Founders often describe their unit economics in terms of their LTV/CAC ratio - the ratio of the Lifetime Value (LTV) of a customer to the Cost of Customer Acquisition (CAC). The LTV/CAC metric can be a powerful metric to unpack the health of the go-to-market team of a company, as Netsuite has shown. But this figure is often meaningless for early stage startups.
Why? Because a company one or two or even three years into sales can’t yet accurately forecast customer lifetimes. If a business suffers from a very high churn rate, then, yes, it’s possible to calculate LTV in just a few years.
But most software companies will see 10% or less unit churn per year. At 10% unit churn, three years from now, 73% of customers will still be paying, adding to their LTV. How long will those customers stay? You could project a straight line churn, a fixed churn rate per year, but that may not be realistic. How will those businesses’ spend change over time? You won’t know until you see it for yourself.
Plus, you’ll have to decide which of the several ways to calculate LTV. Last, most early stage companies may not have enough samples to calculate LTV with statistical significance.
Further complicating things, the LTV/CAC ratio is used as a metric of when to ramp sales and marketing spend. If the ratio is greater than 3x, then it’s time to spend more. The challenge with this strategy is it links today’s marketing spend to the projected, discounted future cash flows of a customer, which as we’ve seen above, are tricky to calculate.
In the early stages, payback period is a better metric to use. Why? Because within 14-18 months, most startups will have collected concrete data about the payback periods for customer acquisition, instead of 3, 5 or 7 years for LTV observations.
Because benchmarks exist for public and private payback periods - and the metric is more standardized because it doesn’t require long-dated assumptions - an early stage startup can much more quickly evaluate it’s go-to-market strategy.
Faster iteration cycles are a competitive advantage. Tying marketing spend to LTV is a challenging prospect for early stage startups because they are asked to project many years forward with little concrete data. Use payback period instead.
Published 2017-11-09 in financials