Customer Economics: The LTV/CAC Framework That Predicts Success

The $100M Mistake

In 2011, a promising e-commerce startup raised $100M in funding. Their revenue was growing 20% month-over-month. The press loved them. Investors were excited. Eighteen months later, they shut down.

What happened?

The company was spending $300 to acquire each customer. Those customers bought an average of $250 worth of goods before churning. For every customer they acquired, they lost $50. The faster they grew, the faster they burned cash.

They had mistaken revenue growth for business health. They never measured their unit economics.

This is the story of many startups. Great top-line numbers. Terrible fundamentals. The difference between success and failure often comes down to understanding two numbers: Customer Acquisition Cost (CAC) and Lifetime Value (LTV).

Let’s master these metrics so you never make the $100M mistake.

Customer Acquisition Cost (CAC): What You’re Really Paying

Customer Acquisition Cost is the total cost of acquiring a new customer. It sounds simple, but most companies calculate it wrong.

The Basic Formula

$$ \text{CAC} = \frac{\text{Total Sales & Marketing Spend}}{\text{Number of New Customers Acquired}} $$

But this is too simplistic. Let’s break it down properly.

What to Include in Sales & Marketing Spend

Include:

• All marketing spend (ads, content, SEO, events)
• Sales salaries and commissions
• Marketing salaries and overhead
• Software tools (CRM, analytics, email)
• Agency and contractor costs
• Creative production costs

Common Mistake: Only counting ad spend. Your CAC is actually much higher than you think.

CAC by Channel

Smart companies track CAC by acquisition channel:

Key Insight: The cheapest channel isn’t always best. A $500 CAC is great if LTV is $5,000.

CAC by Cohort and Time Period

Track CAC over time to spot trends:

If CAC is trending up while LTV stays flat, you have a problem.

Lifetime Value (LTV): What a Customer is Worth

Lifetime Value is the total revenue you’ll earn from a customer over their entire relationship with your company.

Simple LTV Formula

For businesses with one-time purchases or simple pricing:

$$ \text{LTV}_{\text{simple}} = \text{Average Revenue Per User (ARPU)} \times \text{Average Customer Lifespan} $$

Example:

• Average purchase: $100
• Customers buy 3 times before churning
• LTV = $100 × 3 = $300

Advanced LTV Formula

For subscription businesses (SaaS, memberships, etc.):

$$ \text{LTV}_{\text{advanced}} = \frac{\text{ARPU} \times \text{Gross Margin %}}{\text{Churn Rate}} $$

Example (SaaS company):

• Monthly ARPU: $50
• Gross Margin: 80%
• Monthly Churn: 5%

$$ \text{LTV} = \frac{$50 \times 0.80}{0.05} = \frac{$40}{0.05} = $800 $$

When to Use Each Formula

Use Simple LTV when:

• You have clear, discrete purchase patterns
• E-commerce with repeat buyers
• Low customer count (can track manually)

Use Advanced LTV when:

• Subscription or recurring revenue model
• High customer volume
• Need to model churn mathematically

The Gross Margin Adjustment

Why multiply by gross margin? Because LTV should reflect profit, not revenue.

If your ARPU is $100 but it costs you $30 to deliver the service (COGS), your actual value per user is only $70.

$$ \text{Adjusted LTV} = \frac{$100 \times 0.70}{0.05} = $1,400 $$

vs.

$$ \text{Unadjusted LTV} = \frac{$100}{0.05} = $2,000 $$

That’s a 30% difference in how you value customers. Get this wrong and you’ll overspend on acquisition.

The Golden Ratios: LTV:CAC and Payback Period

Now that we can calculate LTV and CAC, let’s use them to predict business health.

