If you are a SaaS business, then you must read this article for the following reasons:

• Understand what is LTV CAC Ratio?
• How to calculate LTV CAC Ratio?
• What does it indicate about your business?

At present, more and more businesses are migrating their products from a purchase-based to a subscription-based model. This transition has raised a big challenge for SaaS businesses and that is how to determine the accurate performance of the business?

Selling products or services through subscriptions is completely different from selling on a pay-up-front basis. In the case of a business selling SaaS products and services through a subscription-based model, a giant share of the value is generated after the sale.

This means as compared to the traditional up-front payment model, the value is shifted from the transactional event to a lasting relationship. In other words, a SaaS company earns 60% of the customer value in the first year. However, 90% of the customer value is earned in the subsequent years of a customer’s lifetime with a SaaS business.

What this means is that the subscription-based business shifts the risk from the customer to the vendor. Such a business faces customer retention risk rather than customer acquisition risk.

As a result, a SaaS business offering subscription products is in need of a clear view of its performance. This is because the payoffs from customers arise in the future but they have an immediate impact on the business performance.

Thus, the traditional metrics would not help a SaaS business owner to have a complete view of the performance of the business. One of the key SaaS metrics that can help a SaaS business in evaluating its true performance is the LTV CAC Ratio.

In this article, we are going to learn what LTV CAC Ratio is, how to calculate LTV CAC Ratio, and what does this ratio measure?

LTV CAC Ratio Meaning: What Does LTV CAC Ratio Tell Us?

LTV CAC Ratio is one of the key SaaS metrics that measure the relationship between the lifetime value of a customer and the cost incurred to acquire a customer. This ratio is obtained by dividing the Lifetime Value of a Customer (LTV) by the Customer Acquisition Cost (CAC).

Customer Lifetime Value (LTV or CLTV) is the total value consumers bring to a business throughout their lifetime. It is a key financial metric that indicates the total revenue a business can reasonably expect from a single customer account throughout the business relationship.

Whereas, Customer Acquisition Cost (CAC) refers to money that a business spends to acquire a new customer.  This includes costs associated with marketing and sales that e-commerce businesses incur in order to attract potential customers to purchase their products.

Thus, management teams rely upon LTV/CAC ratio to evaluate the health of a SaaS business. This is because it helps them in understanding how profitable each customer is. In return, this figure helps the business to know how much money it can invest in acquiring a customer without impacting the profitability of the business. 

Note that a SaaS business sells a subscription to the license that will be ongoing. The customer then pays the company on a monthly or annual basis as agreed upon for the length of the contract. As a result, the SaaS business only recognizes revenue in its books of accounts as the subscription services are delivered over the life of the contract. 

There can be a scenario when the customer makes an advance payment. Such an advance is showcased as a liability in the company’s balance sheet as the customer pays for the product or the service that he has not received. 

The liability on the balance sheet is shown under Deferred Revenue until the service is delivered. However, the expenses related to acquiring the customer are recognized upfront in the period in which they were incurred.

This concept of front-loading most sales & marketing expenses, but stretching revenues out over the contract duration creates a lag in cash flow. Such misaligned cash flows make it challenging for a business to figure out the relationship between expenses and revenues when it relies on traditional GAAP metrics. 

Now, before we learn how to calculate the LTV/CAC ratio, let’s understand the terms LTV and CAC individually to make things simpler.

Customer Lifetime Value (LTV)

CLTV is the value of discounted future cash flows expected to arise from a single customer or a group of customers. The rate of discount used is the SaaS firm’s average cost of capital. This means that the CLTV of a SaaS business is a forward-looking metric responsible for driving customer profitability.

It is important for a SaaS business to calculate its CLTV as it helps the firm to:

i. Determine how much it needs to spend to acquire a customer

This is possible only if the business knows how much money it can generate from a customer. In the case of the SaaS business, firms spend more to acquire customers compared to what they spend on retaining the existing customers. To generate profits, the cost of acquiring a customer must be lower than the revenue generated from customers during the period when they remain subscribed to the firm’s service. If this is not the case, then the SaaS business will find a great challenge in generating profits in the long run.

ii. Segment its customer data into different categories

These categories are established based on the customer’s ‘lifetime’ values. For instance, a SaaS business can identify the customers who are expected to abandon the subscription early. Once a business has such insights, it can take proactive decisions. Like it can offer special discount rates to customers in order to encourage customer retention in specific segments. Also, determining segments can help the business to use similar successful models for acquiring similar and high-value customers.

iii. Undertake mergers and acquisitions

CLTV can help investors obtain insights that go a long way in helping make strategic decisions like identifying profitable market segments, CAC, customer retention rate, etc. In addition to this, a firm’s CLTV can give insights into the overall value of the firm. 

iv. The optimal level of service to be rendered for each customer base

SaaS businesses can provide a differentiated level of service to their customers depending on the CLTV of each customer segment. Profits from a customer may vary significantly from one period to the next. This means that the decisions a business makes on the basis of the customer profitability in 1 year might look unfortunate in the next year. 

v. Allocate marketing budgets across customers or market segments using different customer profitability metrics

A SaaS business can allocate resources in such a way that it maximizes the return on marketing investment. Provided, the business has access to valid profitability measures. This means a subscription-based business should not simply allocate the resources to customers or market segments in direct proportion to profit. Rather, it should allocate the same according to both profit and customer responsiveness.

