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A lot of the startups that have quickly reached millions in monthly revenue rely on the arbitrage of being able to acquire customers through paid marketing for less than the lifetime value of that customer.

CAC < LTV

As a reminder, lifetime value, or lifetime contribution as it should perhaps more accurately be named, is given by the formula:

LTV = Expected Life x ARPU x Gross Margin

where Arpu = average revenue per user in each time period. This equation can hold whether you are in a subscription business or an ecommerce business with repeat purchase behavior. Although you need to be a bit more nuanced with non subscription businesses, the same cohort analysis techniques still allow you to approximate LTV in this manner. I’ll post more about this later.

Both LTV and CAC are key metrics that the management teams should be focused on improving.

Usually CAC is a blended average of several customer acquisition costs from several different channels. Each of these channels typically can be optimized by better targeting, better copy and creative on the advertising, better landing pages,optimization ofthe flow through to checkout, more and better payment options, and increased viral pass along.

Some of the tools that can be used to improve LTV include retention programs to extend life, cross sell and upsell campaigns to increase ARPU, and improving gross margin.

Both metrics are very important. However, if resource constraints force a choice between focusing on one or the other (it can be hard enough to do one thing at a time at a startup!), I would choose to focus on lifetime value. There are two reasons for this. Firstly, most of the improvements that can be made to LTV will improve LTV for all users, both current and future, and regardless of channel of acquisition. In contrast, many of the improvements that can be made to CAC are channel specific (e.g. copy of a particular ad) and none of them improve the economics of existing customers, only new customers. You get more leverage out of your efforts on LTV.

Secondly, because LTV is typically already higher than CAC, an x% increase in LTV has more impact to the company than an x% reduction in CAC.

I’d love to hear what others think about this choice, and about other ways to improve both CAC and LTV

  • http://www.sachinrekhi.com Sachin Rekhi

    Great post Jeremy! Would love to see more discussion like this on optimizing revenue vs acquisition costs.

    I definitely agree that it is often the right decision to focus early on on maximizing LTV. In addition to your reasons, I think another important one for focusing on LTV first is that you can potentially open up new acquisition channels by increasing your LTV. For example, paid search might not make economic sense for your startup when you have a low LTV, but as your LTV increases, it may become an option. And ultimately you may find it to be a better ROI to optimize a new acquisition channel that becomes available to you instead of prematurely optimizing your initial limited channels.

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  • http:://www.linklifter.de/ Chris

    Your math is a little simplistic, as it focusses on average. I prefer to do a cohort analysis, i.e. calculating the lifetime value for different segments at a different time. E.g. of 100 acquired customers via TV ads from calendar week 15 there are 80 left in week 16, 60 in week 17 and so forth, then looking at revenue per cohort.

    This way you can max CAC spending on segments where LTV are even bigger, and you get an early warning system when LTV change over time. Been there, done that, works miracles.

  • http://Udemy.com Eren Bali

    Nice post Jeremy.

    I want to add that for startups that have a reasonable virality coefficient, we can improve the equation as
    CAC 1) or the advertising game. However if you have decent virality (let’s say 0.5) and LTV, you can afford to invest on acquisition channels that are not immediately profitable.

    My 5 cents,

    Eren Bali
    CEO & Co-founder, Udemy

  • http://Udemy.com Eren Bali

    Sorry my comment got screwed because of the greater-than, less-than symbols.

    The equation would be
    CAC less-than LTV * (1+V)
    where V = Virality coefficient (how many users an avg user brings to the site from various viral channels)

  • http://www.limecellular.com patrick

    Good stuff, but gee — didn’t book clubs, record clubs, etc. pioneer this in the 1960’s? I think so…

    In fact, the basic direct marketing actuarial math which has been around for decades is at the core of many web and mobile businesses today. What held them back years ago were crushing production and distribution costs — and the good ones still made tons of money doing it. You could actually jazz this up a bit by throwing in revenue bands at different confidence intervals, or some multivariate forecasting based on observed variations in leads and sales generated.

    Still, another step in the right direction: accountability in marketing spend is here to stay.

    .

    .

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  • spanky

    Yes, I agree w/ Eren, it’s imperative to model the viral ratio into the LTV calculation to get your CAC below LTV, especially in today’s competitive ad space. Another lever worth mentioning is to tweak your pricing via split tests to increase your ARPU.

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  • Ritesh Tiwari

    considering budgeting constraints..
    the money u save on CAC aids u to target and acquire more customers and thereby have a CLV in the first place. thus optimizing CAC vs CLV is important and cannot be generalized to “investments in CLV is better than CAC”…
    the catch here becomes CAC is what % of CLV… and the expected CLC(customer life cycle)
    granted, for very long CLCs it would be true.

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  • http://www.facebook.com/profile.php?id=1841591348 Nick Lim

    Hi Jeremy, good post. I believe that with connected games, the game industry will eventually look like traditional consumer industries, except with greater frequency and depth of touch points.

    I believe the days of focusing only on player acquisition are fading. It’s time for the games industry to adopt well used customer (player) lifecycle management techniques from other consumer industries to improve LTV. Telcos and finsrv companies all have well honed loyalty programs and predictive analytics capabilities to optimize LTV.

    The main business opportunity here is how to lower the barriers and cost of these programs. Telcos and finsvcs all spend upwards of millions per year on these programs with large customer or base management teams. That won’t work for games. But since more game developers can survive due to greater internet/mobile distribution, any company that can provide lifecycle management services efficiently can also reach a larger market.

    In terms of LTV versus CAC, I agree that LTV is first. However, there will come a point where you want the LTV techniques to also spill over into acquisition -> ie. how to acquire players with high predicted $ value and social influence.

    Best,
    Nick Lim
    Sonamine LLC

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  • http://newunlockedphone.com/ Android guy

    Is the formula applicable to all types of companies ? Looks like there could be some deviation when you compare it to mobile phone companies ?

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  • Thasneem

    Is this formula right?
    LTV = ARPU x Gross margin / Churn Rate

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