Paid marketing glossary of terms
The terminology around paid marketing can be as inscrutable as any other insider jargon: LTV, CAC, payback period, conversion rates, channels, churn and the list goes on. The following is a basic glossary of the terms around paid marketing:
Channel: A channel is a method for you to acquire customers.
Examples: organic search or search engine optimization (SEO), paid search or SEM, mailing lists, partnerships, Facebook ads, salespeople, trade shows, etc.
It is critical to analyze each paid marketing channel individually to understand the ones that work, the ones that scale, and the kind of customers you get from each.
Customer acquisition cost (CAC): How much did you spend, and how many customers did you acquire?
CAC is calculated on a per-channel basis to separate the good channels from the bad and to avoid erroneously crediting your paid marketing spend for acquiring customers who would have come to you organically anyway.
Payback period: How long does it take for you to earn back the amount you paid to acquire a customer?
The payback period is typically measured in weeks or months, and it should only count a customer’s marginal contribution net of costs (not their revenue contribution). The best feature of this metric is its objectivity (unlike LTV). There are no variables to tweak and no assumptions to make. Either you’ve earned back what you spent on marketing or you haven’t. Clear and simple.
Customer Lifetime Value (LTV or CLTV): Generally, LTV is calculated as follows:
Keep in mind that LTV is the most misused paid growth metric around largely because it is synthetic. In other words, the definition depends on assumptions made by the person wielding it. As a result, you should always treat LTV with skepticism.
- Average revenue per user (ARPU) is the marginal revenue that a customer generates in a certain period
- Costs are those of supporting that user during that period. In the LTV calculation, it’s important to include both operating costs–e.g. cost of goods or cost of supplying a service–and one-time costs like onboarding expenses. One-time costs can either be allocated as part of CAC (SAC in the formula above) or broken out as a separate term in the equation
- “n” is the number of periods in a customer’s lifetime. Lifetime can be measured in days, weeks, months or years with months or years being the most common, as long as all measurements are recorded and calculated on a consistent basis
- Weighted average cost of capital (WACC) is a discount factor
- Customer acquisition cost, which we also describe above is SAC, aka CAC
There are other formulations with slight variations. For instance, you can remove the customer acquisition cost (SAC/CAC) from the equation and directly compare LTV with CAC, but all formulations have the same caveats:
- Arbitrary customer “lifetime”: The duration of a customer’s “lifetime” is arbitrary, especially in a company’s early days. Some seed stage startups decide their customers have a 12-month lifetime and others pick five years or more. There are ways to be more rigorous about defining how long a “lifetime” should be, but the ultimate decision about how to spend against LTV comes down to how aggressive a company wants to be. LTV is meant to be a guidepost, not a rule.
- Organic vs. acquired customers: LTV varies materially for organic customers as opposed to those acquired via paid marketing channels, and it also varies between paid marketing channels. In other words, paid customers behave differently than customers who started using your product organically. Like CAC, LTV should be calculated and analyzed on a channel-by-channel basis.
- Change in one variable can affect others: A business decision that changes one of the variables in the LTV formula also can affect other variables. For instance, if you increase marketing spend, then at some point you will see CAC rise and/or ARPU decline since supply of customers is finite. Alternatively, if you raise prices (increasing ARPU), you are likely to see an increase in churn (or a decrease in a customer’s lifetime) and/or an increase in CAC. None of the variables exists in a vacuum.
There are some slight nuances in these general concepts as you move between product types like consumer vs. enterprise or à la carte vs. subscription fees, but this basic terminology allows you to understand and analyze the effectiveness of any paid marketing you may employ.