Your customer acquisition cost (CAC) is the amount you spend to acquire a customer. But it means little to nothing without another key metric: lifetime value (LTV). Because while CAC is a smart way to learn the efficiency of your marketing spend, it’s completely out of context without understanding how much money you’ll actually make from each of the customers you bring in.
That’s why your LTV:CAC ratio is so important. This ratio can tell you a few things:
- It tells you whether or not you can grow sustainably. A dangerously low LTV:CAC might mean you’re spending too much for too little. And vice versa.
- It tells you how efficient your marketing spend actually is. It contextualizes your CAC so you can understand whether you’re making good use of your marketing dollars.
- It’s not uncommon for your customer LTV to vary by channel. Comparing your LTV:CAC ratio by channel gives you a smarter picture of your best-performing channels than if you simply compared CAC.
What LTV: CAC ratio should I be aiming for?
As high as possible. There’s no “perfect ratio” at which point you’re comfortable so sit back and watch ARR pile up. However, as a rule of thumb, a 3:1 LTV:CAC ratio tends to indicate success.
Don’t take this as one-size-fits-all advice, though. Here are a couple scenarios to visualize why this ratio may (or may not) be a fit for your startup:
- Your customer LTV is $300 and your CAC is $100. But your payback period is 18 months and your startup has 8 months of runway. In this case—because LTV is spread out across such a large period of time—your LTV:CAC ratio isn’t sustainable. You might run out of money.
- Your customer LTV is $300 and your CAC is $100. Imagine that in this scenario, payback period is two months: you earn most revenue upfront. If your startup has 12 months of runway, you’re in a position to earn sustainable growth.
Point being, there’s no “golden” LTV:CAC ratio. Once you calculate yours, take into account the your startup’s overall situation and, from there, decide if you’re in a good place.
How do I calculate my LTV:CAC ratio?
Here are a couple basic formulas:
- LTV = Average revenue per user / churn rate
- CAC = Marketing & sales expenses / number of customers acquired
And, finally, LTV:CAC = LTV / CAC. Simple as that.
So, once you’ve got the number, how do you go about improving it?
How can I optimize my LTV:CAC ratio?
In reality, you’re not optimizing the LTV:CAC ratio. You’re actually optimizing two separate things: LTV and CAC. If you’re looking to optimize CAC, read this piece: we’ve written about a few novel tactics for bringing your CAC down. If you’re looking to optimize LTV, read on.
At its core, improving your LTV means doing one of two things:
- Increasing how much each of your customers spend.
- Decreasing your churn rate.
Let’s walk through a few novel ideas for doing both.
How to increase your revenue per customer
To increase the amount your customers spend, you can 1) add additional value to your platform so customers want to pay more, 2) change the way you bill customers to maximize revenue, or 3) do both at the same time.
How to increase on-platform value: Sit down with your ideal customers. Ask them what they’d like to see. What is the platform missing? Then build those features. This is the easiest way to figure out how to add value to the platform. Of course, just because a customer says they’ll pay for something doesn’t mean they actually will. But it’s a good starting point.
How changing your billing can help you increase revenue: If you’re billing the traditional way—flat-rate, inflexible plans—it’s likely some customers are paying for more than they use, and other customers are paying for less. It’s also possible that the amount you’re charging customers isn’t directly tied to the value they get from the platform.
To solve this, I recommend startups think about usage-based pricing. A usage-based pricing structure lets your company pick metrics your customers derive value from & charge them based on how much they use. It’s a smart way to maximize revenue per customer, because your customers get to pay for the things they care about.
There are lots of ways to implement usage-based billing, of course: you don’t have to flip the switch all at once. I commonly see software startups implement usage-based billing alongside a flat-rate fee for access to the product, for example. There are plenty of ways to implement it. We’ll go over this in more detail at the end of this piece.
How to decrease churn
This is a trickier one to tackle. Customers churn for lots of reasons: your product is too expensive, it’s not what they expected, they aren’t finding value out of it, they pivoted and no longer need the product, and the list goes on.
To effectively decrease churn, ask customers to provide feedback when they churn. Ask them why they’re leaving—then evaluate if it’s something you can fix. If a founder tells you “we had to drop your product because we no longer have a need for it,” that’s a whole lot less fixable than if a founder tells you “we felt we were paying too much for the value we were getting.” In the former case, there’s not much you can do—but in the latter, you could switch up your billing structure to deliver more value.
Want to try usage-based pricing? Let’s chat.
If you’ve come to the conclusion that usage-based billing might help improve that LTV:CAC ratio, I’d like to introduce Octane. We make it easy for startups to implement usage-based billing by eliminating the months-long engineering slog it usually takes to get it going.
Truth is, your engineering team should probably (and would rather) work on the core competency of your product. Chat with us to implement usage-based pricing in just a few clicks. No engineering resources required.