A practical guide to a healthy CLV:CAC ratio and subscription business growth

Every business that operates on a recurring revenue or subscription business model needs to track performance metrics to make smart, informed decisions and gauge success. The most fundamental of all recurring revenue metrics – also known as key performance indications (KPIs) – is customer lifetime value (CLV or CLTV). 

CLV indicates how much revenue a given customer generates over the lifetime of the subscription relationship. A related metic is average customer lifetime value (ACLV), which indicates how much revenue the average customer generates over the average duration of your subscriptions. The upside of the subscription business model is the simple truth that the longer you retain a customer, the more value they create.

To calculate the customer lifetime value for a given subscriber, simply take the monthly revenue you receive from the subscriber and multiply it by the expected duration of the subscription relationship:

CLV = monthly revenue from the customer x expected lifetime

To calculate average customer lifetime value, take the average monthly revenue generated by all your subscribers and multiply it by the average duration of your subscriptions:

ACLV = average monthly revenue per customer x expected average lifetime

For example, a customer paying $9.99 per month for a subscription to a streaming service has a customer lifetime value of $119.88 after one year and $599.40 after five years, making CLV the key metric for measuring your break-even point and profitability.

CLV is an important KPI to track because you cannot improve something unless you know what it is. It’s also a matter of economics, because it costs considerably more resources and budget to find and acquire a new subscriber than it does to retain an existing one by extending the lifetime of the subscription relationship. By tracking what type of customers have higher CLV than others, you can identify which audiences to target in your promotional campaigns.

Growth is the very lifeblood of any subscription business, but it comes with a cost and must be balanced against expected revenue. The customer acquisition cost (CAC) metric will help your business answer the question of how much you should be spending on customer acquisition marketing activities.

To calculate customer acquisition costs, first choose the time period you want to evaluate (for example, month, quarter, or year). Then add up your total marketing and sales expenses. Finally, divide total costs by the number of new subscribers acquired during the period you selected:

CAC = total acquisition marketing and sales spend for a given period / new paying customers converted during that period

If your subscription-based business spends $50,000 in marketing and sales to sign up 3,000 new subscribers over a given time frame, then your CAC would be $50,000 / 3,000 = $16.67.

The CAC metric is important for every business operating on a subscription or recurring revenue business model. CAC will tell you how effectively each dollar you direct toward acquisition is performing, across every channel, so that you can optimize budgets and strategies to increase conversion efficiency.

The CLV:CAC ratio is – as its name implies – customer lifetime value vs. customer acquisition cost. Sometimes referred to as subscriber return on investment (sROI), this essential KPI indicates how much your subscriber base is worth compared to how much your company is spending to acquire them.

Subscription businesses should leverage their CLV:CAC ratio in order to establish optimal budgets for marketing, sales, and customer service activities. For a typical subscription or recurring revenue-based operation, a healthy CLV:CAC ratio is approximately 3:1. In other words, the value of your subscriber should be three times more than the cost of acquiring them.

If your company’s CLV:CAC ratio is around 1:1, then you are provably spending too much to acquire new subscribers. A 1:1 ratio means you are spending just as much money on acquiring new subscribers as they are spending on your products or services. If your ratio is something like 5:1 or 6:1, then you are spending too little and are most likely missing out on opportunities to grow your business with new subscribers.

Your subscription business should aim to find the right balance for this ratio to ensure that you are getting the most out of your sales and marketing investments.

Each billing period, your business undoubtedly loses some subscribers to both active and passive churn. This results in a reduction in your CLV and a negative impact on your CLV:CAC ratio. With active churn, your subscriber made a conscious decision to leave your subscription service. Combating active churn and increasing customer retention rates is vital to sustainable market growth and ensuring the long-term health of your subscription business. Read this article for some best practices to combat active churn.

With passive (or involuntary) churn, your subscriber intended to stay but couldn’t – usually due to a credit card payment transaction failure. Too many businesses treat those lost subscribers as they would voluntary cancellations. They invest to win them back, but that is a double waste. You lose revenue from any gap in the subscription, and you spend money to lure back someone who didn’t want to leave in the first place.

A better solution to combatting passive churn caused by payment failures is to deploy a revenue recovery solution that can automatically resolved failed payment transactions.

Even the smallest improvements in recovering failed payments and preventing passive churn can have a large impact on your company’s recurring revenue stream and CLV. For example, a modest increase of just 5% in your monthly customer retention rate can increase your subscriber base by 40% after 24 months. Refer to our interactive retention calculator to see how small increases in failed payment recovery and customer retention can result in substantial gains over time.

In addition to CLV, CAC, and CLV: CAC, businesses that operate with recurring revenues need to adopt other metrics that reflect the economics of the subscription business model. Subscription businesses have unique data points and KPIs that traditional reporting and analyses cannot serve. To be successful, subscription businesses should also track the following KPIs:

• Annual recurring revenue (ARR). ARR is a key metric for any subscription company. It gauges the performance of the business on a year-over-year basis. This metric is critical for cash flow forecasting and real-time insight into financial health.
  ARR = annual price of service x number of active customers
• Monthly recurring revenue (MRR).  MRR is similar to ARR. This metric is a gauge of the revenue a business can depend on from month to month. It is helpful in measuring the immediate effects of product or pricing changes, and also helps track seasonal fluctuations.
  MRR = monthly price of service x number of active customers
• Average revenue per user (ARPU). Subscriber revenue is rarely a simple calculation. Beyond the regular fee, revenue can rise or fall due to discounts, freemiums, upgrades, downgrades, or one-time purchases, to name a few factors. The ARPU metric provides a single, rationalized figure that takes all these variations into account.
  ARPU = total revenue in subscription sales / total number of customers
• Churn rate, While churn is inevitable in a subscription business, the concept of “acceptable levels of churn” is intolerable. Churn is insidious, driving companies to invest more in acquisition to sustain growth targets, and ultimately damaging to brand value.
  Churn rate = (total cancellations for a given period / total number of customers during the same time) x 100
• Growth efficiency/magic number. Growth efficiency is known as the “magic number” because it captures how much growth in revenue can be generated by a dollar spent on marketing or reinvested in the business. Investors like to use the growth efficiency metric to evaluate a company’s performance.
  Growth efficiency = (recurring revenue in present quarter - recurring revenue in preceding quarter) / total marketing and sales spend for quarter 1 (Rounded to the nearest tenth)
• Lead velocity rate (LVR). LVR is a real-time metric that measures whether companies are doing a good job of growing their pipeline.
  LVR = (number of qualified leads in current month - number of qualified leads in preceding month) / qualified leads in current month x 100