Customer Lifetime Value Calculation

A SaaS business can use the following Customer Lifetime Value Formula:

Lifetime Value = Average Value of Sale x Number of Transactions x Retention Time Period

Customer Lifetime Value (CLTV) = Lifetime ✕ Margin

Note that the customer lifetime value calculation takes into consideration the customer acquisition costs, operating expenses, and costs to produce goods or render services that the business is offering. 

Now, let’s understand each of the components of the Customer Lifetime Value formula.

I. Average Purchase Value

It refers to the average value of a sale for a SaaS business. To calculate the Average Purchase Value, a firm needs to divide its total revenue over a period of time by the number of purchases that customers make over the same time period.

Average Purchase Value = Total Revenue of a Business/Number of Orders

II. Average Purchase Frequency Rate

It refers to the number of purchase transactions that the customers of a SaaS business make over a specific period. To calculate the average purchase frequency rate, a firm must divide the number of orders placed or purchases made over a period of time by the individual customers who made those purchases during such a time period.

Average Purchase Frequency Rate = Number of Purchases/Number of Customers

III. Customer Value

The value of a customer refers to the amount of revenue that a single customer generates over its lifetime with a SaaS business. To calculate customer value, a firm needs to multiply the average purchase value by the number of times a customer makes the purchases.

Customer Value = Average Purchase Value x Average Purchase Frequency Rate

IV. Average Customer Lifespan

It refers to the average number of years for which a customer continues to purchase the goods and services from a SaaS business.

Average Customer Lifespan = Sum of Customer Lifespans/Number of Customers

V. Lifetime Value 

A firm calculates the CLTV of a customer by multiplying the average customer value and its average lifespan with the SaaS business. The lifetime value of a customer is a financial performance metric that helps a business determine the revenue that it can expect to earn from a customer over the life of its relationship with the firm.

Customer Lifetime Value (CLTV) = Customer Value ✕ Average Customer Lifespan

There’s even a traditional method to calculate CLTV and that is the Net Present Value model. In this model, a SaaS business has to assume that it has the estimates of the average contribution margin per customer per period (M).

Accordingly, the CLTV formula is:

Customer Lifetime Value (CLTV) =t=0T M(1+d)t * rt

Where,

r = constant rate of retention of customers per period

d = constant discount rate

t = time period

T = total number of time periods considered

The above formula indicates the net contribution margin a SaaS business achieves per customer once acquired. In short, this formula represents the sum of the revenues gained from the SaaS firm’s customers over the lifetime of transactions. Such a figure is calculated after deducting the total cost of attracting, selling, and servicing customers, taking into account the time value of money.

Customer Acquisition Cost (CAC)

Customer Acquisition Cost (CAC) is the money that a SaaS business spends to acquire a new customer.  This cost covers the costs related to marketing and sales that attract potential customers to purchase products. Such expenses are only related to acquiring new customers. 

Further, CAC may also include other forms of acquisition costs like freemium offerings, hardware subsidies, promotions, and installation costs.

In fact, some SaaS businesses also include the cost of the customer experience in CAC. That’s because customer experience is a critical factor that motivates a consumer in choosing a given product over other competitive products.

CAC helps a SaaS business to measure its performance and understand the consumer segments that are more profitable for it. In addition to this, this cost even helps investors to understand the scalability of a given SaaS business and evaluate the company’s profitability.

How To Do CAC Calculation?

To calculate CAC, a SaaS business first needs to add the marketing, advertising, and sales personnel costs incurred to acquire customers. Then, the firm needs to divide the total of such costs by the number of customers acquired. 

In simple words, a SaaS business needs to add all the costs associated with converting prospects into customers and divide that amount by the number of customers acquired.

Thus, the formula for calculating CAC is as follows:

Customer Acquisition Cost = (Marketing Costs + Sales Costs)/Number of New Customers Acquired

Note that the above formula has a disadvantage. It fails to consider a lot of details with regard to different variables in the equation. This means that SaaS businesses using this formula to calculate CAC may have misleading results. 

For instance, the above formula does not consider the fact that not all customers are new customers. That is, some customers are returning customers. Secondly, it does not cover the cost to support customers when they are using the free tier of a freemium product.

Also, the above formula fails to consider that it takes more time than expected for a lead to get converted into a customer. Therefore, a SaaS business must take into consideration the following factors in order to calculate a near to accurate CAC figure.

1. Time Between Marketing Expense and Lead Conversion

The first factor that a SaaS business must consider is the time between the expenditure incurred on its marketing or sales touchpoints and the lead becoming a customer. 

For instance, if a SaaS business offers a freemium product, the user would first sign up for the freemium tier of the product. Then, he will use the freemium version of the product for some time until he hits the limit given within the free version. Once this happens, he might plan to upgrade the plan and go for the premium product.

