CAC and LTV Due Diligence

Beyond profit, the most important two metrics in Buy Side Due Diligence are Customer Acquisition Cost (CAC) and Customer Long Term Value (LTV). Simply put, the higher the LTV:CAC ratio, the higher the profit and the higher the valuation. Nearly all sophisticated investors use the LTV:CAC ratio and so should you. A good benchmark that’s accepted amongst the community is 3:1, therefore, for every dollar spent to acquire a customer, the customer will return three dollars in lifetime value.

So, why don’t more people talk about LTV:CAC during due diligence? Because it’s hard to measure in a lower-middle market business that may not routinely track these metrics. It can take a lot of time during due diligence if you aren’t familiar with finding the data and working through it. A lot of due diligence is focused, rightfully so, on ensuring that underwriting is completed, the tax documents have been completed properly, and that legal paperwork is reviewed and drafted. If the due diligence period is 60-90 days, that leaves little time to focus on core metrics due diligence, like LTV:CAC. We think that’s a shame because you may not know if you are fully exposed or you are getting a deal. If the previous owner did a great job of retaining clients and maximizing opportunity or if they left earnings on the table. If the company is a platform to build off, or a turnaround. What we can positively say is that you want to know the LTV:CAC ratio prior to signing acquisition documents.

Additionally, most blogs written about LTV:CAC ratio are for reoccurring revenue businesses, but LTV:CAC should also be reviewed for non-reoccurring revenue businesses. Even for single purchase businesses, you should know if customers are being acquired efficiently and they are generating enough value.

In this blog, we’ll talk about why LTV:CAC is so important, how you can measure LTV:CAC with limited data, how to use LTV:CAC in due diligence, and why you must be focused on LTV:CAC post-acquisition.

How to Calculate LTV:CAC

Long Term Value Calculation

LTV is simply the average amount of earnings a company generates over the lifetime of a customer’s relationship.

First, never use Revenue to calculate LTV. Using revenue will generate very misleading data and could lead to incorrect decision making. We also recommend not using Gross Profit. Gross Profit is calculated as Revenue minus Cost of Goods Sold (COGS). Using Gross Profit does not include other import costs. We prefer to use Contribution Margin which is calculated as Revenue minus all Variable Costs (including COGS).

For recurring revenue businesses, a quick search will show you how to calculate LTV.

Calculating LTV for Non-Recurring Revenue Businesses

Step 1: Calculate Purchasing Frequency

365 Days / (Total Quantity of Purchases in Last 365 Days / Total Number of Customers in Last 365 Days)

Note: There may be multiple items purchased in one sales order. For our purposes, each time a customer purchases, it will count as one.

Step 2: Calculate Date Ranges

Second Date Range: From (Today’s Date - (Purchase Frequency x 3)) to Today’s Date

First Date Range: The Start of Second Date Range to (The Start of Second Date Range - Purchase Frequency)

Step 3: Average Customer Life Span (ACL)

1 / ((First Date Range Customers – Customers Retained in Second Date Range) / First Date Range Customers)

Step 4: LTV

ACL x (Last 365 Day Contribution Margin) x (# of Customers in Last 365 Days)

Calculating CAC

CAC is the total cost of acquiring new customers. Although calculating CAC is more straight forward, you must account for all Marketing and Sales expenses, not just the Marketing and Sales expenses spent on new customers. Additionally, the total salaries of the Sales and Marketing team must be included.

CAC: (Marketing + Sales Expenses + Fixed Expenses) / Number of New Customers

Why Is LTV:CAC So Important to Measure

Because there is so much literature and benchmark data, LTV:CAC is a de-facto metric for evaluating businesses and determining their valuation. As Andrew Chen from A16z points out in this article, an LTV:CAC ratio of 3 is ideal because it means the company has efficient returns on Sales and Marketing spend. It means the company being evaluated also retains their customers and has the capacity to re-invest in their products and services. And, to extrapolate further, companies with a higher LTV:CAC ratio have higher valuations because they make money and operate better. They are better run companies and less risky.

Benchmark LTV:CAC Metrics

LTV:CAC Ratio	Meaning
1	Losing Money on Each Customer
2	Need to Find More Profitable Ways to Acquire Customers
3-5	Ideal

How You Can Measure LTV:CAC With Limited Data

In the Lower-Middle market, there is a strong chance that LTV:CAC is not being measured. There may, however, be a CRM in place to help you measure LTV:CAC. Even if the CRM is “home grown,” an effort should be made during due diligence to sort through the data to better assess the company’s efficiency in attracting and retaining customers.

Another source of information is the P&L. If the P&L and very basic, you should check spend in the accounting ledger, like Quickbooks.

If there is no CRM in place, the situation may be more complicated, but an attempt should still be made. A Simple way to get to this data is to review purchase orders or client engagements from sales receipts. Much of the data can be normalized and formatted with Excel. At a minimum, this data will help to baseline yourself.

How to Use LTV:CAC in Due Diligence

The most straightforward way to use the LTV:CAC ratio during diligence is to determine if the company you are evaluating it undervalued or overvalued. For example, if the company has a valuation at a 5x multiple, but the LTV:CAC ratio is 2, it means that the company is likely overvalued. On the opposite, if the company’s LTV:CAC ratio is high and the company valuation is low, you may be getting a deal.

Another due diligence item to consider when reviewing LTV and CAC data is to see where opportunities lie post-acquisition, especially on repeat purchases and upsells. For example, if you know that the average customer purchases five times in their life with your company, you can review the customers purchasing less than five times. These customers should be modeled to demonstrate how increasing their lifetime purchases can increased revenue and profit. Additionally, you can model how upselling can increase profit.

Why You Must Be Focused on LTV:CAC Post-Acquisition

Post-acquisition, you should be laser focused on using LTV:CAC as a north star metric in your business. Why? Because just like you are doing due diligence on the business you’re acquiring, someone will eventually complete the same due diligence on your business. If you start measuring your LTV:CAC ratio post close you can chart its path over the lifetime of your ownership. You can also build goals and plans to meet those goals. We would go so far to say that LTV:CAC should be a metric reviewed both at your operating and board meetings. The rest of the rest should be cognizant of the LTC:CAC metrics and think of ways to improve them. The same holds true for both reoccurring revenue and non-reoccurring revenue businesses. Because regardless of the business, you want to make sure that customers are staying with you longer and you are acquiring them more efficiently.