A founder’s guide to calculating CAC and LTV the right way
As a former venture capitalist, I always tell founders that the most powerful tool they can employ while fundraising is a data-driven pitch.
Leading with data is even more valuable during periods of uncertainty and market volatility. With investors looking to de-risk their investment decisions, coming to the table with hard evidence portraying your company’s growth potential is the key to success for companies fundraising.
Volumes of valuable, real-time financial data are now at our fingertips because of cloud software, but without proper guidance — or data fluency — founders and investors alike are missing out on the opportunity to leverage these assets. I’m a firm believer that greater data fluency not only unlocks potential for individual companies, but also an entire generation of founders from traditionally underrepresented backgrounds.
Zooming in a bit further, there’s one metric that companies must get right in order to demonstrate their potential for growth and attract investors: their LTV/CAC ratio.
What is LTV/CAC and why does it matter?
Lifetime value (LTV) and customer acquisition cost (CAC) are two of the most common metrics used by investors and companies alike to provide a cost-benefit analysis and ultimately predict a company’s value.
When companies acquire customers, the right way to view that customer is not just as a one-time purchaser but as a long-term cash-flowing asset. LTV helps both investors and companies calculate the long-term potential value of its customers, especially when they are expected to continue paying for goods and services over a sustained period of time.
While founders with an eye on high valuations may hesitate to follow a conservative approach, doing so can be pivotal for building trust with investors.
To acquire these customers, companies have to spend capital (using equity, debt or their free cash flow) on tactics like paid ad campaigns, sales personnel and more. The total expenses that contribute to acquiring a certain cohort of customers is considered the CAC for that cohort.
Investors use LTV/CAC to measure whether a company’s short-term investments into sales and marketing are creating or destroying value for the business and determine if additional capital will help the business scale efficiently. Measuring the ratio between LTV and CAC allows investors to predict if giving a company more money to spend on CAC will yield a positive or negative ROI.
A low LTV/CAC ratio is a red flag, as it shows the company is not efficiently acquiring high-value customers and will ultimately require more investment to grow. On the flip side, a strong LTV-CAC ratio indicates that injecting new capital can help accelerate growth exponentially.
Where do companies go wrong?
Many common mistakes boil down to using the wrong metrics to tell your story. I often see founders calculating LTV/CAC on a revenue basis, when in reality, calculating LTV/CAC on a gross margin basis is imperative for growth financing.
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