Customer Lifetime Value to CAC Ratio - The Ultimate Compound SaaS Metric

This episode explores the significance of the Customer Lifetime Value to Customer Acquisition Cost (CLTV to CAC) ratio in SaaS business models, highlighting its use as a key metric for evaluating business efficiency and investment potential.

1. The CLTV to CAC ratio is crucial for measuring the return on investment in acquiring customers versus the revenue they generate over their lifetime.
2. Different calculation methods can significantly affect the ratio, impacting how businesses assess their performance and attractiveness to investors.
3. Historical context and benchmarking are essential for understanding shifts in metric expectations, with recent standards suggesting a CLTV to CAC ratio closer to 4x, up from the previous 3x norm.
4. Expansion revenue and how it's factored into the CLTV calculation can greatly influence the metric, highlighting the need for segment-specific analysis in more mature companies.
5. Despite its importance, the CLTV to CAC ratio has limitations and can be misleading, especially for early-stage companies with limited data on customer retention and expansion.

1. Introduction to CLTV to CAC

A debate on the importance of the CLTV to CAC ratio in SaaS metrics, including various calculation methods.
Ray Rike: "It really measures the lifetime value of your customer compared to what it costs to acquire said customer." Dave Kellogg: "We're going to debate everything on this episode."

2. Deep Dive into Calculation Methods

Discussion on different approaches to calculating lifetime value and customer acquisition costs.
Dave Kellogg: "I use a period metric approach, which considers sales and marketing expenses for a specific time." Ray Rike: "I use average ARR per account to include the benefit of expansion revenue."

3. Historical Context and Investor Perspectives

Exploration of how historical changes and investor expectations shape the use of CLTV to CAC.
Ray Rike: "Investors love this metric because it simplifies assessing company health and growth potential."

4. Challenges and Limitations

An analysis of the challenges and potential misinterpretations of the CLTV to CAC ratio.
Dave Kellogg: "The problem is, you get ridiculously large numbers due to long lifetimes driven by low churn rates."

1. Understand Your Metrics: Familiarize yourself with different calculation methods and choose the one that best suits your business model.
2. Segment Your Analysis: Break down metrics by customer segment to get more accurate insights, especially in mature companies.
3. Use Historical Data: Compare current metrics against historical benchmarks to track performance and set realistic goals.
4. Communicate with Investors: Clearly explain your calculation methods to potential investors to align on expectations.
5. Monitor Regularly: Regularly revisit and revise your calculations as your business grows and market conditions change.

Dave "CAC" Kellogg and Ray "Growth" Rike discuss the Customer Lifetime Value to Customer Acquisition Cost (LTV:CAC) Ratio - a metric many consider the ultimate compound metric that investors love!

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Ray Rike, Dave Kellogg

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Gainsight

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Dave Kellogg

Live from Schenectady, New York, it's SaaS talk with the Mettrics brothers, growth in CAC. And I'm growth, better known as Ray Reich, founder and CEO of Benchmarket. And I'm Kak, better known as Dave Kellogg, independent consultant, eir at Baldersham Capital and the author of Kell Blogger. And together we are the Metrics brothers. And we go together like Andreessen and Horowitz.

Ray Reich

I think you need to stop letting me write the jokes. But I am funny, Dave. Yeah, yeah. Just like Lieutenant Hawk and good morning, Vietnam, if anyone remembers that fantastic movie in the scene where they fire the not funny guy and he goes, sir, in my heart I know I am funny. And then, thank you, Lieutenant, that'll be all.

Dave Kellogg

Yep. So how are we talking about Andreessen Horowitz again? Do you want to debate public policy or effective accelerationism or something like that? Right. I'm just trying to get Mark Andreessen or Ben on my podcast.

