In case you missed it, our CEO, Mike, wrote about Natural Rate of Growth in his weekly newsletter last week. In short, OpenView Labs recently featured a new SaaS metric…
Why Does LTV Matter?
There’s a reason why many experts insist Customer Lifetime Value (we’ll use LTV for short) is the most important metric for your startup. The data points you gather for the LTV formula can help assess…
There’s a reason why many experts insist Customer Lifetime Value (we’ll use LTV for short) is the most important metric for your startup. The data points you gather for the LTV formula can help assess the overall health of your company. Not only does LTV provide insight into the long-term trajectory of your startup, but it also gives immediate insight into specific areas that need improvement. Knowing how valuable it is to gain each customer is essential.
Why does LTV matter to investors?
LTV has a major impact on how you determine and justify customer acquisition costs to your investors. You don’t want your backers to worry that you’re paying huge marketing or sales dollars for customers that aren’t worth the investment. But for SaaS companies and any business relying on a recurring revenue stream or repeat customers, acquiring customers at an initial loss is a necessary component in the long-term success strategy. Many raised questions around Salesforce’s share price when the company’s stock topped $128 in 2011 despite a P/E of 234. But Salesforce’s model is based on incurring high acquisition costs upfront in order to enjoy recurring revenue for years after. The LTV of each customer ultimately becomes a high multiple of the initial acquisition costs. As long as the company maintains a high retention rate, their long-term revenue works like an annuity.
I have very little doubt that in the early years of Salesforce, Benioff and Co. maintained trust with their investors by showing them a strong LTV model that projected massive value on the customers they were acquiring at a short-term loss. It’s impossible to justify large acquisition costs in marketing and sales if not. A solid LTV approach can alleviate any reactionary fears from investors when they see a string of months or years in the red and get everyone on board with the long-term focus of the company’s growth.
How do you calculate LTV?
Now, let’s get down to the math to make sure your model is solid.
First grab the following data points for your company (we’ll use annual data for the purpose of this example):
- Customer churn rate
- Annual Revenue
- Annual costs to serve the customer
- Gross margin percentage
Next, calculate your costs to acquire a customer (CAC):
Now, with your churn rate you can easily determine customer lifetime. Here’s the simple equation ForEntrepreneurs uses:
Finally, it’s time to calculate LTV. If there is no expansion revenue expected for the customers, you can simple use this:
LTV = Average Customer Revenue (MRR or ARR) x Customer Lifetime
To get a clearer picture of LTV, also take into account your gross margin percentage. Here’s how the equation should look:
Finally, if there is customer revenue expansion over time, you need to add that into the equation. Here’s what ForEntrepreneurs used for this equation:
a = initial Average Customer Revenue
m = Growth in Revenue Per Account (monthly or annual)
c = Customer Churn Rate %
We constructed a model using annual revenue figures. Here’s a look at LTV that you can share with investors:
|Average Contract Value (ACV)||$5,000||$5,000||$5,000||$5,000||$5,000||$5,000||$5,000|
|Customer Acquisition Cost (CAC)||$14,286||$14,286||$14,286||$14,286||$14,286||$14,286||$14,286|
|Sum of all Sales & Marketing Expenses||$500,000||$500,000||$500,000||$500,000||$500,000||$500,000||$500,000|
|Number of New Customer Added||35||35||35||35||35||35||35|
|Lifetime Value (LTV)||$53,125||$53,125||$53,125||$53,125||$53,125||$53,125||$53,125|
To make your cost to acquire is worth the lifetime value of the customer, it’s helpful to check the ratio between both. Here’s the equation:
Having around 3:1 ratio of LTV to CAC will likely impress your investors. Here’s how that would look in the model:
For a more in-depth look at these formulas, check out this post.
Retention is essential
An LTV model is exactly what is says it is: just a model. After you project your retention rate percentage, your company has to hit those numbers–just as if it were a revenue or profit goals. Otherwise, good customers can quickly become a terrible loss if they don’t renew enough times to turn a profit.
The LTV exercise will help keep you on track and determine where your company might need to deploy additional resources to hit retention goals. If the percentage slips, it’s time to figure out why you users are leaving. Is this a product problem? Is customer service underperforming? Sticking to your LTV model will be the canary in the coalmine to know when retention is a problem area for your company and it time to solicit advice and help from your investors.
Finally, make sure to adjust your LTV when product improvements or retention efforts increase customer value. Especially for enterprise software companies that continuously add features and raise the annual subscription costs as a result.
You can also increase LTV by offering better customer service. Clients will stick around longer and pay more money when their questions are answered quickly and problems are solved. It seems so simple, but customer success can be one of the defining features of a success SaaS company. Reducing churn will really shine in your LTV formula.
Discuss with your investors your strategy for improving LTV over time. You can justify prioritizing product or service investments if you can point to the value payoff as a result.