We always love to share helpful insights from our amazing community — both from operator investors and founders alike. This month, we’re wrapping up our three-post series with finance leader Christina Ross (former serial CFO turned CEO/co-founder of Cube). She’s already provided great tips around how to interpret SaaS metrics, including customer retention and the SaaS magic number. This month, we’re excited to share her valuable advice about using customer lifetime value and acquisition costs to measure a company’s return on its sales and marketing spend. Another way to think about this is the rate at which revenue is staying with the business over time, or “net dollar retention” (NDR).
Anyone who’s watched Shark Tank knows that investors often obsess over customer acquisition cost (CAC). Why is this metric so crucial in enterprise software?
CHRISTINA: Well, it’s super important for any business to earn more from its customers than it spends to acquire them. CAC measures exactly what you’d think: how much do we have to spend (on average) in order to acquire a customer? To calculate this, you take your total sales and marketing spend for a given period and divide it by however many new customers you acquired in that same period.
CAC = (Sales + Marketing Spend) / # of New Customers Acquired
Now, most SaaS companies have several different groupings of customers, some of which are more expensive to acquire than others. For this, cohort CAC analysis is extremely valuable in helping you get specific insights into a targeted subset of customers.
How should companies think about customer lifetime value (LTV)?
CHRISTINA: This is the amount of revenue you expect the average customer to generate during their time as your customer. But there’s actually no universally agreed upon way to calculate this common SaaS metric. So unless you have a specific need for a different formula, I always recommend keeping it simple:
LTV = Average Revenue Per User (ARPU) * Average Customer Lifetime (LT)
To get there, you’ll of course need to calculate your ARPU by dividing monthly recurring revenue by your number of users. The length of time you expect a customer to stay with you can be a bit trickier, especially if you’re a newer company that doesn’t have years of historical data to reference. The easiest way to approximate this is to base LT on your churn rate.
Customer Lifetime = 1 / Monthly Churn Rate
For example, if you see 1% churn each month, then your LT = 1/0.01 = 100 months (8 years and 4 months). And to get your LTV from there, you just need to multiply ARPU times that LT number. So if your average monthly revenue per user is $100 and your expected customer lifetime is 100 months, then LTV = 100 * 100 = $10,000.
What’s a good LTV/CAC ratio?
CHRISTINA: The baseline ratio for early-stage, high-growth companies is 3:1, meaning an LTV that’s 3x your CAC. Knowing this ROI on your sales and marketing spend is key because it tells you how sustainable your business model is. If your LTV/CAC ratio is above 3:1, then you probably have the funds to expand your sales and marketing team and go after some tougher-to-acquire customers. On the other hand, if it is below 3:1, then you’re either spending too much on sales and marketing, or you need to increase the LTV of your existing customers.
How can companies use the LTV/CAC ratio to understand their different customer segments?
CHRISTINA: In aggregate, this metric tells you how on-track you are as a company and gives you helpful insight about your “average customer.” However, all of your customers are probably not the same, so the LTV/CAC ratio is most powerful when you segment it. By digging into individual cohorts within your customer base, you can benchmark each group to your average.
The Pareto principle tells us that a subset of customers (say, 20%) are responsible for the majority (maybe 80%) of a company’s revenue. Analyzing your LTV/CAC ratio by cohort helps you identify exactly who those most profitable customers are, as well as which customers you might be spending too much on acquiring.
What are your tips for improving LTV/CAC ratio?
CHRISTINA: If a company’s LTV/CAC ratio is low, that either means its CAC is too high or its LTV is too low. There are several ways to reduce the costs of customer acquisition, such as:
- Focus on more efficient channels: Content marketing, ad retargeting, email marketing are all cheaper (and more efficient) marketing channels than running ads to a cold audience.
- Go after different customers: Is there any low-hanging fruit you haven’t gone after? Could you be using better prospecting tools?
- Increase your conversion rates: Find ways to convert more customers for the same amount of spend, perhaps by investing in user research and copywriting.
- Simplify your sales cycle: If your sales cycle is lengthy, that usually means it’s also more expensive, so you’ll want to look for ways to speed it up.
When it comes to increasing customer lifetime value, start by reducing your customer churn or increasing the average customer lifetime. Of course, increasing average revenue per user will also increase LTV. Here are a few things to try:
- Improve customer success: By investing in customer success and ensuring you offer a great support experience, you’ll keep customers around longer.
- Experiment with pricing: Consider raising your prices for new customers (as long as that doesn’t also increase your churn rate).
- Focus on expansion offers: Up-sells, cross-sells, and expansions are all powerful ways to increase your ARPU.
What pitfalls of the LTV/CAC ratio should people watch out for?
CHRISTINA: It’s easy to miscalculate or misinterpret your LTV/CAC ratio if you’re not comprehensive in your approach. In particular, misrepresenting CAC might inflate your LTV/CAC ratio and paint a much rosier picture than reality. When calculating CAC, you should include more than obvious paid advertising costs. Be sure to factor in other sales and marketing spend like creative (design, copywriting, content marketing), acquisition-related employee salaries, software (such as website hosting costs), and lead scoring and strategy as well.
In addition, since not all customers are created equal, don’t forget that LTV/CAC ratios will differ by cohort. For example, if a small subset of customers are wildly profitable but your largest customer cohort only has a LTV/CAC ratio of 1:2, that’s a huge insight that should be incorporated into your growth strategy.
We’ve talked a lot about LTV and CAC, but you’ve hinted that NDR might be the more favorable metric. Tell us more.
CHRISTINA: Across our customer base, NDR consistently comes up as the revenue metric investors are watching. Over the past few years, there’s been an ever-growing focus on retention, engagement, and customer loyalty. NDR, sometimes referred to as net revenue retention (NRR), shows you how well your business keeps, engages, and upgrades your customers. It measures how much of your annual recurring revenue (ARR) or monthly recurring revenue (MRR) your business keeps over a time period, and includes expansions, contractions, and losses. The bottom line here is that creating a positive customer experience is a proven way to maximize NDR.
What does NDR tell you and why is it important to track?
CHRISTINA: NDR can help stakeholders gauge how well a business is retaining and growing customers. It signals how well cross-sell and upsell strategies are working.
NDR > 100% indicates growth.
NDR = 100% means the business is static.
NDR < 100% indicates decline.
A high NDR means customers are climbing the value ladder. You’re offering the right things they need as they grow. Meaning: keep doing what you’re doing. If it’s low, it could signal that you’re not offering the right upgrades, the customer success experience is difficult, or a need to build brand loyalty. Across the board, these are all business health essentials to constantly monitor especially in an ever-changing market like today.
Thanks to Christina for sharing all of these best practices around SaaS metrics! If you’d like to learn more about the LTV/CAC ratio, check out Cube’s blog post on the topic.