As mentioned in Parts 3 and 4 of the KPI Series, two of the oft-most talked about and essential metrics for any business, particular for those in the SaaS / technology industry, are customer acquisition costs and customer lifetime value. Each of these provide unique and useful insight into a company’s customer base, with CAC conveying the efficiency of sales and marketing team performance, and CLTV providing a detailed look into the average economic value of a customer over its lifetime. Luckily, there is a KPI that combines both of these valuable metrics and is tracked by investors and individuals across the industry: the CLTV to CAC ratio. We will explore the importance of monitoring CLTV / CAC, and how it varies for companies across their growth and maturity lifecycle.
The Importance of the CLTV / CAC Ratio
Alone, CAC and CLTV tell only two separate parts of a company’s performance story: CAC conveys the initial investment made to acquire a customer or set of customers and CLTV conveys the value an average customer provides over the length of the customer’s lifetime with the company. Together, these metrics convey a prototypical return on investment received from an acquired customer. This not only can help show how efficient a company’s sales and customer acquisition process currently is, but combines that with how valuable customers can be to a company over their average lifetime. Through vigilant monitoring of the CLTV to CAC ratio, companies can begin to understand how profitable / unprofitable they currently are across their customer base, and take initiative to implement the necessary adjustments to maintain / enhance their profitability.
For companies to achieve high levels of growth, making investments in customer acquisition will always be critical. However, through this all, companies must understand what levels of CAC and investment are sustainable for long-term business viability and value creation, thus making CLTV to CAC ratio an even more critical KPI to track. Let’s explore the symbiotic relationship between CLTV and CAC over time and how it trends as the company’s sales efficiency and lifetime value improve in the example below. It is worth noting that the illustrative example will use simple calculations to derive CAC and CLTV, excluding the discounting of cash flows or the consideration of another key metric that should be tracked (this metric, average cost of service, will be written upon in a future article in the KPI Series):
In the example presented above, the operational improvements made by Company ABC are very evident as the CLTV / CAC ratio continues to increase over the five-year period. The variety of factors (e.g. increase in ARR for new customers and subscription gross profit margin, lower churn and sales & marketing costs per new customer) work in tandem to provide Company ABC with an enhanced financial profile, which can lead to incremental value creation, as investors evaluate the Company’s KPIs.
CLTV to CAC Across a Company’s Lifecycle
When evaluating CLTV to CAC ratios across companies, two additional items that must be taken into consideration are a company’s maturity and its current growth rate. Early stage, high-growth companies operating with a large total addressable market opportunity can make aggressive go-to-market decisions, such as increasing sales and marketing spend or discounting the prices of solutions to secure more new logo additions. These actions may lead to increases in CAC and/or decreases in CLTV, driving a company’s CLTV to CAC ratio downwards. Over time, as companies mature and begin to enhance operational processes that lead to better financial performance, both CAC and CLTV can trend positively, leading to a higher CLTV to CAC ratio. Such improvements in operational processes can come in the form of higher ROI on sales and marketing spend (e.g. more experienced, effective sales and marketing personnel, improved lead generation and pipeline conversion), churn reduction (e.g. enhancements in product delivery, dedicated customer success personnel improving retention) and increased value extraction from customers (e.g. higher prices for products / services sold, add-on products and services in the form of upsells and cross-sells). Although these aforementioned improvements tend to be more relevant for companies as they mature, early-stage, high-growth companies can also see an increase in performance and in their CLTV to CAC ratio from implementing these initiatives.
As was conveyed in the illustrative example in the prior subsection with Company ABC, it should be the goal of a company / business owner to drive gradual improvements in both CLTV and CAC over time. The graph below depicts Company ABC’s CLTV and CAC metrics over time, a representative journey that other companies should aspire to track towards over their maturity lifecycle.
Similar to other rules of thumb presented in earlier articles in the KPI Series, the rules of thumb to be presented for CLTV to CAC ratios are not representative of all scenarios and companies, given the unique nuances and intricacies that businesses operate under in today’s complex environment. In order for CLTV to CAC ratios to be truly meaningful, business owners and investors should track the metric consistently over a period of time to ensure there are enough datapoints available for comparative purposes. Additionally – as a company matures and begins to scale its internal processes and teams (e.g. new systems put in place, new hires across sales and marketing organization), the CLTV to CAC ratio becomes more essential, as it can be used as a benchmark to inform strategic and operational initiatives. By doing so, companies can minimize operational hiccups and missteps that may hinder its performance and financial metrics. For further reference, below are CLTV to CAC ratios that businesses can utilize as rules of thumb / targets:
Concluding Thoughts: CLTV and CAC are Better Together than Apart
There are variety of standalone metrics that companies track in their performance planning and KPI dashboards, each of which tell a story about a company’s operational and financial standing. CAC and CLTV are certainly powerful KPIs by themselves, helping convey the effectiveness and efficiencies of a business’ customer acquisition and retention model. Together, however, these metrics make an even more powerful KPI – a ratio that businesses of all types and sizes can utilize to inform better long-term strategic and operational decisions. By using the CLTV to CAC ratio in financial reporting and planning, business owners and investors can work to not only improve their company’s / investment’s internal processes and procedures, but also create benchmarks to track towards and compare to other entities within a company’s competitive landscape.
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