In a recent podcast, Ron Gill, the CFO of Netsuite - a $7B+ market cap company with about $600M in 2014 revenue, which provides ERP software to mid-market companies - articulated the importance of the Lifetime Value / Cost of Customer Acquisition (LTV/CAC) ratio for his company. LTV/CAC is often used to justify marketing and sales investment to acquire customers. But there’s much more to it.
LTV/CAC is a powerful diagnostic tool for the performance of almost every team within the company: product, engineering, sales and marketing. Gross margin, which is an important factor in LTV, reflects the engineering architecture and the hosting costs required to support customers. Average revenue per customer is a function of the product and the sales efficiency (and arguably marketing/positioning.) The chart above isn’t meant to be comprehensive, but illustrate for a hypothetical company some of the constituent parts of the LTV/CAC. A real tree would be much more granular and could extend several layers deeper.
In the past few years, Netsuite’s LTV/CAC ratio has more than doubled (an impressive feat given the stage of the business). In the 2009-2011 period, churn mitigation improved the LTV/CAC. At some point, the company couldn’t squeeze any more juice from that lemon. Companies churned from Netsuite because they went out of business or were acquired, not because they selected a competitor. More recently, as Netsuite has moved up market, and the larger average revenue per customer has improved the LTV/CAC.
To identify the most important contributors impacting the LTV/CAC, Netsuite performs a regression on the underlying variables. Afterwards, the company calculates the ratio’s sensitivity to each variable to understand the potential improvement attainable by focusing on reducing hosting costs for example. These analyses lead to a set of priorities for the business which will ultimately improve LTV/CAC.
Tracking the metric over time provides SaaS companies with an indicator for the health of the business. But because the LTV/CAC ratio is a composite number which encapsulates many other key figures, it shouldn’t be used as the exclusive measure for the health of the business, but as an instrument to question the underlying dynamics, as those contributing factors can change the LTV/CAC ratio dramatically.
Understanding the major drivers of this metric, the contributions of each team, and the sensitivity to investments in particular departments is a great way to prioritize internal growth and retention efforts for SaaS startups.