Tech’s Flat Earthers

Conventional wisdom around LTV:CAC economics is mostly nonsense.

One oddity downstream of market participants not understanding the cost of capital is the voodoo around customer LTVs and CAC payback periods.

You’ve probably heard that companies should have an LTV:CAC of at least 3x, or that the “benchmarks” indicate “best-in-class” companies have a CAC payback period under 18 months, or that shorter payback periods are more “efficient.”

At best, these are only loose heuristics appropriate for enterprise software companies funding customer acquisition solely with equity dollars on their own balance sheets. At worst, this “wisdom” is total nonsense, the tech equivalent of Flat Earth theory. This becomes obvious when you ask people “why?” They will stare at you blankly, mutter something vague about a blog post they read or dashboard they saw, then turn the conversation to something else.

Consider one of the foundational lessons of microeconomics: a profit-maximizing firm produces its good/service in the quantity at which marginal revenue equals marginal cost. To produce more is obviously inefficient, because cost exceeds revenue, and the firm loses money. To produce less is also inefficient, because there’s still a spread between revenue and cost: the firm leaves dollars on the table.

If your goal is to build the biggest possible company and maximize long-term enterprise value, the same lesson holds true for customer acquisition: spend until the marginal CAC equals the marginal LTV of that customer. This is why the insistence that short payback periods are “efficient” makes no sense. If customers have long lifetime values that can support long payback periods, targeting short payback periods is definitionally inefficient and means you’re leaving money on the table!

Consider the following example: if I offered you the opportunity to pay me $20 to spin a wheel with a payout of $100, you’d obviously play. If I then offered you the opportunity to pay me $30 to spin a wheel with a payout of $90, you’d still play. And you’d keep playing up to the point that the cost to play equaled your payout. It would be inefficient to do otherwise. Likewise, the rational founder keeps spending to acquire customers until the marginal CAC equals the marginal LTV.

The optimal CAC payback period or LTV:CAC for a company depends, then, on many factors: business model, ACVs or ARPUs, fully burdened gross margin profile, customer stickiness/lifetimes, founder psychology and priorities, and capital structure. The capital structure point is important; because CAC occurs up-front while LTV is earned over time, the LTV must be time-weighted. A dollar tomorrow is less valuable than a dollar today, making a company’s discount rate, which depends entirely on its cost of capital, a critical input to optimizing its GTM decisions.

A consumer business with 14-month lifetimes must obviously have a payback period less than 14 months. A highly retentive enterprise system of record with strong NDR and near-infinite lifetimes can afford much longer than 18-month paybacks. And a business using low-cost capital to fund GTM can afford a lower gross LTV than the same exact business using high-cost equity; the optimal/efficient LTV:CAC for the former is often far less than 3x. Companies that are thoughtful about capital structure can be far more aggressive – and grow more quickly – than their financially illiterate peers.

Thinking clearly about unit economics matters in a world where distribution is only becoming more important. The conventional wisdom around the economics of customer acquisition is broken and downright value-destructive. Great companies with big ambition are wise to ignore it.

If you have questions, comments, or feedback, please reach out: andrewziperski [at] gmail [dot] com.

The views expressed herein are the author’s own and are not the views of General Catalyst Group Management, LLC or its affiliates.