity with which invested CAC comes back in the form of LTV. He's developed a metric he calls CACD (the D is for "doubled"). CACD answers the question, "If we spend twelve dollars in customer acquisition activities, how long does it take for us to get twenty-four dollars' worth of gross profit back?" As an investor, he wants to see a business with a CACD of less than eight months.

Tim's formula gets to the heart of an inherent flaw in the LTV:CAC ratio: it doesn't include a time factor. A business with an LTV:CAC ratio of 5:1 might seem good at first, but if you have to service a customer for ten years before you make back the money you spent getting that customer, then it doesn't seem so good, right? Velocity matters, so think about how you can measure CACD for your business. Spending twelve dollars where it returns with a high velocity will accelerate your engine of growth (and make Tim happy).

Common Mistakes in Calculating LTV:CAC

Not adding in staff costs.

I've had entrepreneurs proudly tell me that they spent five thousand dollars on advertising in one quarter and got five thousand new customers, so their CAC was just one dollar! But then I look at their financials, and they have a full-time marketing person, two marketing assistants, a fancy graphic designer, an inside salesperson, and someone handling inbound web leads. Their actual all-in customer acquisition costs were way more than a dollar — because math.

Thinking your time is free.

I've had entrepreneurs tell me that their customer acquisition cost is zero because they do all the selling themselves! That's only if you think your time is worthless. Also, it's not scalable. When you are calculating CAC, make sure you ascribe a reasonable value to the time you personally spend selling.

Thinking CAC is always a marketing problem.

I met with a startup recently that said they fired their marketing person because the customer acquisition cost was just too high. We dug into the funnel metrics together and found that plenty of customers were entering the top of the funnel on their e-commerce website, but very few were completing a purchase — most got all the way to the payment screen and then left. It turns out the payment gateway they were using was a really crappy user experience. They switched to a new one, and the number of people completing purchases doubled, cutting the CAC in half. It wasn't a marketing problem; it was a crappy payment gateway problem.

Overestimating repeat purchases.

Every entrepreneur thinks their product is so excellent that customers will come back and buy more and more. Every startup with a subscription model thinks no one will ever cancel their subscription. This isn't reality. Be conservative with how you calculate repeat purchases in order to come up with your LTV. It's better to be surprised in a good way than to end up in surprise bankruptcy.

Not factoring in promotions.

Let's say you find that offering a "no questions asked" return policy increases your sales. That's great! But if fifteen percent of all purchases get returned, then you need to either reflect this as part of your customer acquisition cost or within your gross profit or LTV numbers. Don't just wave your hands and pretend those economics don't apply to you. They do.

Not benchmarking.

If you show me your pitch deck, and it says that your LTV will be seventy-two times your CAC, I'm going to laugh and ask you whether pigs can fly. Look up the LTV:CAC ratio for similar businesses. Generally, you want to have an LTV:CAC ratio higher than 3:1. Seldom have I seen anything more than 10:1. If you're way outside that range, you probably have some assumptions wrong.

Using gross revenue instead of gross profit.

It seems silly, but I've seen entrepreneurs get confused by this. If we sell widgets for $20 (gross revenue), and those widgets cost us $12 each to make, then the gross profit is $8 — so that's what we're actually making from the customer.

Let's face it — as entrepreneurs, we are naturally optimists. We all underestimate what it will cost to get a customer, and we all overestimate how much we will make from customers. Sadly, this optimism drives a lot of startups to failure because they realize too late that they have their CAC < LTV expression upside down. Do this math early, and do it with a solid dose of realism. You will dramatically increase your odds of growing a successful startup venture.

Some of Silicon Valley's worst failures have stemmed from the fact that the company (and its investors) thought that somehow the laws of economics had been suspended. An infamous example is pets.com, which raised $180 million with their great idea of selling bags of dog food at a loss and hoping to turn that model into a winner eventually, maybe, somehow. They went bankrupt in eighteen months, sending $180 million down the toilet.

Or take the much-hyped Y Combinator company, Homejoy. They were a startup marketplace for connecting consumers with home cleaning services, and they raised an impressive financing round of $38 million. Their cost of one house cleaning was $35, and they sold one house cleaning for $95 (unit economics). They ran a promotion offering the first cleaning for nineteen dollars, figuring that customers would come back for several more cleanings — except that people took the nineteen-dollar cleaning and never came back. Fundamentally, their LTV:CAC ratio was flawed, but they spent millions advertising their promotion, hoping that the economics would magically change at some point. Finally, they went bankrupt four years after founding, losing thirty-eight million dollars in investor money.

Most companies start with a CAC much higher than their LTV. As you optimize your marketing and sales, hopefully your CAC will come down, and as you build brand loyalty and happy customers, hopefully your LTV will go up. The point at which those two lines cross is the notional point at which the company turns profitable.

The CAC < LTV concept applies to every business of every kind. Every venture must have a sustainable way to get customers at a cost less than the venture can make from them. It's an immutable law of economics. Ignoring the formula (or misunderstanding it) remains a leading cause of startup death. As the venture capitalist Bill Gurley once wrote, "the formula can be confused, misused, and abused, much to the detriment of the business." So, don't do any of those things, or it will make Bill mad, and you won't like Bill when he's mad.

Sharpen the tool by tracking customer cohorts, improve the formula by adding a time factor, and remember that not all customers are created equal, and you will have an engine of growth that makes you happy and investors eager.

Ultimately, the success or failure of your venture will distill to this one equation: CAC < LTV. Every business of every kind must have a way of getting a new customer at a cost less than they can make from that customer. It's a simple concept, yet getting it wrong remains a leading cause of startup death.