Ray Reich

But no, really, a 16 z was the catalyst for this week's episode because back in August, and we started talking about this eight months ago, Dave, they published an article on why do investors care so much about customer lifetime value to CAC ratio? So I thought it'd be fun to dive into it. Okay, well, I've been working on a seminal post on LTV to CAC for about that entire eight month period, Ray, and I'm not quite done yet. Yeah, well, waiting for you to finish that post is like waiting for Godot. Wow, we're getting deeply intellectual today here, Ray.

Dave Kellogg

Samuel. Samuel Beckett plays, originally written in French, as you reminded me in the warm up, but he's going to show up any day. Showing up any day, Ray. Maybe we'll have to change our nicknames and I'll be Vladimir. Okay, in the meantime, we're gonna let you discuss LTV to CAC.

I know you've got a hot take on it and we want to hear it and I want to debate you on it. But before we do that, let's hear. A word from our presenting sponsor. Sas talk is presented by Gainsight, the first digital customer platform, including customer success, management, product experience, customer communities, and customer education. Find out why more than 1500 companies, including SaaS leaders like Zoom, Atlassian and Okta, and hundreds of early stage startups, rely on gainsight to efficiently retain and expand existing clients through an integrated digital first post sales customer journey.

C

Gainsight has affordable packages for younger companies and goes live in two to four weeks or less. Visit www.gainsight.com now back to the show. Okay. Now even the acronym for Customer Lifetime value to CAC can be debated. So I use CltV to CAC ratio, but some people use lTv to CAC.

Ray Reich

So let's start right there. But it's really measuring. What's that? Lifetime value of your customer compared to what it costs to acquire said customer. Yeah, so we blow up an agreement right out of the gate on this one, Ray, because I'm not, I don't call it Cltv colon CaC like you do.

Dave Kellogg

I call it ld LtV slash Cac. So I leave the c out. So I just say lifetime value to CAC ratio. So we could debate the name. We're going to debate everything on this episode.

This is going to be a more back and forthy than usual. One thing we won't debate is the point. And the point is to compare, call this the ultimate SaaS metric once because we're trying. Why ultimate? Because we're trying to compare how much you spend to get something versus what it's worth.

And that's really the best thing about this metric, is its intent. Yeah. And once we get into what the rate of return says, if you hit the industry benchmark, it's pretty incredible. But let's start with the customer lifetime value component. And I think this will.

Ray Reich

I know there's a debate here, so I use the formula. You take the average ARR per account, you multiply that by the recurring revenue gross margin, and then you divide that by the annual customer churn on an ARR basis, and that gives you customer lifetime value. So, Dave, I think you might have a question right off the. Yeah, I mean, there's two things you're doing here. You're doing it on a gross margin basis, and I don't think I do.

Dave Kellogg

I think I do it on an ARR basis. Can't remember. I have to go look at my post. So there's two debatable points. When we talk about someone's value, are we talking about their value in terms of ARR revenue?

Are we talking about their value after cost of goods sold, goods sold? That is recurring revenue gross margin, as you call it, or simply subscription gross margin. So that's one element of debate. Ray goes on the gross margin side. I think I go on the ARR side because you asked me how much it was worth.

I didn't. Asked me anything about how efficiently I ran my service. Then the other issue here, this is a little bit of slight of hand that brother Ray did, is he's using average ARR per count. And, Ray, what do you mean by average? Average of a particular time cohort or average of what?

What? Average? Yeah. This is a debate. So I typically like to do this on an annualized basis, or I can look at a trail in twelve months and I'll look at the total ARR for that time period, and I divide it by the average number of customers on contract during that same time period.

Ray Reich

And the reason I said that, because you're going to have the number of accounts keeps going up. Right. And even though you have churn. So I use the average ARR per account. If you read the Andreessen Horowitz article, two things, they did it more b, two c.

So they used ARPU, average revenue per user, and they did a version, not gross margin adjusted. Then they did another version, gross margin adjusted. So they hedged and said, we do both. Now there is a debate, Dave, should you just use the ARR for a cohort of customers acquired in a specific period this year? I don't.

