Why LTV:CAC is a Key Metric For Investors

An article we liked from Thought Leaders Jamie Sullivan and Alex Immerman of Andreessen Horowitz:

Why Do Investors Care So Much About LTV:CAC?

To put it simply: higher LTV:CAC → higher margins → higher valuation.

Investors often use 3x LTV:CAC as a rough benchmark of a consumer company’s financial health. If your customer lifetime value (LTV) is 3 or more times your customer acquisition cost (CAC) within 5 years, that means your company has efficient returns on sales and marketing spend. But there’s little discussion of how a higher LTV:CAC actually translates to long-term profitability and, ultimately, valuation.

Solid unit economics has a cascading effect across your business: a higher LTV:CAC ratio means for every dollar of sales and marketing investment, your company has higher margins and so more profit to reinvest back into its business, which means that you can build better products and, hopefully, capture more market demand. Companies are ultimately valued on their future cash flow generation, so the higher your margins, the higher your valuation.

In fact, improving your LTV:CAC from 2x to 3x can nearly triple your valuation.

To illustrate, let’s walk through some calculations using the long-term margin projections across 60+ US public consumer internet companies with extensive sell-side equity analyst coverage.

A few notes before we jump in. For the sake of this post, we consider LTV as your gross profit (as a proxy for contribution profit) from a customer over time and CAC as the total sales and marketing (S&M) spend that goes into acquiring that customer. We generally prefer to calculate using historical monthly customer cohort data for LTV and the CAC associated with that specific month, but there are several ways to calculate LTV:CAC. (Our piece on 16 startup metrics offers more details on how we approach calculating it, while this piece is a great deeper dive into the various considerations that go into an LTV:CAC calculation.)

In our calculations for this piece, we’ve calculated both margins and valuations based on gross profit. Relative to enterprise companies, consumer companies have a wider range of business models (e.g., first-party e-commerce, third-party e-commerce, social networks, subscription-based content, etc.), and thus COGS (cost of goods sold) structures. Focusing on gross profit can help standardize across these differences. As such, S&M, R&D, G&A and operating margins are calculated here by dividing by gross profit, instead of by the more commonly used revenue.

Higher LTV:CAC → higher margins

Let’s start by looking at the inputs into a company’s OpEx (operating expense) lines. Typically, OpEx spend breaks down into 3 buckets: R&D (research and development), G&A (general and administrative), and...

Read the rest of this article at a16z.com...

Thanks for this article excerpt to Jamie Sullivan, Partner on the Growth investing team and Alex Immerman, Partner on the Growth investing team at Andreessen Horowitz.

Photo by Towfiqu barbhuiya on Unsplash

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