The LTV/CAC ratio purports to be one of the best ways for SaaS companies to show profitability over time.
It's a lie.
The LTV/CAC ratio is, in fact, an utterly useless metric.
"If I'd learned anything, it was that conventional wisdom had nothing to do with the truth." - Ben Horowitz
Companies using LTV/CAC are up to no good
Last week, I met a CEO at a venture capital-funded SaaS company. He talked a lot about LTV/CAC and asked me what ours was.
He looked astonished when I answered that we don't measure LTV/CAC at Upsales.
"Why not?" He wondered.
"Because what decisions can I make in my B2B SaaS business based on LTV/CAC?" I said.
He looked even more confused when I elaborated.
"LTV/CAC doesn't say anything valuable for a B2B SaaS company. Sure, the KPI makes sense in some industries. E-commerce, for example, needs to find a sustainable level of ad spending. Where they also account for overhead costs. A B2B SaaS company doesn't have the same issues. We have the most scalable business model, and operations don't require much capital."
"But isn't it great for you to say that for every euro spent, we get 13 back?" He said.
"That's the problem", I replied. "The LTV/CAC always looks good since it's calculated on highly theoretical numbers. So yes, maybe if you want to fool investors."
"Yes, exactly", he answered.
Need to hide inefficiencies? Use LTV/CAC!
The moral of this story is baffling. Even companies that measure LTV/CAC seriously know it's a fantasy KPI. Made to fool investors and other decision-makers.
The truth is that companies with an actual track record have much better KPIs to showcase. If you don't have an impressive growth pace, you need to find something that looks good to the market.
The LTV/CAC ratio omits that there are a lot of inefficiencies hiding in the business. It might work when the economy is booming. Now, however, the reality is creeping up on us. Inflation and interest rates keep getting higher. And time is running out for companies that overlook inefficiencies in their business model.
What's fundamentally wrong with the LTV/CAC as a SaaS metric
The LTV/CAC ratio compares how valuable a customer is over time to the cost of acquiring them. That should, in essence, give you an idea of profitability. Yet, there are many flaws with the metric.
Most SaaS companies calculate LTV like this:
The average revenue per account * The average customer lifespan
It's attempting to consider the nature of the subscription-based business model.
The assumptions in this calculation, however, are wrong.
1. You assume there are constant churn rates, which in reality, will differ.
2. You don't account for price differences, which makes the average revenue less relevant. In most B2B SaaS, the biggest customer pays a thousand times more than the smallest one. The average can make sense in some industries where the variations are smaller, such as e-commerce. But in B2B SaaS, it just doesn't.
3. You assume all customers eventually churn, which they don't.
Also, if you're a young company, the years behind you won't look anything like the ones ahead. So how on earth would you be able to calculate your LTV?
SaaS is also a business model with short sales cycles. You should be able to become profitable within months, not years. At least, if you're doing it right, with good sales management and a decent cost culture.
It's, in other words, highly theoretical guesses we're making when using LTV/CAC. These oversimplifications lead to nothing but nonsense.
What to do if you're in it to win it
If you're building your SaaS company long-term, you should go back to the basics.
Ask yourself: what did we receive from the money we poured in?
Take what you spent on sales and marketing and compare it with the amount of ARR you closed in the same period. You want a 1:1 relationship or better. And maybe, just maybe, if you are in a stage of hyper-growth, it's ok to get your money back a quarter later.
Spend more time thinking about growth and cash flow
It's also better to look at growth and cash flow since your business should generate money. The recent years' excessive access to risk capital has put the market out of sync. A couple of years ago, the demands were much higher to raise capital. Lately, nobody has seemed to care as long as your business grows. Entrepreneurs need to reestablish that for a fast-growing company a -30% margin might be ok, but a -200% margin isn't.
Retire LTV/CAC and start looking at E40 growth efficiency
Truly efficient SaaS companies retired the LTV/CAC metric long ago or never even used it. Something you should measure instead is E40, calculated as:
Net revenue growth rate + free cash flow margin
It gives you a solid understanding of how you're balancing growth versus profitability. Insights that you, unlike the LTV/CAC, can use for decision-making.
The proper way to make decisions in the board meeting
Imagine you want to hire five new sales reps and increase the marketing budget by 50.000 euros next quarter. Your new sales reps should reasonably be up and running within a few months if you're doing it right.
And if they're not, you're not ready to scale. If only two of the five sales reps deliver as expected, you still have work to do. But what most companies do here is press down the gas pedal anyways. Usually, it doesn't end well or takes much more time than expected to reach the desired results. Many executives think it's more important to keep scaling rather than getting things right from the beginning. So, they keep hiring more people for the upcoming quarters. And suddenly, they end up with 150% less margin than they could've had.
A better approach is to look at what impact the changes would have on your E40 next quarter. If you don't like what you see, it's time to reconsider. You can also decide that a weakened E40 is ok for that quarter if you're committed to bringing it back the next. Give your idea a go for 1-3 months and follow up on it. If it doesn't work, kill the initiative fast and regroup. And most importantly, never go back to looking at your LTV/CAC.
/ Daniel Wikberg
CEO & Founder of Upsales