I do it across the entire customer base. And the reason I do that is it then includes the benefit of expansion revenue. So I don't factor it using NR, I just use the average revenue per account. Yeah, it's pretty implicit there. I want, I wanted you to hear Ray's explanation of what Ray does, because it's not how I do things first and second.

Dave Kellogg

It's pretty implicit. So if you ask Ray, how do you factor expansion into this? He'd say, yes, I do. Right? He'd say, I've got it captured by using the average ARR per account.

Really as of that moment in time, for all time. The last time we had this debate, Ray, it was effectively just look over all time, tell me how big the ARR pool is. Divide by the number of customers. Bang, there's my average ARR per account. So kind of snapshot as of now, that's how Ray do it.

I do it differently. I look at this as a period metric, so I would calculate it for a quarter or for a year. Why do I view it as a period metric? Because you asked me how much it cost as well. So I need to know how much it costs to get all those customers I got in Q two, therefore I get q one.

Sales and marketing, right? I've already just looking at the CAC side of it. It's inherently a period metric, so I keep that philosophy. When I look at lifetime value, I say, okay, then, what was my most recent churn? Let's invert that and multiply by the new ARR on the period.

I would include both new customer, new logo ARR and expansion ARR there. So I would include expansion arrangements because it's a subtype of new ARR. But that's how I would do it. I would calculate LTV to CaC for a time period like q two, and therefore I'd use q one sales and marketing q one churn rate as the actuals to try and do the calculation well. And the other reason I do it, and there's no right or wrong here, but I was taught this back at GE years and years ago, and we were doing customer lifetime value.

Ray Reich

If you have a customer that's around for four or five, six years, you really don't know what the lifetime value is unless you have a predictive variable that says, here's how much a customer expands a relationship with you every year. And then we would, there, we would multiply it by that growth factor. If a six year life, you got to use the six year life growth factor. Yeah, it helps when you're a couple hundred year old company with a lot of operating history, right, as opposed to a two or three year old startup. So, I mean, Ray, you're actually hitting on, one of the biggest flaws in this metric is you have very young companies getting very long lifetimes off very low churn rates.

Dave Kellogg

And that's a problem. So this is why I don't like this metric, frankly. You know, at one point I really called it the ultimate SaaS metric because that's its intent. It wants to be all in, how much are we spending to get somebody? And after we get them, how much are they worth?

And I actually think that how much are we spending metric? CAC is a pretty good metric. We've talked about that a lot already. It's the LTV part where I get nervous because it's an attempt to value the install base. Basically.

That's what it's trying to do. How much are those people worth? And the fullness of time in LTV to CAC, you do it, but you, you get the lifetime by inverting the churn rate. You get the lifetime value by multiplying that time. Some ARR figure either raise average ARR for the whole base or my average ARR for the set of customers we just acquired, one or the other.

But the problem is, due to long lifetimes driven by low churn rates, you can get ridiculously large numbers. So that's the flaw in the metric. It is a flaw, but now, why do investors love it so much. Right? Because I, and maybe it's wrong, but I always look at a metric.

Ray Reich

Is it more operator friendly or more investor friendly? But investors love this because let's say the benchmark to common wisdom was three x. So customer lifetime value is three times more than a customer acquisition cost. The last two years of benchmark saved, that's closer to forex. So CLTV is four times customer acquisition cost.

So let's use an example. If I'm in a business where it's $50,000 to acquire a new customer, I have a forex that's a 200k lifetime value. Dave, you did the math for me, but over a five year period, that's a 61% compounded annual growth rate. Right. Not a growth rate.

I'm sorry, I totally said that wrong. It's a rate of return. I trust you on that. Right, keep going. So you're basically saying it approximately, it gives you an Roi.

Dave Kellogg

Basically that. Lt is one step away from Roi. Exactly. And I think that's why investors love it. Now, there's a big risk here, and I can't believe I even hear this thing, but I've had seed stage companies said, well, the investor just asked me what my CLTV to CAC is and I'm like, well, how long have you had subscriptions that you've renewed?

