Understanding LTV:CAC for Product/Market Fit
The Metric That Matters Most for Startups
If you’re a startup founder or executive, you’re probably familiar with the KPI’s Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC). That’s because they are arguably the two most relevant KPI’s for startups and growing businesses of all stages. If your growing startup only tracks a single KPI moving forward, it should be LTV:CAC, but let’s dive into why.
Defining LTV and CAC:
Before we dive into the "So What?" of LTV to CAC, let's break down the components:
LTV (Customer Lifetime Value): LTV quantifies the long-term value a customer brings to a business during their entire engagement. It's not merely about revenue; it should take profit margin into consideration, I prefer Net Margin over Gross Margin and have found investors tend to agree. Here’s how you can calculate LTV:
(Avg Monthly Revenue per Account * Net Profit Margin)
Monthly Churn Rate
CAC (Customer Acquisition Cost): This metric represents the cost a business incurs to acquire a new customer. It encompasses marketing, advertising, sales, and other expenses associated with attracting and converting leads into customers. Here’s how you can calculate CAC:
Total Sales & Marketing Expenses
# of New Customers Acquired
LTV:CAC Ratio: This ratio measures the relationship between lifetime value of a customer and the cost associated with acquiring that customer. This ratio is a signal of Return on Investment (ROI). If you have an LTV:CAC of 3:1 (or 3x), it means that for every $1 you spend on sales and marketing, you can generate $3 of net profit.
Trending LTV:CAC visual in the SeedMetrics Demo .
LTV:CAC as an Indicator of Product/Market Fit
LTV:CAC is most commonly used as a signal of ROI, but LTV:CAC carries more nuanced insights often overlooked by founders and decision-makers as an indicator of product-market fit.
A Brief Look into Product-Market Fit:
This could be a blog topic on its own, but product-market fit is the sweet spot where the value proposition of your product resonates with your target audience. It means you're creating value that customers are willing to pay for, which is the ultimate goal of a startup or growing business:
"The reality of startup life is that you're in a race to achieve product/market fit before you run out of money. Nothing else much matters until you can come up with a strong product that meets the needs of an initial market, so most of the focus of the young company is necessarily on the product." - Marty Cagan, Inspired
When looking at LTV:CAC, it's not merely an ROI metric; it's a litmus test for product-market fit.
What is a good LTV:CAC Ratio?
A general benchmark for a LTV:CAC ratio is typically 3x. Investors of high-growth startups sometimes want to see LTV:CAC Ratios in the 3-5x range. This indicates that you're acquiring customers and generating returns at a scalable rate. You’re able to identify your target market and communicate a value proposition effectively (Low CAC) and customers are willing to continuously pay for that value (High LTV). This is the definition of product/market fit.
Unfortunately, most startups don’t start with a 3-5x LTV:CAC ratio.
So what? How can you address a low LTV:CAC?
Let’s say you have a LTV:CAC of 1-2x. What does that tell you about your position? If you find that your CAC is too high, it's essential to evaluate whether you're targeting the right market and if you’re properly relaying you value proposition. Your product may be solving a problem that your target market doesn’t have. In this case, consider revisiting your value prop, conducting further market research, or potentially refining your product to align better with market needs.
Alternatively, if your LTV is low, one of two things are true, (1) you aren’t making enough per customer or (2) your churn is too high. You can experiment with pricing strategies or offer upgrades and add-ons to address the former, but churn is a bit trickier. Was the product not what the customer expected? Consider adding churn-related clawbacks to your sales commission plan. Was the product not an ideal solution to the customer’s problem? Leverage customer feedback to find out how to iterate on your existing product, a core element of the Lean Startup Methodology. To get more tactical, Tomasz Tunguz has an effective blog post of 8 Customer Discovery Questions To Validate Product Market Fit For Your Startup.
How can I continuously track my CAC:LTV Ratio?
I’m glad you asked. As a fellow startup in quest for product-market fit before running out of money, SeedMetrics has set out to help answer that question. SeedMetrics offers founders & decision-makers access to real-time KPIs such as LTV:CAC. Try our free demo to see what that looks like for your business.
