Webcast: What is a good LTV:CAC ratio? And other important unit economics rules to follow
There are a number of different terms to understand in unit economics, and also a number of ratios that you can create from those terms. They are what really allow you to unlock the power of unit economics and map out your financial potential.
The keys to know are your customer acquisition costs (CAC), lifetime value (LTV), revenue per customer (ARPU), cost of goods sold (COGS) and churn rate. From these, you can create a number of ratios to represent the potential profitability of your business. Andre and Sara discuss this in a little more detail, showing you how to optimise for unit economics.
Read on to get to grips with CAC payback, LTV:CAC and how you can optimise them to minimise your churn.
Andre : If you look just at CAC, then gross profit divided by the CAC will tell you the number of months to get that paid back. It’s called the ‘CAC payback’. And that’s a measure of your cash burn per unit, or per customer.
“The higher the CAC payback, the more money you’re going to need to raise to finance your business.”
So, generally speaking, the higher the CAC payback, the more money you’re going to need to raise to finance your business. So, you want to have the shortest CAC payback possible.
Generally, investors look for less than twelve months payback, because that’s the standard fundraising cycle. So, just knowing that you’re not going to burn through all your money in that period. So, that’s the CAC payback.
Sara : So, if I have a really long CAC payback now, how can I go about optimising my CAC payback?
Andre : You need to then start testing different channels. Either you need to find a method of acquiring more customers for the same cost, or you need to lower the costs and still maintain the same level of customers. And that’s basically a sales and marketing focus.
Sara : Okay. But if I lower my costs, there are some interdependencies that you have to be aware of. You can’t just go changing your numbers.
Andre : I’ll give an example [of interdependencies]. The most direct influence on profit is price.
So, say I raise my price. That increases my revenue per customer. Then you think, ‘great, my lifetime value has gone up’.
But, if you increase your price, your churn is going to go up as well. Then, if you’re churn goes up, your lifetime value is going to go down. So there’s an indeterminate impact.
Similarly, if you enter into a new market, you think, ‘oh great, I’m going to sell more units’, or ‘my lifetime value is going to go up’ for whatever reason. However, your CAC is also going to go up, because you’re going to have to spend more acquiring these new customers.
So, there’s an interdependency there that you need to think about when you’re doing modelling.
“So, investors are looking for, as a rule of thumb, an LTV:CAC ratio of at least 3x.”
Andre : So the other element is lifetime value (LTV) to CAC, so your LTV:CAC ratio.
So, you divide one by the other. As an example, if it’s 1:1, that means the gross profit that I get from that customer per unit only just covers the cost of acquiring that customer.
That means your unit economics would be flat. Some people would say, ‘oh, well that’s okay. At least we’re not losing money.’
But there are other expenses in the company!
So, you’ve got everything else, the operating expenses, the rent, or whatever. Stationary - well , no one uses stationary anymore, but stationary! So, investors are looking for, as a rule of thumb, an LTV:CAC ratio of at least three.
“So, an investor will look at that and go, ‘okay, they’ve got a great LTV:CAC ratio and that means if we invest in them now, they will turn it around and make a lot of money.”
And the reason is so that, not only does the gross profit that you make from this customer over that lifetime relationship cede the costs of getting that customer, but it also leaves you with extra money to pay off all these other expenses.
So, an investor will look at that and go, ‘okay, they’ve got a great LTV:CAC ratio and that means if we invest in them now, and they start ramping up, then they will very quickly - if they’re not already making any money - at a bottom line level, in a traditional economic sense, turn it around and make a lot of money.’
Sara : Okay. So, how do you go about optimising the LTV:CAC ratio?
Andre : Well, you look at the components of it. Keeping in mind that everything is interdependent. Its the same way that I would advise a client on going through improving their cash flow, or the valuation for the sale of a company. So you look at the components of LTV.
You’ve got ARPU, so average revenue per user, which is price x quantity per user. There, you can think about increasing your price or lowering your price. Price has an impact on quantities as well, on quantities sold.
Then you’ve got the cost of goods sold, so that’s customer success team, hosting fees, any third party stuff that’s in the product that you’re selling, those sorts of things. You look for economies there.
Then you’ve got your churn ratios. These are all components of the LTV. So, your churn ratio: how do you minimise that? If you want to improve your churn rate, you may have to improve your customer success team, but that increases your COGS, as that’s interdependent. So, how do you retain the customers?
Then with CAC, it’s sales and marketing expense per new customer. How do you get the most out of that team and attract customers for the lowest possible cost. So those are the drivers that you need to look at.
Sara : So then, we have been discussing this because I was confused in the beginning about COGS and cost of sales (COS) - are they the same thing? Or, what’s the difference?
Andre : So, COGS is cost of goods sold. So it’s for a company that makes a physical product. And cost of sales is usually for a software business, traditionally. But they are really the same thing.
This post, in some ways, poses more questions than solid answers. Hopefully, it has made you think about the interdependencies of the aspects of your business and what you might need to do to make them work together. What can you do to decrease your churn that doesn’t raise your COGS out of budget? How do you improve your customer success team without increasing your CAC?
Unit economics help you to keep a better eye on how these things interrelate and how you can keep them in check. Numbers will always change, so naturally your ratios will too. You’re never going to be able to stop that from happening, but you can equip yourself to deal with it better.
Are you enjoying our blog to video ratio? Let us know at email@example.com!
If you want to see some of these ratios in action and how they will work for your startup, sign up for Canaree where your first financial model is free.