Ray Reich

It's like, well, we've had nine to twelve months. Yeah. So how can you know your churn rate in the first? I always say you should have two annual renewal periods, Dave, not just one. Yeah, so I approach this differently, Ray.

Dave Kellogg

So look, there's two questions you asked. One is why do investors like it first? Because it actually predates nr as a metric. Let's be clear. In the beginning there was LTV Dek, and then people came along and said, hey, wait a minute, isn't nrr a better way to value the install base, which is really what the LTV part of LTV Dekak is trying to do?

So one, I think history is on the side of LTV to CAC. It came first. It is the standard way to do things. And I think your point is well taken that, I mean, again, the reason people like LTV to CAC is you're trying to measure what something's worth versus what you paid for it. And you could express that as an ROI if you want to.

So I do think, for whatever it's worth on my side, that a multi year nR, if I want to know what happens to the customer base over time, I could invert the current period churn rate. And that's pretty dangerous for reasons discussed. Or I could just say, if I've got three, five years of operating history, what happened to the people I acquired three years ago? I could do a three year NR, not something most people talk about, and just calculate NRR for the three year period and then use that to get a three, three year LTV to CAC. Right.

So there are other, in my opinion, better ways to answer the question, how do I value the installed base than inverting the most recent churn rate? And now for everyone who's listening to us can understand why at the SAS Metric Standards board, it's so hard to come out with these standards because there's so many great perspectives and trying to get the industry to rally around one standard. Dave, it's really important, because if the benchmark is, like I said, closer to four x to one versus three x to one, how do you know that? Is it using gross margin adjusted? What is the calculation for the average revenue?

Ray Reich

Right. It's really hard to use benchmarks when you don't have standard calculations. Yeah, that's why I applaud the work you're doing. And that's why this one's particularly hard, because it is a compound metric. It's got so many questions wrapped into it.

Dave Kellogg

But look, I'll be practical for a minute. You are going to get asked about this. If you're a SaaS company, an early stage SaaS company, you should calculate it. In my opinion, you should calculate SAS metrics by default to your advantage. So by default.

So I would do it on an ARR basis, not a gross margin basis. And I would calculate the churn side of it exactly the way Ray does, which is just one minus GRR, then invert that to get lifetime and then multiply by average ARR. I do it for time period, Ray doesn't for the whole base. If you're an early stage startup, it probably won't be that much different. So the place where that really comes into play, Ray, is when you're an older startup and you're starting to drive your Asp up.

And I'd argue your formula makes me carry the baggage of all the old small customers and it will show less progress on my upmarket initiative. And by the way, and conversely, yeah. But you know me, Dave, I don't think any metric as a company matures should be calculated if you're not calculating it by segment. So my SMB versus mid market versus enterprise, I think you should be calculating CLCV to CAC across all three of those segments. That's excellent.

It's an excellent solution to the problem. Right? To be honest, yeah, because I was assuming a blended one, and the old guys are going to hurt you if you segment it. That solves that problem. Now, here's another thing, and one of my favorite presentations I've ever heard you do is why you can't fix a CAC payback period.

Ray Reich

So, same with CLTV to CAC. You can't fix the CLTV to CAC, but you can identify the primary input variables that are creating a lower one than a benchmark. Would you agree with that? Yeah, I think the point, Ray, and thanks for saying that. Nice thing about that presentation, the whole point of that presentation was you can't fix a compound metric.

Dave Kellogg

Right? And investors, this is back to what you talked about earlier. Investors like compound metrics because they're great for screening. They work at a high level of abstraction. There's plenty of nice things to say about compound metrics, but when you actually want to fix problems, if you tell me your LTV to CAC is two, I go, well, that's bad.

We can all agree that's bad, but what do we do about it? Where's the problem? Is your deal size too low? Your CAC too high? Your churn too high?

Right. We need to drill in. So, yeah, in the same sense that you can't fix CAC payback period. Because it's a compound metric with many levers, you can't quote unquote, fix LTV to CAC for the same reason. But it does.

