Understanding Unit Economics

What is CAC and LTV and how do you use these metrics

One of the key mental models that VCs use to understand the profitability and the long-term viability of startups is to understand the unit economics of the business. Most startups are unprofitable for years at end but if they have strong unit economics that are trending in the right direction, then VCs will continue to fund these startups. There are essentially two key metrics that startups need to track – Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC). Generally, VCs like to see an LTV to CAC ratio that is at least 3:1. This allows the business to generate enough margin to cover its operating costs and generate a profit for its shareholders.

Customer Lifetime Value

The Customer Lifetime Value measures the profitability of the customer over the lifetime of the customer’s relationship with the company. Imagine that you are an e-Commerce site and you conduct an SEM campaign to attract customers to your site. Let’s say you attract a 100 customers who make total purchases of $5,000 for a gross margin of a $1,500. You register these users and a month later email them for a new promotion and another 50 of them make a purchase of $2,500 for a gross margin of $750. None of these customers make any subsequent purchases for the foreseeable future. The LTV for these customers will be equal the Total Gross Margin of purchases/Total number of customers. In this case, the LTV for each customer will be equal to ($1500+$750)/100 = $22.50.

As another example, let’s say that you are offering a SaaS subscription offering that’s priced at $10/month with a 60% gross margin and a monthly customer churn rate of 2%. The LTV for the subscription offering will be calculated as follows:

                                    LTV = Monthly Gross Margin/Monthly Churn rate

In this case, the LTV will be equal to $6/2% which equals $300. This means that you can spend up to $100 to acquire the customer to maintain at least a 3:1 ratio of LTV to CAC.

Note that many people make the mistake of using the revenues they earn to calculate the LTV which is not correct. Figure out the gross margin for your offering and use that in calculating your LTV.

Customer Acquisition Cost

The Customer Acquisition Cost measures the cost of acquiring each customer who makes a purchase. Going back to the e-Commerce example, let say that you spent a $1000 on the SEM campaign to acquire 100 customers, your CAC would equal $10. Since you received only $22.50 as the LTV, you didn’t hit the minimum threshold of a 3:1 ratio of LTV to CAC.  As a result, you need to either find a less expensive acquisition channel or you need to do more marketing to your acquired customers to get them to purchase more over time and, therefore, increase the total LTV.

As another example, let’s say that you have an enterprise sales force of 5 sales people that’s calling on customers. Each sales person closes an average of 10 customers a year. You pay each sales person $200,000 per year in salary and commissions. In addition, you spend a total of $100,000 on a marketing campaign to generate leads that the sales people can call on. Your average LTV = ($200,000 + $100,000/5)/10 which equals $22,000. To maintain, a LTV to CAC ratio of 3:1, you should make sure that your LTV is at least $66,000 per customer.

You should also understand your LTV and CAC by customer segment. If you have a solution that is purchased by enterprises of different sizes you may find that the LTV and CAC for a small business customer may be very different compared to a large enterprise customers with long sales cycle. Your pricing strategy, as a result, should be to charge a significantly higher price for large enterprise customers to take into account the higher customer acquisition cost. In turn, to justify the higher price, you will need to offer differentiated features that large enterprise customers value as compared to small business customers.

Note that in calculating the CAC, you should only include customer acquired through paid acquisition channels and not customers that you acquire organically. It is certainly possible that some of the organic customers come because of advertising that they see from you. To be conservative in calculating your CAC, include only the customers that click through on your advertising and become customers. If you like, you can also calculate a “blended” CAC that takes into account your organic customers with the assumption that many of them were influenced by your marketing campaigns.

LTV and CAC can also change over time. As you offer more compelling features to your customers that improve engagement, you will find that the churn rate will come down which in turn will increase the LTV. You will also find that typically CAC will rise over time until it stabilizes in a narrow range. Advertising costs, for example, will increase as you spend more money to acquire customers. Zullily, an e-Commerce startup, found early eager customers in its infancy at a relatively inexpensive CAC. However, as it expanded beyond its early customers, it found that its CAC and churn rates increase significantly.