The LTV:CAC Ratio

$$ \text{LTV:CAC Ratio} = \frac{\text{Lifetime Value}}{\text{Customer Acquisition Cost}} $$

What the ratios mean:

Example:

• LTV: $800
• CAC: $200
• Ratio: 4:1 ✅

The Goldilocks Principle:

• Too low (< 3:1): You’re spending too much to acquire customers
• Too high (> 5:1): You’re not spending enough — competitors will outgrow you

Payback Period: When You Break Even

Payback Period is how long it takes to recover your CAC.

$$ \text{Payback Period (months)} = \frac{\text{CAC}}{\text{Monthly Recurring Revenue per Customer} \times \text{Gross Margin %}} $$

Example:

• CAC: $600
• Monthly ARPU: $100
• Gross Margin: 75%

$$ \text{Payback Period} = \frac{$600}{$100 \times 0.75} = \frac{$600}{$75} = 8 \text{ months} $$

Benchmark: Best-in-class SaaS companies have payback periods < 12 months.

Why it matters: The longer your payback period, the more cash you need to fuel growth. A 24-month payback period means you need 2 years of runway for every new customer cohort.

Churn Math: The Silent Killer

Churn Rate is the percentage of customers who stop doing business with you in a given period.

Monthly vs. Annual Churn

$$ \text{Monthly Churn Rate} = \frac{\text{Customers Lost in Month}}{\text{Customers at Start of Month}} \times 100% $$

$$ \text{Annual Churn Rate} = 1 - (1 - \text{Monthly Churn Rate})^{12} $$

The Shocking Reality:

At 5% monthly churn, you lose nearly half your customers every year.

This is why SaaS companies obsess over reducing churn by even 1%. Going from 5% to 4% monthly churn is the difference between 46% and 38% annual churn.

Logo Churn vs. Revenue Churn

Track both:

Logo Churn (Customer Churn): $$ \text{Logo Churn} = \frac{\text{Number of Customers Lost}}{\text{Total Customers}} $$

Revenue Churn (MRR Churn): $$ \text{Revenue Churn} = \frac{\text{MRR Lost from Churned Customers}}{\text{Total MRR}} $$

Example:

• Lost 10 customers out of 500 = 2% logo churn
• Lost $1,000 MRR out of $100,000 = 1% revenue churn

If revenue churn < logo churn, you’re losing smaller customers. That’s usually good.

If revenue churn > logo churn, you’re losing big customers. That’s a red flag.

Cohort Retention Analysis: The Truth Revealer

Aggregate churn rates hide the truth. Cohort analysis reveals it.

A cohort is a group of customers who started in the same time period. Track how each cohort behaves over time.

Sample Cohort Retention Table

What this tells us:

• Retention is improving over time (good!)
• Early cohorts (Jan-Feb) have worse retention than later ones
• Something changed in March that improved retention
• April cohort is tracking even better

Action: Figure out what changed in March and do more of it.

Visualizing Retention Curves

Healthy retention curve: Steep drop in first 3 months, then flattens out. Retained customers stick around.

Unhealthy retention curve: Steady decline throughout. You have a leaky bucket.

Magic Number: SaaS Efficiency Metric

The Magic Number measures sales efficiency: how much revenue you generate per dollar spent on sales & marketing.

$$ \text{Magic Number} = \frac{\text{Net New MRR (or ARR)} \times 4}{\text{Sales & Marketing Spend}} $$

Why × 4? Annualizes quarterly MRR growth (quarterly growth × 4 = annual impact).

Benchmarks:

Example:

• Q1 Sales & Marketing Spend: $500,000
• Q1 Net New MRR: $150,000

$$ \text{Magic Number} = \frac{$150,000 \times 4}{$500,000} = \frac{$600,000}{$500,000} = 1.2 $$

Interpretation: For every $1 spent on S&M, you’re generating $1.20 in annualized revenue. That’s excellent. Increase your S&M budget.

Negative Churn and Expansion Revenue

Negative Churn is the holy grail of SaaS. It happens when expansion revenue from existing customers exceeds revenue lost to churn.

