Summary:
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- LTV/CAC, or Lifetime Value to Customer Acquisition Cost, is a prominent but potentially misleading metric for startups founders that is often oversimplified as a measure of ROI.
- The three primary issues of LTV/CAC is sensitivity to retention rates, tendency to deteriorate at scale and poor reflection of capital efficiency, especially in the short term.
- Instead of solely relying on LTV/CAC, startups should consider a broader range of metrics like CAC payback, CAC doubling time, and CAC return at different time intervals.
- It’s essential to understand the nuances of these metrics and tailor them to the specific customer lifecycle and business model rather than treating them as absolute indicators of success.
Why I hate LTV/CAC
In the dizzying world of startup metrics, few have gained as much prominence and provoked as much frustration as LTV/CAC. For those uninitiated in the jargon of the startup world, LTV/CAC stands for Lifetime Value to Customer Acquisition Cost. On the surface, it seems like the Holy Grail – a simple formula to prove that your investments in growth generate massive ROI, and your business therefore “works”. If you peel back the layers, however, you’ll find a metric fraught with pitfalls and nuances that can mislead even the savviest of entrepreneurs.
For the sake of brevity, I’ll assume here that you all know what LTV/CAC is and how to calculate it. I’ll also hope that you know to calculate LTV using gross profit (not revenue) and include all sales and marketing costs in CAC (even personnel!). My goal today is to prove that you should be appropriately skeptical of your LTV/CAC and look at a broader range of sales efficiency measure when making important decisions.
Three problems with LTV/CAC
1. Over-sensitive to retention
The “LT” in LTV/CAC is only accurate if you know how long customers will actually stick around. No business knows this for a fact, as the landscape of customers and competitors is always shifting: your customers may change their preferences, and your competitors will inevitability evolve to copy what is working in the market. If your LTV depends on a long-tail of revenue, consider what might change to cut that tail short a few years from now.
Startups in particular are prone to boasting long “lifespans” after seeing promising retention in their first year or two. The academic formula for a lifespan is the inverse of churn, so 1% churn in year one would suggest an average customer lifespan of ten years. If nine of your first ten customers renew for a second year, can you really count on your next 100 customers sticking around for ten years on average? The answer is “no” and you should budget accordingly. A good rule of thumb: if your “academic” lifespan is calculated at more than five years early on, you should ensure you achieve a good LTV/CAC measure even if the average lifespan is cut in half. You can also think of your “minimum viable lifespan” as the number of months or years you must retain customers in order to achieve an LTV/CAC of 3x or higher.
2. Prone to deterioration
Most startups use historical CAC and retention to predict how much they will grow once they raise new capital, but historical metrics rarely hold up at scale. Your CAC will likely increase when you’re deploying more dollars across more channels to access a broader audience, and your retention will likely decline as you stretch to make your product work for the masses. Your marketing strategy and product features will be copied. You’ll have to stretch beyond your most-core ICP to keep growing. You’ll grow less efficient as your budget balloons and your org chart bloats.
Metrics are important to measuring your past and making decisions about your future, but you can’t pretend the metric is set-in-stone or destined to scale infinitely. If you’re basketball team shoots ten three-pointers per game and makes four of them, it is likely smart to encourage the team to shoot more threes. But if the team then tries to shoot 50 three-pointers per game, they’ll be shooting more contested shots from further away, and therefore making a much lower percentage of the shots. The same thing will happen if you tell your marketing team to increase their Meta ad budget by 5x.
3. Poor measure of capital efficiency, especially in the near-term
Startups don’t have the luxury of being patient, long-term investors with their growth capita. The quicker you generate 1x or 2x return on CAC, the quicker you can reinvest in acquiring more customers. Longer payback cycles lead to more dilution, as businesses need to raise outside funding to continue growing while they wait for their last CAC investments to pay off. LTV/CAC is the metric you should optimize for if your budget and timeline is infinite, but real-world startups must balance long-term ROI with short-term capital efficiency.