Thus, it is important for a SaaS business to consider this time lag while calculating CAC. Otherwise, it may lead to the results getting overestimated or underestimated.

2. Expenses To Be Included In CAC

The second factor that a SaaS business must consider is the type of expenses to be covered in marketing and sales expenses incurred on acquiring a customer. The following is the list of expenses that a SaaS business must include in CAC:

• Salaries of all marketing and sales personnel 
• Payroll and other related expenses of part-time employees in marketing or sales
• Overhead expenses like rent, equipment, etc
• Expenses incurred on sales and marketing tools 

Note that the sum of part-time employees and full-time employees engaged in marketing and sales to acquire customers for a SaaS business is called Fully-Loaded CAC. Thus, the formula for Fully-Loaded CAC is:

Fully-Loaded CAC = Marketing Costs + Sales Costs = Salaries + Overhead + Cost of Tools

Once the SaaS business calculates both the CLTV and CAC, it needs to calculate the LTV/CAC ratio to determine its return on investment. 

LTV CAC Calculation: How Do You Calculate LTV CAC Ratio?

A SaaS business can use the following LTV CAC formula to calculate the ratio:

LTV CAC Ratio = Customer Lifetime Value of a Company/Customer Acquisition Cost

To understand, the LTV CAC ratio calculation, we need to consider an example. The following are financial highlights for Workday.

Andreessen Horowitz is a renowned venture capital firm wrote a paper in May 2014. In this paper, the firm demonstrated how a leading venture capital firm would apply the LTV framework to analyze public market SaaS companies like Workday. 

Workday is a provider of cloud applications for finance and human resource functions. All financials are based on publicly available GAAP disclosures.

Financials of Workday

Fiscal Years Ending January 31	2012	2013	2014
Subscription Services Revenue	$89	$190	$354
%YOY Growth	142%	115%	86%
Professional Services Revenue	$46	$83	$115
%YOY Growth	34%	82%	38%
Total Revenue	$134	$274	$469
Research and Development	98%	104%	71%
Gross Margins	51%	57%	62%
Operating Margins	-58%	-43%	-33%

The above table showcases that the gross margins and operating margins of Workplace improved steadily over the years 2012, 2013, and 2104. This is reasonable as Workday amortizes significant operational costs of running the software and the R&D costs of supporting the software against a larger customer base. 

Also, they receive recurring revenue from customers whose CAC they incurred in previous quarters. As a result, the business is trying to fix the timing mismatch of revenue and expenses at the earlier stages of development.

The following table showcases the proxy numbers for Workday’s customer acquisition costs:

Fiscal Years Ending January 31	2012	2013	2014
Sales and Marketing Expense	$70,000,000	$123,000,000	$197,000,000
Sales and Marketing Expense for New Customers (assuming 70% allocation)	$49,000,000	$86,100,000	$137,900,000
Total New Customers	98	141	200
Total Customers	259	400	600
% YOY	–	54%	50%
CAC	$500,000	$610,638	$689,500

The CAC of a business is calculated by dividing the sales and marketing expense of a company in a period by the number of new customers acquired in the corresponding period. 

CAC of Workday = Sales and Marketing Expense in Period/New Customers Acquired in the Period

CAC of Workday (2012) = $49,000,000/98 = $500,000

CAC of Workday (2013) = $86,100,000/141 = $610,638

CAC of Workday (2014) = $137,900,000/200 = $689,500

Now, let’s calculate the Customer Lifetime Value (LTV) of Workday. 

Lifetime Value = Average Value of Sale x Number of Transactions x Retention Time Period

Customer Lifetime Value (CLTV) = Lifetime ✕ Margin

Customer Lifetime Value (CLTV) = (ARR ✕ Gross Margin)/(Churn Rate + Discount Rate)

Fiscal Years Ending January 31	2012	2013	2014
Implied Customer Lifetime = 33.33 years
Annual Churn Rate = 3%
Discount Rate = 8%
Total Subscription Revenue	$89,000,000	$190,000,000	$354,000,000
Total Customers	259	400	600
Average Subscription Revenue Per User	$343,629	$475,000	$590,000
Subscription Gross Margins	75%	79%	80%
LTV	$2,342,927	$3,411,364	$4,290,909
CAC	$500,000	$610,638	$689,500
LTV/CAC	4.7	5.6	6.2

LTV of Workday (2012) = ($343,629 x 0.75)/(0.03+0.08) = $2,342,927

LTV of Workday (2013) = ($475,000 x 0.79)/(0.03+0.08) = $3,411,364

LTV of Workday (2014) = ($590,000 x 0.80)/(0.03+0.08) = $4,290,909

To calculate the CAC, Andreessen Horowitz made the following assumptions:  

• Sales and Marketing Expense Allocation for New Customers: 70%  Number of New Customers
• Annual Churn Rate: 3%
• Discount Rate: 8%

Thus, the following is the LTV/CAC ratio for Workday:

LTV/CAC (2012) = $2,342,927/$500,000 = 4.7

LTV/CAC (2013) = $3,411,364/$610,638 = 5.6

LTV/CAC (2014) = $4,290,909/$689,500 = 6.2