The Formula

$$ \text{Net Revenue Churn} = \frac{(\text{Churned MRR} - \text{Expansion MRR})}{\text{Starting MRR}} $$

Example:

• Starting MRR: $100,000
• Churned MRR: $5,000 (5% churn)
• Expansion MRR: $7,000 (upsells, cross-sells)

$$ \text{Net Revenue Churn} = \frac{$5,000 - $7,000}{$100,000} = \frac{-$2,000}{$100,000} = -2% $$

You have negative churn! Even without acquiring new customers, your revenue grows 2% per month.

Why Negative Churn is Powerful

Companies with negative churn:

• Snowflake
• Datadog
• MongoDB
• Twilio

They can afford to lose some customers because existing customers spend more over time.

How to Achieve Negative Churn

1. Usage-based pricing: As customers grow, they pay more
2. Tiered pricing: Natural upgrade paths
3. Cross-sell: Multiple products
4. Annual contracts with growth clauses: Lock in expansion
5. Land and expand strategy: Start small, grow big

Target: Best-in-class SaaS companies maintain -5% to -10% net revenue churn.

Real Examples: How the Giants Stack Up

Spotify

• CAC: ~$25 (mostly organic, freemium model)
• LTV: ~$150 (based on 30-month average subscription)
• LTV:CAC: 6:1
• Monthly Churn: ~5%
• Strategy: Low CAC through freemium, convert free users to paid

Netflix

• CAC: ~$60 (content marketing, word of mouth)
• LTV: ~$750 (based on 4-year average subscription)
• LTV:CAC: 12.5:1
• Monthly Churn: ~2.5%
• Strategy: Massive content library reduces churn, brand drives low CAC

Dollar Shave Club (Before Unilever Acquisition)

• CAC: ~$35 (viral video, referrals)
• LTV: ~$200 (subscription model, 3-year average)
• LTV:CAC: 5.7:1
• Monthly Churn: ~8%
• Strategy: Viral marketing lowered CAC, convenience reduced churn

Slack (Pre-acquisition metrics)

• CAC: ~$200
• LTV: ~$3,000+
• LTV:CAC: 15:1+
• Payback Period: ~5 months
• Net Revenue Churn: -8% (strong negative churn from expansion)
• Strategy: Freemium + network effects = efficient growth

Calculator Template: Your Turn

Here’s a framework to calculate your own metrics. Plug in your numbers:

Your Inputs

Sales & Marketing Spend (monthly): $_______
New Customers Acquired (monthly): _______
Average Revenue Per User (monthly): $_______
Gross Margin %: _______%
Monthly Churn Rate: _______%

Calculate Your Metrics

CAC: $$ \text{CAC} = \frac{\text{Your S&M Spend}}{\text{Your New Customers}} $$

LTV: $$ \text{LTV} = \frac{\text{Your ARPU} \times \text{Your Gross Margin %}}{\text{Your Churn Rate}} $$

LTV:CAC Ratio: $$ \text{Ratio} = \frac{\text{Your LTV}}{\text{Your CAC}} $$

Payback Period: $$ \text{Payback} = \frac{\text{Your CAC}}{\text{Your ARPU} \times \text{Your Gross Margin %}} $$

Your Results

Key Takeaways

1. CAC is more than ad spend — include all sales and marketing costs, salaries, tools, and overhead

2. LTV must account for gross margin — revenue doesn’t matter if you’re not profitable on the unit level

3. The golden ratio is 3:1 to 4:1 — lower means you’re spending too much, higher means you’re underinvesting

4. Payback period should be < 12 months — the longer it takes to recoup CAC, the more cash you need

5. Small changes in churn compound massively — reducing monthly churn from 5% to 4% saves 8 percentage points annually

6. Cohort analysis reveals the truth — aggregate metrics hide whether you’re improving or declining

7. Negative churn is the holy grail — when existing customers grow faster than churn, you’ve built a compounding machine

8. Track Magic Number for efficiency — tells you whether to step on the gas or pump the brakes

Next in Series: Learn how to analyze profitability beyond the surface with gross margin, contribution margin, EBITDA, and the Rule of 40.