LTV / CAC: A Ratio Contributing to Tech Bubble 2.0?
As businesses search for ways to grow efficiently and effectively without incurring fixed costs, they often turn to metrics like customer acquisition cost (CAC). But calculating CAC can be complex and misleading, as it involves both variable and fixed costs that may not accurately reflect a company's true efficiency and scalability. Companies imply that a healthy 5x LTV/CAC means the company makes 5x on their acquisition costs, but most don’t realize this 5x is on revenue not profits. They also don’t realize that the CAC tends to only capture year 1 of acquisition costs and none of the ongoing costs to serve that revenue.
Traditionally, CAC calculations include costs such as hardware, software, sales, marketing, and other expenses like onboarding, training, etc. These costs are important to consider, but they may not necessarily provide insight into a company's ability to scale when they are all bundled together. For example, needing to add $150,000 in customer care resources for every $1 million in new annual contract value (ACV) slips through the cracks as companies calculate this CAC for year one, but ignore it for years two onward; while at the same time they take credit for the “LTV” over that period’s gross revenue (ignoring all the costs to serve said revenue).
Wouldn’t it be nice if we could all count years of revenue with no costs and divide that into our year one costs? To get the true “value” you can obtain from customer acquisition costs, I suggest looking at LTV on a “net” basis, net of all ongoing costs to capture the revenue made over the lifetime of a contract.
Customer Lifetime Value (CLTV) can also be misleading if it is calculated based on revenue alone and used to compare companies with drastically different gross margins. To truly understand the efficiency of a company's CAC, it is necessary to consider both incremental variable and fixed costs in the calculation, subtracting these costs from the CLTV of a customer and dividing by the one-time CAC. Instead, if you Google what assertions can be made about LTV/CAC, you get results like this that conflate LTV with gross profits. I understand marketing companies being confused about this, but these ratios have become commonplace in Silicon Valley as well. Imagine thinking a 5x or better LTV/CAC is incredible when one company could have a 5x customer lifetime value and grow revenue lean, while the other at 5x could be headed to insolvency? Acquisition costs ignore management and maintenance of revenues sold. Instead, look at revenue and costs together to avoid being fooled.
Lastly, there is practicality to consider. If two companies both have a $100,000 CAC, but one’s is comprised of hiring hard-to-find engineers or specialists and management time and effort, while the other company at $100,000 CAC is nothing but automated costs of acquisition being billed like performance marketing or sales commissions, it’s hard to compare the two. What if we need 20 specialists? Not all CAC is the same, and having a handle on what work has to be done to scale. alongside scaling revenue, should be reflected in how we think of CAC relative to growth.
It is our view that there is a growing need in the market for companies that can scale revenues with 100% variable selling costs and without sacrificing customer quality, net promoter scores, and market reputation.
If you are looking for support to help you grow your B2B business, contact Silver Birch Growth today. We offer a free consultation to discuss your growth goals and how we can help you achieve them.
-Randy Gilling, Co-Founder, Silver Birch Growth
