It doesn’t matter whether you talk to an investor or a startup founder who has tried to raise capital at any time, the one thing you will find common in the wisdom they impart would be that the LTV/CAC ratio is sacrosanct when you are talking about your business.
LTV = Lifetime Value of your customer
CAC = Customer acquisition cost
How this ratio looks for your business is what determines if your business is healthy or not. A bad LTV/CAC was the primary reason why Dropbox decided to have the customer referral program as the front and center of their marketing channels.
And they did it all while managing to stay healthy. When they were doing traditional ads, their cost of acquiring a customer was averaging $250-$300, and this was for a product where the LTV would be $99. That didn’t make any sense, did it? So they went for a strategy that did.
Having a healthy LTV/CAC ratio determines the ability of the business to survive while scaling up. It helps justify spending hundreds of thousands of dollars into acquiring customers. If each customer you are acquiring is going to end up costing your business money, then the whole concept of building a business goes for a toss. After all, businesses are in the business of making (and not losing) money.
So, you tend to keep a close eye out on your LTV/CAC, you measure the rate at which your acquired customers are churning out, you deploy measures to retain customers and bring back customers who have churned out of the system. You do it all to ensure that your LTV is as high as possible so that your business remains viable and lucrative, not just for the investors but foremost, for the business itself.
ARE ARPU AND LTV THE SAME?
It is perfectly understandable why you would think that way; they are indeed metrics that are closely related to each other. But while they are related, they are not the same. Not by a far stretch.
Lifetime value or LTV measures how valuable each customer signing up with you is going to be for the business. It will factor in variables like support/servicing costs involved on an average, transaction fees incurred, expected refunds etc. In short, it will factor in the cost of doing business for each customer and make the required adjustments from what the customer is actually spending on your platform.
ARPU is relatively simpler. It simply factors in the revenue each customer is expected to bring to your balance sheet.
Different businesses will measure these metrics differently. For example, if you are a SaaS business, you may be calculating ARPU on a monthly basis by simply dividing total revenue for the month by the number of active users in the month. On the other hand, some businesses may be calculating this on a quarterly basis.
HOW SHOULD YOU TRACK ARPU?
Let us answer another question first. How do you track CAC? Do you simply divide your total spend into customer acquisition activities by the number of customers acquired? Or, are you measuring the CAC for different marketing channels and campaigns and activities individually? More often than not, businesses are doing it the latter way, and that is the right way of doing it. This helps you identify the marketing channels and campaigns that are working for you, the ones that make sense and weed out the ones that aren’t. That is how Dropbox knew they needed to get rid of the traditional ads if the business was to survive.
And that is exactly how you need to be tracking ARPU as well!
You need to check if customers acquired via different mediums are different from each other in terms of the money they are bringing in to the table, thereby contributing to the overall health of the business. If you are indeed doing that right now, great. But if you are not, start tracking that and start tracking it now!!
Once you start tracking these numbers, you may discover that there are marketing channels that are healthier as far as the CAC is concerned, but the customers acquired so aren’t transacting much on the platform, if at all. While other marketing channels may be a tad bit expensive but are bringing in much more valuable customers as well. Tell me, if that is the case, which marketing channel do you think you would be diverting your attention to?
WHY ARE WE EVEN TALKING OF MULTIPLE ARPUs
Because our business will have a bunch of different customer types. Clusters of consumers that act similarly to each other, and yet completely different from a different cluster. That is the reality.
Whether it is the average disposable income you look at or the reason why a customer transacts on your platform, customers will get segmented into different clusters — each cluster carrying a different weight in how valuable it is to your business.
And a lot of times you will find these clusters originate from different marketing channels and/or campaigns. So to identify them well, you need to measure, analyze and track them the right way.
SO DO YOU DITCH THE CHANNELS WITH LOW ARPU?
Well, that is quite a subjective question, to be honest. I, for one, have never been much in favor of ditching a channel completely because it is not yet performing at the optimum/desired benchmark. What I would do is reduce its contribution to the overall pool and focus a majority of my resources and bandwidth on the channels that are performing exceptionally, and allocate a restricted resource pool to the low performing channels to experiment and see if their performance can be improved.
But there are more reasons why you could consider not letting go of any channel 100%.
Let me take a slightly unrelated example. Adwords. Let us say I am making a B2B campaign. I have identified one particular keyword. Now how do I target it? Do I keep it broad so that people making related queries also see my ad? Or do I keep it an exact match so that I get the most contextually relevant users via my ads — users who most likely have the highest intent in looking for an answer? What do I do? Wisdom dictates that I go for the exact match because I would get a better conversion rate, my ad’s quality score would be higher and as a result my ads will start getting more and more priority and prominence in search results, and all of this would in turn help with getting consumers even with a lower CPC (cost per click) bid.
But there is a catch.
I would be getting better conversions, I would be getting a much more targeted and promising lead-base, but I would be getting far fewer leads. Why? Because I chose to tune things up and precisely focus on a targeted userset.
If I had, on the other hand, opted for a broader match in my ad-targeting, I would be getting in a lot more inbound traffic. But at the cost of all the plus points we talked about above.
And that is where the trade-off is. So, what would I personally do in such a scenario? I would go for a mix of both — broad targeting and exact targeting. This ensures that I can continue building a wider entry funnel into my prospect list, but at the same time have a list of prospects that are most likely to convert — my A-list, if you may.
(I may even throw in a third contestant in the pool by the name of phrase match, but for the sake of simplicity, let us ignore that for this discussion.)
That is what my recommendation would be to you as well. Go for a mix, but know what you’re expecting out of the different components.
Get more and more consumers from all channels, but dedicate a substantial portion of your resources into getting customers from the channels that are high up on the ARPU index. This way, while you keep on casting a wider net and build up a base to capitalize on later, you are focused on generating revenue from the channels that bring in the most valuable consumers. That is the best way to be maximizing ARPU, without compromising on growing the potential customer base who could get valuable to the business later. (There are a bunch of strategies you could use to maximize the revenue from this wider base of low-transacting consumers as well, but that’s a story for some other time.)