The holy grail metric for subscription businesses.

The CLV:CAC ratio has long been a trusted metric for evaluating the financial health of a subscription-based business. However, in recent years, the accuracy and relevance of this metric have come under scrutiny. As a result some have abandoned the CLV:CAC ratio entirely, others persevere despite the flaws of the conventional method of calculating customer lifetime value

When calculated correctly the ratio of customer lifetime value (CLV, or LTV*) to customer acquisition cost (CAC) has been dubbed the ultimate SaaS metric. It captures the essence of the unit economics of the subscription business, answering the fundamental question: How much can I spend on customer acquisition and still be profitable?

In his blog post The Ultimate SaaS Metric, influential Dave Kellogg explains why the CLV:CAC ratio is the ultimate SaaS metric: “Because what you pay for something should be a function of what it’s worth.”

From my own experience, one of the key questions in a growing subscription business is how much can reasonably be spent on growth marketing to acquire new customers. When faced with the sales and marketing expense line in the income statement, uncertainty arises. Are we spending too much? Should we be spending more to grow faster? Are we winning the right types of customers? We don’t want to spend so much on sales and marketing that it can never be recouped, but if an acquisition approach is working, we should be doing more of it. The question is, how far can we go with it while remaining profitable?

But what is the threshold for a healthy CLV:CAC ratio?

According to Dave Kellogg, “The rule of thumb is 3. The higher, the better.” To expand on why the rule of thumb would be 3 or higher, consider an example. If you spend on average $1,000 to win a customer who will eventually earn you $3,000, that difference of $2,000 has to go towards paying for overheads, product development, and all the other expenses. After all of that, there needs to be profit remaining, sooner or later. This illustrates one of the strengths of the CLV:CAC ratio as a powerful metric that helps understand whether the business is viable.

However, be careful with this powerful metric.

There are pitfalls and traps that have deceived many of the smartest operators. Amongst the most common mistakes in calculating the CLV:CAC ratio are:

• Using customer lifetime revenue instead of CLV by failing to account for the costs involved in serving customers. CLV is a margin-based metric, not a revenue-based metric.
• Omitting significant costs such as subscription payment processing, retention-related activities, and operational technology platforms from the calculation of margin and cost-to-serve. The principle is to include all costs incurred in business operations relating to existing customers. When calculating cost-to-serve, ask yourself, “What costs would we still have if we weren’t pursuing any new customers?”
• Failing to adjust the value of future cash flows to allow for the time value of money, which is achieved by applying a discount rate to represent the cost of capital, as in net present value (NPV) or discounted cash flow (DCF) financial analysis. In times of low-interest rates and terms less than a couple of years, this effect may not be material, but in times of inflation, it must not be ignored.
  
• Using churn rate to estimate customer lifetime, which is one of the primary factors in calculating customer lifetime revenue and customer lifetime value. Customer lifetime is commonly (and wrongly) calculated as the reciprocal of churn rate, but this deceptively simple shorthand method is mathematically flawed. Any calculation of CLV that uses churn rate will yield invalid results that should not be trusted.

These mistakes can lead to misinformed business decisions and a false understanding of your business’s unit economics, which are so fundamental to its success.

CLV:CAC > Net Revenue Retention

Several influential SaaS commentators including, Dave Kellogg have written pieces promoting the virtues of the net revenue retention metric (NRR), suggesting that it should be used in preference to the CLV:CAC ratio. In doing so they seem to be overlooking several important points, such as:

• NRR is a backward-looking metric and cannot replace the forward-looking customer lifetime value (CLV), which answers the unit economics question of how much to spend on customer acquisition to remain profitable. 
• Many criticisms of CLV stem from calculating CLV incorrectly, and those criticisms are irrelevant when CLV is calculated properly.

While NRR has its uses, it cannot replace CLV as the ultimate measure of subscription unit economics. The superior approach is to calculate CLV using a sound method that avoids churn rate, and to harness the power of the CLV:CAC ratio as the ultimate measure of subscription unit economics.

_{*It's worth noting that CLV and LTV are interchangeable terms, and I have used the long-established CLV acronym throughout this article.}

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