Measuring Lifetime Value Is Stupid

This is the Unbreakable Business newsletter - created just for COOs and Operations Teams who want to build a company that won’t fall apart.

In this issue, I’m going to pick a fight with a tried-and-true SaaS metric, because I think it’s kinda stupid. We’ll discuss the ins and outs of measuring customer acquisition costs (and why it matters). And of course, I’ll give you a better way to do it.

Today, I’ll cover:

• Why CAC:LTV ratio is not as useful as everyone thinks it is

• How to measure acquisition costs in a way that actually makes sense

• Which decisions should be driven by these numbers (and which shouldn’t)

Enjoy!!

🪓 Let’s Kill Some “Old Knowledge”

If you were to collect all of the VC lore from the past 20 years and create a series of dusty leather-bound books with it… there’d be at least one chapter on why CAC:LTV is the best way to measure the efficiency of your customer acquisition.

Alright, let’s break that down (because everyone hates random acronyms).

The old school says that you should measure your Customer Acquisition Cost (CAC) and compare it to your Customer Lifetime Value (LTV) to come up with an efficiency ratio.

On the surface, it sounds logical.

1. Buy customers at a lower cost than what they’re worth.

2. Profit

One article I read broke this down and said:

“If your CAC:LTV ratio is between 3 and 5, that’s healthy. If it’s over 5, you should spend more on sales and marketing. And if it’s below 1, you’re losing money on every customer.”

If only it was that simple.

📈 Measuring Value Over A Lifetime

Ok, let’s give this sweet little ratio some contact with real life.

The rub for me is around measuring Lifetime Value - when most companies haven’t been around long enough to actually know the number.

Hypothetical scenario: you’ve been in business for two years, and you still have 60% of your original customers from your first few months…how long will they stay?

Uncertainty ensues.

And based on that uncertainty, we find the next “hack” - a formula that can kinda sorta calculate your lifetime value:

Avg. Monthly Revenue per Customer / Monthly Churn %

So, in our hypothetical two year old business, let’s say our customers pay us $500 per month on average, and our churn last month was 4%.

$500 / 0.04 = $12,500 Lifetime Value

And armed with that number, we decide that we can spend about $4.1k to acquire a customer (CAC:LTV ratio of ~3).

Maybe we make a hire, ramp up some ad spend, buy some new prospecting software, etc…based on the numbers, we think we can keep our costs to under $4.1k per customer. Life is good.

Another two months go by…new hires are in the seats, software is implemented, and numbers haven’t changed…we’re feeling pretty smart right about now.

Month three…churn bumps up to 6%.

$500 / 0.06 = $8,333 Lifetime Value

Shit. All of a sudden, our magic LTV formula says our customers are worth 32% less over their lifetime.

Now we’re spending 50% of this alleged LTV on customer acquisition. And our CAC:LTV is down to about 2. Danger zone.

Our logical brains clock in for a minute. This is just a monthly blip, right? If churn goes back down, we should still be good, right? How many months do I roll with this before I get rid of that new hire? Does this ratio mean that I’ll run out of cash?

This is that magic moment where many founders and COOs decide that it’s too hard to pull the insights from the change, so they make a “gut feel” decision and keep rocking.

🧠 Can We Just Stop And Think For A Sec?

If you think like I do, the first thing you’re doing in this example is zooming out and saying, “Is this even true?”

Or, more specifically, “Does churn going up 2% mean that I need to dial back my investment in customer acquisition?”

I’m not saying it does. I’m not saying it doesn’t.

I’m just saying it’s a shitty mechanism for making the decision.

First off, every entrepreneur (and every business itself) has a different risk tolerance. Some would choose to weather the storm, some would pull back spend. Some have easier ways to pull back spend (like ads), and some take longer to adjust (outbound SDRs, inside sales teams, etc).

And my issue with using LTV to guide these decisions is that since most companies don’t really know it, we use this super-volatile “divide by churn” approach that moves the goalposts a huge distance with every percentage point.

Might work for enterprise SaaS with very consistent/low churn…might work for 10 year old companies with buckets of cash…

But for the vast majority of SaaS companies that I actually help, it’s crazy harmful to measure against a metric where the finish line moves faster than our ability to change the strategy. It’s a frantic feeling that makes us want to stop measuring against it in the first place.