Consider the example of two companies with the same selling price ($1,000 per year), gross margin (80%): Company A boasts an LTV/CAC of 8x: they only churn 5% of customers annually, so their LTV is $16,000 (20 year lifespan X $800 gross profit per year), and they spend $2,000 in CAC. Company B believes its LTV/CAC is only 6x: they churn 33% of customers annually, so their LTV is only $2,400 but their CAC is a healthier $400.
Company A seems like the better business on paper, but it takes them 2.5 years to recoup the initial $2,000 they spend to acquire a customer. This means they have to wait a very long time to reinvest their revenue into growth, so if they’re trying to grow quickly, they will inevitably need to raise continuous VC capital to fund sales and marketing. Company B, on the other hand, recoups its $400 CAC in just six months. If this company spends $100K today to acquire 250 customers, they will have another $100K available (via gross profit generated from those customers) to get 250 more customers within six months. They can repeat this cycle continuously to grow quickly using money that comes from customers rather than VCs.
Furthermore, as we covered early, retention patterns aren’t guaranteed to continue forever. Company B will achieve a 4x LTV/CAC by keeping customers around for just two years, while Company A must keep customers around for ten years to hit the same metrics. A lot more can change in ten years vs. two years.
A Better Way to Measure Sales Efficiency
Instead of looking at one “holy grail” metric as the indicator of efficient growth, consider calculating a few different metrics and comparing them side by side. All of these metrics should look solid if our growth function is working well, and you can cross-compare them to identify what is working best vs. what could be improved. For instance, a good CAC payback with a poor LTV/CAC means retention is an issue, while a bad CAC payback with a good LTV/CAC means marketing is the problem. Here is the library of metrics I look at when assessing sales efficiency:
- CAC payback: the number of months it takes for your CAC investment to pay itself back via gross profit from a newly acquired customer. If you spend $1,000 to acquire a customer who provides you with $250/month in gross profit, then your CAC payback is four months.
- Ideal: six months or less
- Acceptable: 12 months or less
- CAC doubling time: the number of months it takes for you to double your CAC investment via gross profit from a newly acquired customer (or, more simply, 2x your payback period). CAC doubling time is a great metric for early stage startups who don’t know their long-term retention patterns, but need to validate that they’ll generate a sufficient ROI on CAC in a short-enough timeframe.
- Ideal: ~6 – 12 months
- Acceptable: ~13 – 24 months
- CAC return at 3-ear and 5-year increments: if your early retention data suggests a long lifespan (more than 5 years), calculate your “LTV/CAC” with 3-year and 5-year lifespans. If the output is more than 3x at both checkpoints, you have some assurance that your business can grow efficiently even if retention deteriorates.
- LTV/CAC: yes, I still think it’s useful to look at your LTV/CAC. Just don’t go bragging about it or using it to justify huge growth budget increases unless all the other metrics above look solid too.
Final pro tip: these metrics don’t have to be linear, so consider your business’ actual customer lifecycle when calculating them. If you charge a big implementation fee upfront, for instance, you may find your CAC payback period is one month (excellent!) but it still takes you 15 months to double your CAC (decent!). Alternatively, if you bill annually, your CAC payback could come at the 12 month renewal mark, even if you recoup 75% of your CAC in month one. To get granular, create a table in excel with months 1 – 60 as the column headers, then add an average customer’s payments in the appropriate months, then calculate the cumulative amount paid by a customer over-time and see when it crosses 1x, 2x, 3x, etc.
Final thoughts
While LTV/CAC can offer valuable insights into the health and trajectory of a business, startup founders must approach it with caution and humility. Recognize its limitations, acknowledge the uncertainties inherent in early-stage ventures, and resist the temptation to lean too heavily on a single metric. After all, in the unpredictable journey of entrepreneurship, there are no shortcuts or silver bullets — only relentless adaptation and a healthy dose of skepticism.
