As an entrepreneur of any kind, one of the most important skills to master is doing as much as possible with your resources: money, people, and time. One of the primary ways to understand if you’re using your resources effectively is by looking at the unit economics of your company.
Unit economics are used to measure the viability of a business, like startups aiming to grow into billion-dollar companies. It’s a fancy way of asking “Are you spending the right amount of money to acquire and serve your customers?”
It seems like a simple question, but to accurately answer it, we need to to know two very important metrics: LTV and CAC.
Your customer acquisition cost (CAC) is how much you spend to acquire a customer. Take into consideration every resource (software, human power, ad spend, etc.) involved in getting someone from “what’s ACME?” to “ACME is exactly what I need!”
CAC is impossible to know until you start getting customers. It’s also highly dependent on the acquisition channels you use. (Word of mouth is the cheapest since it costs you nothing! Start building good rapport and reputation now.)
And, that customer’s lifetime value (LTV) refers to how much revenue you get from them before they eventually leave you for any number of reasons. (Spoiler alert: every client will likely leave you someday.) LTV is impossible to know until you start losing customers.
How CAC and LTV relate to each other
As with everything in life, you have to balance these numbers.
When CAC is higher than LTV, you’re losing money on each customer and you’re default dead. If your LTV is 50 times your CAC, you should be spending more on sales and marketing, and you aren't capitalizing on your market opportunity.
In Silicon Valley, the magic CAC to LTV ratio is 1:3. In other words, if you spend $100 to acquire a customer, that customer should yield you $300 in revenue over their lifetime. Right now in the early stages of GigLoft, we aim a bit higher: typically 1:5.
Do you even CAC?
I remember when Jeremy and I were pitching PubLoft/GigLoft to VCs in San Francisco during LAUNCH Accelerator, and when they asked us about our CAC, we told them we had practically $0 CAC because I was doing all the recruiting myself.
This was so wrong.
The fact of the matter is that I was getting a salary and I was spending time selling for GigLoft, so we actually did have a CAC. It was my time and what I was getting paid for it. Basically, my average monthly salary divided by the number of new customers each month.
Many freelancers and business owners fall into the same trap we did. They think they have no CAC because they sell everything themselves. This is not an accurate way to think about your unit econimics.
You’ll never know if you could grow more quickly through ads, event sponsorship, or hiring salespeople. But the sooner you figure out your CAC, the sooner you know how efficient you’re being with your resources, and make the necessary course corrections.
How freelancers can think about LTV and CAC
The easiest way to think about the relationship between CAC and LTV can be shown with an example of our student Susan. Susan is smart, and wants to understand how efficient she is being with her business. I asked her to put together a list of every client she’s had since she started, and to include some extra details.
See all info below.
Here is an Airtable tracking each individual customer based on how long they worked with Susan, their monthly spend (currently or past tense), and what the LTV of that customer has been so far. As we can see, each customer’s lifetime value is their monthly spend multiplied by the number of payments they’ve made.
So, does Susan have a good business?
Making $2,010 per customer on average doesn’t seem too shabby. But it’s hard to know how good a business it is without understanding the CAC per customer and the average CAC.
If Susan spent $5,000 worth of resources to get these customers, then she’s going to have to shut it down or turn it around. If she spent on average $500 to get each customer, then the business is healthy. Why? The CAC to LTV ratio is more than 1:4! $500 spent: $2,010 made. A 1:4 CAC to LTV ratio is right in the sweet spot.
But Susan asked me to give her answers, not guesses. This is about knowing the details and making an educated business decision on if this is an efficient sales process. First, based on the data we have, let’s make some educated assumptions about these 5 customers.
- Company C was her best customer
- Company D and E were just as valuable
- Company B was the least efficient customer
Ok, we made our predictions. Now, the truth! Time to unveil the magic number…CAC!
Alright, now this makes things interesting. All of a sudden, our predictions are all wrong. The reason for that is the gross revenue only tells part of the story. It’s like a vanity metric. The real story is brought to life once you know how much it costs to acquire a customer.
For example, darling Company C came from a conference Susan sponsored, from which she only got one customer. She spent $4,000 to sponsor the event, which eventually had an LTV of $6,500. It was a good investment, since it still brought in $2,500 in profit. But was it their most successful customer, where they made their dollar stretch the farthest? Nope. The CAC to LTV ratio is 1:1.6, a bit low.
Take a look at Company B. They had an LTV of $750, which is nothing compared to Company C’s $6,500. But, the CAC for company B was a mere $50—that’s a ratio of 1:15 !!!
This makes me think that although the revenue number is lower, the profit margins are higher and the CAC:LTV ratio is very healthy. Let’s break out the ratios in the form of percentages, on the far right.
Based on this data, Companies A and B both were fantastic investments, and Susan should try to get as many of those types of customers as possible! Because that ratio is around 1:10, she has a great opportunity to get even more of those customers by investing into those channels.
I would advise Susan and her business partners to double down on the acquisition methods that were used for A and B, keep it up for the channel for D, and re-evaluate their investments in the growth channels that got them Companies C and E.
Susan knows which marketing channels were most efficient for her, and can now make educated decisions on where to invest her time and money, instead of just throwing shit at the wall and hoping something sticks.
As freelancers and business owners of all kinds, we’re going to start by throwing shit at the wall. The important thing is to start throwing strategically, and see what sticks ASAP. Learn from every bit of information you have.
I believe that knowing our unit economics is worth its weight in gold. Yes, even though knowledge weighs very little, it’s crucial that you understand the LTV of every one of your customers, the CAC per customer, and your overall averages—ideally between 1:3 and 1:5.
If the ratio is less than 1:3, then you aren’t building a capital-efficient acquisition strategy—something that can grow enough to support you and others. If it’s more than 1:5, you could be leaving customers on the table and may want to consider investing more into growth.
Other ways to think about CAC
In games we have the concept of a multiplier: put on a super-suit or a magic hat, earn 5x the points for everything you do. In the same way, a 1:3 ratio means that customer brought you three times the money that you spent to get them as a customer. A ratio of 1:20 means what you spent to get that customer has since been returned to you twenty times over by that same customer.
This is how venture capital investors think, by the way: they look for the highest possible expected returns. To a degree, so should you and every freelancer who seeks to build a financial safety net around herself.
Even as young children, we inherently understand CAC:LTV ratio. Think back to when you put a lot of effort into getting something, only to find out it wasn’t worth it after all. That effort-to-reward ratio is an early lesson in CAC:LTV.
So listen to your inner child, your inner gamer, your inner investor. And master your unit economics so you can go on to create value in our world.