Why CAC Payback is More Important Than LTV:CAC Ratio
At some point in the past few years customer lifetime value (LTV) to customer acquisition cost (CAC) became an essential ratio for evaluating the profitability of a customer and the growth potential of a business. The higher the LTV:CAC ratio, the greater the return on investment per customer and the faster a company could grow.
However, at some point along the way the metric became the goal. Every startup pitch deck I saw advertised at least a 3-to-1 ratio — seemingly the industry consensus. I always thought this was an optimistic way to extrapolate what was really just a few months of data from very early adopters, as well as a risky way to decide how much to spend on marketing.
To illustrate the point, if the LTV:CAC ratio in an e-commerce business is $60 to $12 (5-to-1), that would imply CAC could rise to $20 and the ratio would still be in-line with the consensus 3-to-1 ratio. The problem is if much of that $60 comes after the initial purchase.
If the initial purchase is $15 of contribution margin, then at $12 CAC it’s immediate CAC payback (bright orange bar below). However at $20 CAC it’s no longer first order payback and relies on a repeat purchase to be unit profitable (bright blue bar below). In this example, if the second purchase happened 3 months later that’s 3-month CAC payback that needs to be financed.
CAC payback has a huge impact on your ability to scale capital efficiently. My partner David writes about why you want to aim for as many post-CAC dollars as possible. Without CAC payback on first order, you are betting on repeat purchases and effectively incurring a working capital cycle until the CAC is paid back. I’ve written about working capital cycles as it relates to DTC supply chains. It’s a similar concept here with CAC payback.
Pushing out the CAC payback by paying more for a higher LTV customer could work if you have a high retention, high predictability subscription business plus adequate financing. But it’s a risky bet for a non-subscription businesses and for very early subscription businesses without a lot of reliable retention data.
Industry bankers may tell you the payback windows they see are at 6–18 months for mature businesses, but I wouldn’t take that as gospel for how to run a startup that usually has a lot less cohort data and a lot higher financing costs.
Ultimately with immediate CAC payback on first purchase, you have much greater ability to control your own destiny as a company. That way repeat purchases are “gravy” instead of necessary for your business model to work.
It also protects you from the possibility that you’re wrong on your cohort LTV assumptions and therefore face the possibility of being unit margin negative, which is the death spiral for any business that’s not pursuing that as an intentional market share-grabbing strategy.
That’s ultimately why I think CAC payback is more important than LTV:CAC ratio. LTV relies on too many assumptions for an early stage startup to be a useful guiding metric. It can also lead startups astray by giving them too much confidence to increase marketing spend. CAC payback on the other hand relies on far fewer assumptions to calculate, and is a more important metric for scaling efficiently.
We’ll have more thoughts to come on the topic including shedding some light on how we calculate LTV. In the meantime let us know your thoughts!
