This is not financial advice so use at your own risk. What you read below is just a rule of thumb and every situation has different circumstances that may effect decision making.
Relevant Templates:
The ideal Lifetime Value to Customer Acquisition Cost (LTV:CAC) ratio for a Software as a Service (SaaS) company considering going public is typically around 3:1. This ratio suggests that the lifetime value of a customer is three times the cost of acquiring them, indicating a healthy balance between the cost of acquiring customers and the revenue they generate over time. If your ratio is too high, some would suggest that means you are not spending enough money on sales and marketing and therefore are missing out on growth opportunities. If the ratio is too low, the business might not be profitable.
However, it's important to note that this is a general guideline and can vary depending on the specifics of the business and the market conditions. A higher ratio may indicate a very efficient business model, whereas a lower ratio could suggest that the company is spending too much on customer acquisition compared to the value those customers bring.
Factors like the company's growth stage, market competitiveness, customer churn rate, and the nature of the SaaS product can influence what an "ideal" LTV:CAC ratio should be. Additionally, investors may look at other financial metrics and growth indicators when evaluating a SaaS company for public investment.
Calculating Customer Lifetime Value
Note, there are a few different ways to calculate the lifetime value of a SaaS customer. You need to take into account renewal rates and the average gross profit per user per period. The renewal rate could be a linear decay (meaning on average you lose about the same amount of customers relative to the initial acquisition cohort at each renewal) or it could be exponential decay (losing a lot in the first few renewals and the the remaining stay for a long time) or something in-between. This depends on the data you have and I built a cohort modeling template that can help you calculate these things with your historical data.
The easiest lifetime value calculation is if your customer retention follows linear decay. That means you can just do the following calculation (1 / % lost per renewal period) multiplied by the months in a period (could be 1 or 12 or what have you) For example, if you have 20 new customers, and you lose 20% per renewal period and each renewal period is 12 months, then you do the following: (1 / 20%) x 12 and then that is the average number of months a customer exists for. You then multiple that by the average gross profit per customer, let's say that is $40/month so the average cLTV is 60 months x $40/month or $2,400.
Another way to calculate this is use historical data and calculate the total revenue earned from a cohort of customers over time and divide that by the initial number of customers added in that cohort. If you have good data, you can also multiply that by your average gross margins.
If your gross margins are really high, then it might not make much of a difference if you use revenue or gross profit, but if your gross profit margins are pretty low, then this will have a pretty large impact on the customer lifetime value. No one way is exactly right or wrong and depends on your unique situation.
Once you have the average customer lifetime value, simply divide that by the average cost to acquire a customer to get the LTV / CaC ratio.
Calculating Customer Acquisition Costs
This is fairly straightforward. You want to figure out all costs for sales and marketing for a given period and divide that by the number of new customers that signed up in the same period. These costs should include sales managers, account executives, spending money on ads, general marketing costs, sales directors, and anything that is directly attributable to acquiring a new customer.
Why is 3:1 the Best LTV to CaC Ratio?
The 3:1 ratio for Lifetime Value to Customer Acquisition Cost (LTV:CAC) in SaaS (Software as a Service) businesses is considered good for several reasons:
Sustainable Growth: A 3:1 LTV:CAC ratio indicates that a company is generating enough revenue from each customer to justify the cost of acquiring them. This balance is crucial for sustainable growth. If the cost of acquiring a customer is too high relative to their lifetime value, the company might eventually run into cash flow problems.
Profitability and Reinvestment: This ratio suggests that the company is not only recovering its customer acquisition costs but also generating enough profit to reinvest in further growth, R&D, and other operational expenses. It allows the business to invest in acquiring new customers while maintaining profitability.
Market Competitiveness: In competitive markets, having a higher LTV relative to CAC can provide a significant advantage. It indicates that the company has efficient marketing and sales processes and a strong product-market fit, which are essential for standing out in a crowded market.
Investor Confidence: For SaaS companies looking to go public or seeking investment, a 3:1 LTV:CAC ratio is often a benchmark that investors look for. It demonstrates to investors that the company has a viable, scalable business model and can generate returns on their investments.
Buffer for Market Changes: This ratio also provides a buffer against market fluctuations and changes in customer behavior. If acquisition costs rise or customer value decreases, a company with a healthy LTV:CAC ratio has more room to maneuver and adjust its strategies.
Customer Retention Focus: A healthy LTV suggests that the company is not just good at acquiring customers but also at retaining them. This is particularly important in the SaaS business model, where long-term customer relationships are key to profitability.
Final Thought
You want to understand this: How much does a new customer benefit your company's financials over time and does the initial cost justify that benefit.
Article found in SaaS.
