- Subscription-based business models require B2B sales leaders to focus equally on acquiring and retaining customers
- Customer lifetime value (LTV) and customer acquisition cost (CAC) are two critical metrics that sales leaders should measure
- The LTV:CAC ratio helps sales leaders pull the right levers to align their costs with customer profitability in each segment
Subscription businesses that charge customers monthly for using their offerings are expanding rapidly in response to consumers’ and B2B buyers’ desire to try a product and walk away easily if they’re not achieving the expected value. However, the subscription-based business model puts tremendous pressure on sales organizations to facilitate a seamless transition between the buyer and customer journey and ensure customers are seeing the value they were promised during their evaluation. Many sales leaders are drowning in data and struggling to figure out what key metrics they should track to reveal their progress in growing subscription revenue. One powerful, simple metric enables sales leaders to pull the right levers to grow revenue: the ratio of customer lifetime value (LTV) to customer acquisition cost (CAC).
What Is the LTV:CAC Ratio?
LTV is a measure of the average profit a company makes from each customer. A company can calculate LTV by multiplying the annual payment from an average customer by its gross margin and dividing by the annual cancellation rate, or churn. For example, each customer pays the company $50,000 per year. The company has a 70% gross margin on that customer and its average annual churn is 15%, so the LTV is ($50,000 × 70%)/15% = $233,000. LTV is extremely sensitive to churn because the longer a company can keep a customer, the more profit that company will realize from the sunk cost of acquiring that customer.
CAC is a measure of how much it costs a company to acquire new logos and shows sales leaders the effectiveness of their spend in that effort. A company can calculate CAC by dividing all the costs spent on acquiring new logos (e.g. sales and marketing expenses like advertising, salary, commission, bonuses and overhead) by the number of new logos acquired in the period in which the money was spent. For example, if a company spent $20 million in total sales and marketing expenses in the last fiscal year to acquire 1,000 new logos, that company’s CAC is $20 million/1,000 = $20,000.
LTV:CAC is a ratio that measures the relationship between the lifetime value of a customer and the costs of acquiring that customer. Put more simply, the ratio expresses how much profit is generated for every dollar the company puts into the sales and marketing machine. Healthy subscription businesses should aim for a 3:1 LTV:CAC ratio, or greater than $3 of profit generated for every $1 of costs to acquire the new logo. A company with a 1:1 ratio is spending too much. A company with a 5:1 ratio has a successful subscription business. A company with a 10:1 ratio is probably not spending enough and should increase investment to acquire more new logos.
Why Should Sales Leaders Pay Attention to the LTV:CAC Ratio?
LTV:CAC is the ideal measure of the performance of a subscription business because it isolates the key levers a sales leader should pay attention to and pull to accelerate profitable revenue growth. For example, a sales leader should invest in ensuring high customer retention, because LTV grows as customers stay longer while high churn rates drive down LTV, making a negative impact on LTV:CAC. Sales leaders should also monitor how much it costs to acquire new logos, because higher costs (e.g. adding a business development rep) drive up CAC and make the ratio less attractive.
How Should Sales Leaders Use the LTV:CAC Ratio to Drive Growth and Profitability?
Sales leaders should use LTV:CAC for each customer segment to ensure alignment between the costs to acquire a new logo and the profit from each customer. For example, because small and medium-sized business (SMB) customers typically churn at a much higher rate than mid-market and enterprise customers, their LTV is relatively low; therefore, sales leaders must look for cost-effective ways to acquire SMB customers. Sales leaders can’t afford to invest in expensive field sales resources to acquire SMB customers – they’re not profitable enough. But sales leaders can afford to invest in many resources in the enterprise segment, because most enterprises generate a lot more profit for companies than SMBs. So, although CAC is relatively higher in the enterprise segment, so is LTV.
Sales leaders of subscription businesses who are already tracking the LTV:CAC ratio must make sure they’re measuring LTV:CAC by customer segment – and that they’re pulling levers to spend more efficiently to acquire customers and drive down churn.