The Most Important Metric for Subscription: the LTV:CAC Ratio
LTV:CAC is the lifeblood of any subscription business. The metric measures the lifetime value of a customer versus the cost of acquiring that customer. Yet, there are very few leaders who have successfully optimized LTV:CAC at meaningful consumer scale. Jeremiah joined us for crash course in how to think about LTV:CAC and how to optimize it.
At Freshly, LTV:CAC is derived by the following:
When deriving LTV:CAC, many companies have trouble deciding whether to use gross revenue or take gross margin into account. Jeremiah’s case for using gross revenue is that, for early-stage consumer companies, it’s a better indicator of whether your product has healthy unit economics. Margin will improve as your company begins to scale and produce at higher volumes. However, if you focus on improving margin too early, you may unnecessarily diminish the overall experience of your product.
As a benchmark, the industry target for LTV:CAC is about 3:1. Increasing your LTV:CAC ratio can occur in two ways:
- Increasing Lifetime Value (LTV)
- Decreasing Customer Acquisition Cost (CAC)
Decreasing Customer Acquisition Cost
There are two major ways to reduce customer acquisition cost and drive conversion:
- Remove friction
- Drive intent
Simply put, removing friction makes acquiring customers as easy and seamless as possible. A key example Jeremiah gave of removing friction was integrating PayPal. As an online payment system, PayPal makes it easy for consumers to checkout with one click, without having to enter credit card information or a shipping address — this is especially effective in the mobile context. PayPal also has a much higher rebill rate than credit cards, as people usually keep their payment information on PayPal up-to-date, rather than letting credit cards expire.
Another means of decreasing customer acquisition cost is driving intent. This means that, for customers who have entered your funnel, reinforcing their intent to purchase at every opportunity.
A method Jeremiah used to drive intent at Bark was by asking consumers to give their dogs’ names and adoption dates. This reset the framing for consumers from thinking about toys and supplies to thinking about the overall well-being of their pet, thus driving intent. This was counterintuitive, as the conventional wisdom would be that adding an extra step in the funnel is always going to lower conversion. But sometimes when you have opportunities to drive more intent, you can actually increase conversion by reinforcing intent.
Discovering retention drivers requires testing and experimentation. At Freshly, they typically run ~100 small conversion tests at a time, of which include UX/UI tests and content testing. As for larger tests (ie: pricing tests) like the ones previously mentioned, there are usually 3–4 running at once. The company doesn’t run as many of these major tests because they impact marketing costs, but they can usually be resolved within a short period of time (~2 weeks). The CTO of Duolingo also shared his experimentation framework with the Guilds.
Several product tools are helpful for running product tests include FirstMark-backed Pendo and others (e.g., Amplitude).
Increasing Lifetime Value
The main lever, outside of pricing, to increase the lifetime value of your customers is to bolster retention. There are two dynamics to think about when thinking about how to improve retention:
- Early user retention: The first few weeks of your user’s experience is the window where you most have the opportunity to make your product sticky. Improving early retention is all about education and encouraging users to form an attachment to the product. For Freshly, this means teaching users how to order, how to unpack their boxes, how to choose meals, etc.
- Long-term user retention: Long-term user retention is about maintaining loyal customers. They’ve been educated about the product, but for some reason the product doesn’t work for them anymore. For Freshly, perhaps a user has gotten tired of the meals they’re being sent and wants more variety.
To discover what drives LTV for your company, start by building a tree of all your metrics. At first, you may not know what drives what, but by building out the tree, you can start investigating and uncovering what within your business correlates to retention.
Early User Retention
An example of a driver of early user retention that Jeremiah discovered using this method was in changing meals. Jeremiah started with the question of “How many times in a year does a user order Freshly?” and segmented it against several different factors including changing meals, skipping meals, etc. to see if changes in those habits effected a customer’s retention. He eventually found that customers that change meals in their second order had significantly higher LTVs. Finding critical events like these and leaning into them can help companies move the needle on retention.
Long-term user retention
Retention tactics for loyal/long-term customers is often more difficult because, in many cases, they require changes to the core part of the business. Freshly’s strategy for increasing long-term user retention has been in finding ways to make the subscription process more flexible; an example of this tactic allowed for customers to pause/skip shipments. If customers paused/skipped shipments in a repeated pattern, Freshly’s platform would catch it and offer to automate the shipment schedule to the customer’s preferences so that they didn’t have to constantly do it manually.
Figuring out how to balance focus between early users and loyal users is an evergreen challenge, and there’s often not one correct answer. For Jeremiah, it made the most sense to focus on early users because they had the most volume around new users. Acquiring a single new order from a new user was more accretive to the business than stretching four or five more orders from loyal users because those changes would take more fundamental changes with major overhead. That’s not to say that one should neglect loyal users; those necessary changes will unlock major value, but often require a longer time-horizon to implement.
Utilizing Qualitative Feedback
Along with quantitative data, qualitative feedback unlock value in two major ways:
- Consumer insights: Qualitative feedback is a great way to discover insights about your customers that you wouldn’t have otherwise known. For example, when Jeremiah was at Bark, a majority of the employees’ dogs were adopted. However, through qualitative feedback, he and the team learned that a huge segment of their customers had purebred dogs. This affected the way they imagined dogs, thought about their dogs’ priorities, etc. The team then discovered that asking customers their dog’s breed was a key insight into assessing what kinds of toys and treats their dog liked.
- Explaining Quantitative Data: Qualitative feedback also allows the opportunity to explain the narrative behind the data. For example, through a complex test, Freshly discovered that users who experienced delivery errors often ended up becoming more frequent users. This data point was extremely confusing until the Product team had conversations with users and discovered that they often made more orders after having delivery errors because they were offered partial coupons after the error.
For subscription startups, customer value extends long beyond the initial transaction. Instead, companies need to create lasting relationships with their customers. Metrics like LTV:CAC can help you measure the health of your business and discover how to unlock sustainable customer value.