CAC < LTV
Selling dollar bills for eighty cents makes you very popular on your way to bankruptcy!
Every venture of every kind distills down to Unit Economics. Your business can produce one unit of something for a cost of X, and a customer is willing to pay you Y for it. For bakeries a unit is a loaf of bread, for consulting firms it’s an hour of time, for airlines it’s a seat-mile. If you want to operate profitably, you’ll need to sell a unit for more than it cost you to produce. Even an 8-year-old with a lemonade stand understands this.
And yet the leading case of startup death is realizing too late that the cost of getting the customer for that unit should have been added in there somewhere.
Let’s look at a quick example: If we make widgets for $6 and sell them for $9, then our unit economics show a nice $3/unit in gross profit. If last quarter we spent $1,000 on advertising and got 500 new customers who each bought a widget then our Customer Acquisition Cost (CAC) was $2. We need to add that CAC into our cost of making and selling one unit, so our all-in unit economics show $8 in costs, $9 in revenue, so $1/unit in gross profit.
But what if we had evidence that once we have a customer they usually come back and buy more widgets? That would be great! Let’s say that, on average, customers come back and buy a total of 5 widgets from us. It still cost us $2 to get the customer, but now the Lifetime Value (LTV) of that customer is $15 (5 widgets sold with a gross profit of $3 each)¹. So our Customer Acquisition Cost (CAC) of $2 looks pretty good against our LTV of $15.
Now our widget business is looking great, assuming those numbers hold up. Unfortunately, many many startups fail because they realize too late that their all-in Customer Acquisition Cost is higher than the Lifetime Value of a customer.
Every business needs to have a way of getting a customer for less than they can make from that customer. CAC has to be less than LTV. It’s a basic law of economics. Ask any 8-year old with a lemonade stand. So why it is still a leading cause of startup death? From my experience, here are the mistakes that many startup founders make:
Not adding in staff costs.
I’ve had entrepreneurs proudly tell me that they spent $5,000 on advertising in the quarter and got 5,000 new customers, so their CAC was just $1! But then I look at their financial statements and the have a full-time marketing person, two marketing assistants, a fancy graphic design freelancer, an inside salesperson and someone handling inbound web leads. So their actual customer acquisition costs were way more than a dollar. Because math.
Thinking your time is free.
I’ve had entrepreneurs tell me that their customer acquisition cost is zero because they do all the selling themselves! That’s only zero if you think your time is worthless. Also, it’s not scalable. So, when you are calculating CAC, make sure you ascribe a reasonable value to the time you personally spend selling.
Thinking that CAC is always a marketing problem.
I met with a startup recently who said that they fired their marketing person because the customer acquisition cost was just too high and clearly it was that the marketing person was doing a crappy job. So we dug into the funnel metrics together and found that plenty of customers were entering the top of the funnel on their e-commerce website, but very few were completing a purchase. In fact, most got all the way to the payment screen and then left. It turns out that the payment gateway they were using was a really crappy user experience. So they switched to a new payment gateway, and then number of people completing purchases doubled, which cut the CAC in half. Bingo. It wasn’t a marketing problem– it was a crappy payment gateway problem.
Over-estimating repeat purchases.
Every entrepreneur thinks their product is so awesome that customers will come back and buy more and more! Every startup with a subscription model thinks that very few customers will ever cancel their subscription! But this isn’t reality. So be conservative with how you calculate repeat purchases in order to come up with your LTV. Better to be surprised in a good way than to end up in surprise bankruptcy.
Not factoring in promotions.
Let’s say that you find that offering a “No questions asked return policy” increases your sales. That’s great! But if 15% of all purchases get returned, then you need to reflect this as either part of your customer acquisition cost, or you need to reflect it in your gross profit/LTV numbers. Don’t just wave your hands and pretend those economics don’t apply to you. They do.
If you show me your pitch deck and it says that your LTV will be 72x your CAC, I’m going to laugh and ask you whether pigs can fly. I’ve never seen anything anywhere near that high and the chances that you are going to be the first person to ever overcome the laws of physics seems very unlikely. So look up what the LTV/CAC ratio is for similar businesses (here’s a good look at the Netflix numbers, for example). Generally, you want to have a LTV/CAC ratio of better than 3x, seldom have I seen anything more than 10x. So that gives you a range. If you’re way outside that range, you probably have some assumptions wrong. Find a similar business you can benchmark to.
Let’s face it — as entrepreneurs, we are naturally optimists. We all underestimate what it will cost to get a customer, and we all overestimate how much we will make from customers. Sadly, this optimism drives a lot of startups to failure, because they realize too late that they have CAC<LTV upside down. So do this math early, and do it with a solid dose of realism. If you do this, you will dramatically increase your odds of having a successful startup venture. I promise.