If you really think about it, all of these mental gymnastics are just trying to answer one simple question:

“Am I comfortable with how much cash I’m tying up vs. how much I’m getting back out?”

That is the ACTUAL decision. It’s the real work. It’s the “why” behind all of these fancy ratios.

Don’t forget to keep the main thing the main thing: Our mission as a business is to deliver a result at a lower cost relative to its value in the market.

So if we let our Customer Acquisition costs spiral out of control, not only will we fail at that mission (as our profits erode, the business becomes unstable, we lay off team members, etc) - but depending on your cash situation, you could also simply run out of money.

Not good. Luckily for us, there’s a better way to measure this - and it uses one of my favorite metrics…

🥇 The Gold Standard Of SaaS Metrics

Readers…meet my favorite metric: CAC Payback Period!!

Look, if the real question is to make sure that we don’t tie up too much cash, why the f$!k don’t we just measure that?

CAC Payback Period: The number of months that it takes to recover what we spent to acquire a customer.

If you know me at all, you know my love for The Goal. It’s the book that instilled my ability to view and system, process, or business as a factory assembly line, which IMO is an incredibly useful model for finding inefficiencies in a business.

So applying that metaphor to this scenario…we have effectively built a customer acquisition machine.

1. We insert money into the machine.

2. After enough money gets loaded up, a customer is produced.

3. That customer, after a time delay (and a number of other steps being executed correctly), starts to produce money back OUT.

4. Some of that “output money” can go back into this machine to make more customers, but some of it also goes to other machines (COGS, R&D, profit, etc).

Using that metaphor, you can see the levers to pull to make it more efficient:

1. You can build the machine where it takes less money to produce the customer (reducing CAC)

2. You can increase the percentage of customers that produce more money (improve activation)

3. You can decrease the time it takes for the customer to start producing more money (a second order effect of needing less money at the start OR a higher price point)

And you can also see how going too long before your customers start “producing money” will back up the assembly line…because arguably, you’ll run out of money to put into the machine in the first place.

Ok, I think I’ve beat the crap out of that metaphor. Let’s move on.

Calculating CAC Payback Period (CAC PBP) is pretty simple:

(CAC / MRR) - 1 = CAC PBP (in months)

Let’s walk through a quick example using the same data as before (spending $4.1k to acquire a $500/mo customer).

(4100 / 500) - 1

8.2 - 1

7.2 months CAC PBP

So now we know that every single dollar we tie up in customer acquisition will remain tied up for about 7 months.

I personally don’t love keeping the money tied up that long (although it’s doable for some businesses)…but just being AWARE of how your assembly line is running is half the battle.

🤔 A Few Common Questions

➡️ “Why are we subtracting 1 at the end?”

Remember that (in most SaaS models), you get paid on Day 0. A new customer enters their credit card to pay for the next 30 days.

So for instance, this $500/mo customer will have paid us $1.5k in the two months following the sign-up.

➡️ “What’s a good benchmark?”

There is some context that could change my answer, but if you wanted a benchmark that I think is the right target most of the time, it would be three months.

Obviously lower is better…and if you can get it to under 1 month, you can put your acquisition on a credit card 😂 which is a fun place to be.

➡️ “How often should I measure this?”

I measure CAC PBP monthly, using fully loaded CAC (that means including everyone’s salaries, etc).

I will also measure unloaded CAC on a weekly basis, but it’s more of a directional measure of efficiency (as opposed to “the truth”).

➡️ “Any other important ratios I should be measuring?”

Probably, but the most important one for today is the GIF to Equation ratio (GEq). This newsletter is a 2.5 (2 GIFs, 5 equations)…I’ll try to get this over 3 in the future 🤣 

📽️ Check Out The Pod

Last week, I rented an AirBnb in Austin TX, turned it into a studio, and shot 4 in-person podcasts for SaaS Academy with some incredible guests.

I can’t wait for them to come out…but in the meantime, check out our latest episode of the SaaS Academy Podcast, where JP and I rock through some questions from our clients.

There’s a cool deep dive on hiring and managing EAs, running a community for your customers, and a lot more.

As I continue to hone the direction of the newsletter, I’d love some feedback from you - this will be in every issue going forward:

Always in your corner,

MV