Ray Reich

We've covered so many of these metrics. If you look at the CAC ratio, how much sales and marketing you're investing to acquire each customer, and specifically each dollar of ARR, that might be one of the input variables. Or maybe you need to look at your. Grr. Hell, if you're using the gross margin, even one or two points of gross margin improvement can increase your LCV to CAC.

So you got to look at all the input variables and decide which ones have the biggest impact on this. Amen. Okay, Dave, anything else we should talk about on this CLTV to CAC, since we're in such great alignment on it? So I think. What do I think?

Dave Kellogg

I don't think so. Look, when I do my posts that I've never done, when I do the waiting for Godot LTV to CAC post, I'm going to drill into the problems with LTV and we hit most of them already. You get heavily forward loaded lifetimes. If you are going to forward load them, just say you're going to try and tell investor you have a 20 year lifetime. Not something I would do, but say you were going to do it, then with these inflation rates today, you're going to have to discount it.

Right. You can't just. But like back in the day of zurp, you could just go, oh, I've got a 20 year lifetime. So if it's 100 units of ARR, that it's going to be the 2000 lifetime ARR value. Right.

No discounting. Well, now you're going to have to, if you want to be credible, not that you're that credible anyway, with a 20 year lifetime, but if you want to play that card, get ready for the next card to come back and say you need to discount that because there's material interest rates. Yeah, it's funny, I even had one vc tell me once. He goes, yeah, so when we do CLTV to CAC, if any of our portfolio companies have higher than ten, we limit it. We never count more than ten.

Ray Reich

I'm like, well, that seems like an easy mathematical way to try to take out some of the outliers, but maybe. You should really look at how they're calculating CLTV. Yeah. By the way, that's an increasingly popular solution, which is you cap it. You cap the lifetime at either.

Dave Kellogg

I've seen five years, right? You call a five year LTV to CAC. So five year LT, or kind of. It's really a five year value to CAC, not an lt's a f, it's a five YV, not an LTV. But, but you could do a ten Yv to CAC as well.

At least those are more descriptive names. They may not be more meaningful. But, but if you want to get rid of being gamed, which I suspect some investors are tired of, it's not a bad example. Just say, hey, we calculate a five year LTV to CAC around here. And what it is mathematically is it just puts a constraint on how bad your cat can be.

I'd have to do a little quick algebra to figure it out. But, but it's effectively, it's changing the metric. But you're right, if you. I'll do the math offline. There's a, there's a new episode.

Ray Reich

Constraint based SAS metric calculations. There you go. There you go. So well, Dave, well, thank you for number one, talking about an irish playwright and waiting for Godot. But thank you so much for going ahead and having this discussion, because I know you wanted to try and have the opportunity to put all your thoughts together, and I really appreciate you using this as one of the ways hopefully to see that post finally come out.

Dave Kellogg

Kak okay, well, thanks a lot. It will hopefully, this will hopefully serve as a motivator. Great talking about this topic with you, and I think that's it for me. Okay, thank you everyone for listening to us this week, and we'll talk to you next week. Bye bye now.

SAs Talk is a production of the Metrics Brothers growth in CAC and a member of the Benchmarket podcast Network. By accessing this podcast, you acknowledge that the metrics brothers make no warranty, guarantee or representation as the accuracy or sufficiency of the information presented or the humor content of the jokes provided. Ray the information, opinions, and recommendations presented are, according to our spouses, probably wrong and provided for general information only. This podcast should not be considered professional or, for that matter, unprofessional advice. We disclaim any and all liability for any direct, indirect, indirect, misdirect, incidental, special, ordinary, consequential, inconsequential, or other damages arising out of any use of or God help you, reliance upon the information presented here.

Ray Growth Reich is based in New York City and available on Twitter x rayreich. Dave Kellogg is based in Silicon Valley and available at Kelblog Schedecti, which is French for unspellable, is not our actual production location. You can reach us@sastalkpodcastmail.com thanks for listening.