Why the 3x LTV:CAC Rule Is Wrong (Here’s What Actually Works)

There is a common rule of thumb that the LTV:CAC ratio of a business needs to be at least 3x.

This rule of thumb is wrong.

The 3x LTV:CAC rule of thumb was popularized in SaaS and venture capital circles. But software companies operate with very different economics than most other businesses.

If you are not in software, then the 3x rule doesn’t apply to your business.

Reminder: In my last post on LTV:CAC I said I use LTV and LTGP interchangeably. The same applies here.

Many software businesses have frictionless customer experiences that are largely automated.

Most businesses are manual, and not ‘automated’ like software is.

Because of this, manual businesses experience lumpy growth.

The more manual a business, the more inefficiencies there are.

Manual businesses require a significantly larger cushion than the 3x LTV:CAC ratio required by software.

Alex Hormozi, founder at Acquisition.com, discusses three key friction points in a business that necessitate higher LTV:CAC ratios.

These are:

1)        Attraction: How the business gets leads

2)        Conversion: How those leads convert into customers at the point of sale

3)        Delivery: How the service is delivered to the customer

Software can be an extreme example of a frictionless and automated customer experience.

Consider a software business that:

• Leverages paid ads or content creation to acquire customers. These media assets keep bringing in customers for months or years.

• Employs a self-service model which allows the customer to pay online and does not require a salesperson to make the sale.

• Does its job in an automated way for thousands or millions of customers without any human intervention.

On the other extreme, consider the following manual business which:

• Gets customers through manual outreach. This involves a human speaking to many individuals.

• Converts them through a 1 to 1 sales meeting. This requires a skilled salesperson and can only be done within certain hours, and

• Delivers a high-touch and personalized concierge service that employs no technology.

Both of the above businesses are at the varying ends of the automation spectrum. This means that they need different LTV:CAC hurdles.

According to Hormozi, an appropriate software LTV:CAC threshold is 3:1.

Extremely manual businesses that want to scale should aim for 20:1 (or 15:1 at the least).

Hormozi says he made most of his material wealth when he was able to unlock 30:1+ LTV:CAC ratios.

Think about it this way.

Manual growth involves hiring more people.

This specifically includes salespeople and those who deliver the actual service.

Those people need time to learn how to be effective at their job and ‘ramp-up.’ 

It also takes time for small businesses to learn how to recruit well. This is especially the case if a manual business is involved in delivering a complex task.

A lot of the early recruits in a company’s early years will not be that good. They will need extensive training before they are fully productive.

Employees quit, get fired, get sick, and have fluctuating productivity levels.

For product businesses, dealing with inventory and supply chain issues also creates lumpiness in delivery.

If you run a service business: 

Look at how automated your attraction, conversion, and delivery are.

And if your LTV:CAC isn’t where it should be, don’t panic. You can increase lifetime value or get more efficient with customer acquisition. Both of these levers will improve the ratio.

This is Part 2 of my Metrics for Scale series. In Part 1, I introduced what LTV:CAC is and why it matters. You can read that here.

Next up: I’ll show you how exactly LTV:CAC impacts profits and valuation.

If you want to share your thoughts on LTV:CAC and how it impacts your business, I’d love to hear from you.

Drop me a message.