During pessimistic market conditions (e.g. market downturn / epic failures of venture-backed companies) you can expect the venture market to shift and the fundraising process to become more difficult for entrepreneurs. Concomitantly, you can also expect investors to return their focus on the “fundamentals” of startup businesses; VCs look hard at burn and unit economics to ensure that their investments can weather leaner conditions.
Two important unit-economics metrics, customer-lifetime-value ("LTV" or "CLV") and customer-acquisition-cost ("CAC"), can often derail the unsuspecting (or unprepared) entrepreneur. These two metrics are a foundation of unit-economics (the amount a company earns or loses on each sale), and tend to be critical in in investment decisions at the venture stage. While seemingly straightforward at a high level, there is a great deal of nuance in determining appropriate CACs & LTVs for a given enterprise.
LTV is slightly less intuitive than CAC. Lifetime value is essentially how much gross profit you expect an average customer to generate over the course of their relationship with you. On one end of the spectrum, this is incredibly straightforward: for a wedding planner, the LTV of a customer is the gross margin you make when you plan their (hopefully) once-in-a-lifetime wedding. You don't have to look any further than the wedding because the relationship between the planner and the customer ends there. On the opposite end of the spectrum, Netflix's LTV for a subscription customer is also relatively easy to calculate. Figure out how many months the average customer stays subscribed and multiply it by the average revenue per month and the gross margin %.
For early stage start-ups that may not have a long enough history to know how long customers stay active this becomes tougher: how do you calculate LTV for an SMB business that's only been operating for six (6) months and doesn't have a single standard contract or the dress shop that doesn't know which customers will come back next season?
For B2B companies: To calculate customer lifetime with relatively little data or in a rapidly changing environment, you can leverage churn to estimate how long you expect your customers to be active on average. There are two types of churn, “label or brand churn” and “revenue churn”. Label/brand churn is the percentage of customers you lose in a given month, revenue churn is the percentage of revenue you lose when customers leave. To calculate lifetime we care about customer churn which is simply the number of customers you lose over a period of time divided by the number of customers you started the period with. To turn customer churn into lifetime, simply take the inverse of the churn. Say, for instance, that your monthly customer churn is three percent (3%).
1/0.03 is 33: your average customer lifetime is 33 months, or just under 3 years.
For B2C companies: If your business has a high frequency of purchase or is a subscription model you can use the monthly churn method as described above. If purchasing frequency is lower, you can still use churn to estimate lifetime, but you're likely going to want to look at a longer period of time, like a year, to find your annual retention rate. So if after twelve (12) months 40% of your customers are still active, take the inverse 1/(1-0.40) = 1.67: your average customer lifetime is 1.67 years.
You also need to factor in the average number of purchases that a customer makes in a year, so your full LTV formula is:
LTV = AOV x Purchases/yr x Lifetime x CM
AOV: Avg. Order Value.
Purch/Yr: Avg. no. of purchases a customer makes annually.
Lifetime: Avg. length (in years) a customer is active.
CM: Contribution Margin
CAC - Customer Acquisition Cost:
CAC is exactly what it sounds like: it's the cost for your business to acquire a single customer. If you're selling dresses online, your CAC is what you spend across multiple channels like AdWords, Facebook ads, and direct mail. If you're selling ERP systems to enterprises, your CAC is mostly comprised of enterprise sales agents and their associated costs (e.g., trade show expenses). Quantifying and understanding your business' CAC is the first step toward mastery of unit economics.
Tactically, you can simplify CAC into two (2) costs: sales and marketing. At its simplest, CAC is simply your total sales cost plus your total marketing cost divided by your total number of new customers over a given period of time (i.e., the 2015 calendar year).
While LTV and CAC are both very useful metrics to calculate, track, and understand on their own, their real value is unlocked when you combine them. This is what we call the LTV/CAC (“LTV to CAC” or “LTV over CAC”) ratio. Fundamentally, a business with LTV/CAC of greater than 1 (LTV is greater than CAC) can be sustainable. Conversely, a business with LTV/CAC of less than 1 cannot be; it will lose money.
In non-math terms: the value of your customers must be higher than the cost for you to acquire those customers, otherwise you will not be in business long (seems pretty straightforward right?).
The LTV/CAC Reality:
Unfortunately, in the high risk world of startups, an LTV/CAC of just over 1 won't attract a lot of excitement from investors. In fact, VCs typically look for a ratio of at least 3:1 or higher in the companies they invest in. For SMB (small- and medium-sized business) focused startups, VCs may really want to see a ratio closer to 5+ because the sales cycles and churn in that space are particularly difficult.
While an LTV/CAC of 1.5 can be a good business in the long-run, it just doesn't make for good sustained growth. Most startups will face significant downward pressure on their LTV/CAC ratio as they grow and mature. LTV will drop or CAC will increase (or both) as the market reaches saturation and other competitors enter the industry. The target of 3+ ensures there is a buffer for your startup to establish itself as a profitable, market-dominant player.