The Central Goal for Success
Part II of The Truth About Customer Success series
In the previous edition of?The Truth about Customer Success, “Starting a Conversation,” I argued that the single best GOAL for a customer success team (and for an individual CSM) is to maximize the lifetime value [“LTV”] of customers.??This may seem like a somewhat arbitrary claim and stands open to debate. In this edition I will elaborate on why LTV is such an important goal. As always, I would love to hear your thoughts, objections, and alternate ideas for Customer Success goal(s).
There are two distinct and valuable ways to employ LTV as a central goal.??First, as an overarching principle or framework for thinking about both the success of a customer and the strategic intent of a Customer Success organization.??Customer LTV helps set priorities and guide work.??In this way it is a?strategic?tool. The second conception of LTV is as a metric – something that can be used to track performance, compare outcomes and direct change.??In this way, it is a?management?tool.
Together, these two conceptions of LTV tie together?solution value, the value a customer gets from a given solution, and?enterprise value, the value a solution provider creates for shareholders by landing, retaining, and expanding customer subscriptions.[i]??
Enterprise Value:??A Finance Moment
What is enterprise value? What is a given company worth and, importantly, why is it worth that amount?????Market aficionados will tell you that something is worth what someone will pay for it.??The market – whether public or private -- is the giver of truth.??OK, great, but that does not provide leaders with much guidance for what they should or should not do to grow enterprise value. A leader cannot take actions and then wait to see what the market says about those actions.??There must a be a way to link management actions to operational outcomes and in turn connect those outcomes to financial impacts.
Benjamin Graham, the father of value investing stated, “The worth of a business is measured not by what has been put into it, but by what can be taken out of it.”[ii]?Expanding a bit on this concept, Warren Buffet provided a good formula for value in the?Berkshire Hathaway 1992 Annual Report?when he paraphrased John Burr Williams’s?The Theory of Investment Value:
The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.[iii]
That makes sense – valuation is based on a future stream of cash flows.??The approach of discounted cash flows has been around a long time.??Even in the recent stock market froth of “eyeballs and clicks and monetizing big data,” at the end of the day, a business needs to generate cash that someone can use to buy something, invest in something, or give back to shareholders.
For a SaaS company, most of those cash flows come from customer subscriptions. Therefore, to maximize enterprise value, you need to maximize those subscription cash flows, or more specifically the margin contribution of those customer subscriptions.?
I will come back to how to calculate LTV and its value as a management tool.??First, I want to pause a moment to reflect on the idea that?maximizing customer LTV?should be used as the overarching goal for a Success Organization.??It is both a very simple and a very powerful idea.
A Big Idea. A Big Responsibility
One of the peculiar dynamics of any subscription -based business is that even with very fast new subscription growth [aka new ARR], the “installed based subscriptions” or renewal ARR quickly eclipses the new revenue brought in by the sales team. In just a few years, the Success team ends up “owning” and being accountable for the biggest chunk of annual revenue.??This is true even if all credit for expansion sales generated from the installed base goes to the Sales team rather than to the Success team.[iv]
As Figure A shows, even with a relatively low assumed net retention rate (85%) and a fairly high new ARR growth rate (50%), renewal ARR surpasses new ARR as a percentage of total ARR in just a few years.[v]??This is the beauty of the subscription business model!
The Success organization functions as a revenue partner to Sales. It is Success’s job to make sure that when Sales lands a new company, that company stays a customer… hopefully forever. Of course, a great Success organization will also generate, or at least create the opportunity for, new / additional sales coming from existing customers but for right now, let’s look past that.
I bring this up because too often people look at the job of Success as downside only. Success oversees and hopefully mitigates or slows churn. All luck is bad luck.??The only future is downside. Life for Success is like that of a pitcher who is only allowed to throw no-hitters or a goalie who always has to deliver a shutout. If that is the only measure, then the future is grim.
To me this is dead wrong.??CSMs are the champions of building great and thriving companies.??Success drives an enormous part of enterprise value in a close and vital partnership with Sales.
Success is not when the product goes live but rather when the customer achieves a business outcome.
- Geoffrey Moore
The Success organization does this by making sure that customers realize tangible business value from their software subscription. Companies invest in a software solution because they have a problem worth solving.??This is particularly true when companies select mission-critical, enterprise-class software. The customer assumes that if the solution is deployed, adopted and works, there should be tangible business value generated. It is the CSM’s job to make sure that the customer solves that problem, knows they have solved the problem, and realizes measurable business value.??In short, the mission of a customer success manager is business improvement for the customer.
While somewhat obvious (especially given that CSM has?customer success?right in the title) many Success organizations seem to forget this. Too often the actions and aspirations of a Success organization are too narrow, too pedestrian, and far too reactive.??“Focus on renewals.”??“Deal with support problems.”??“Respond to product, customer, or competitor issues.”??Not only do these things consume a huge amount to time for some Success teams, this drudgery becomes the bulk of their work.??Worse yet, the problems become the focus of most of leadership’s attention.??Reaction becomes the only action. Firefighting abounds.
Instead of thriving as a value champion who drives growth and success for both company and customer, the CSM is seen as a cog in a relentless machine.??Each quarter the CSM collapses across the finish line with another renewal snatched from the jaws of churn.??And then a new quarter starts.??This can and often does become a soul-sucking death spiral.?
While this may be a bit dramatic, it is clear that the role of the CSM can be relentless, exhausting and, frankly, uninspiring.??The truth is that, in this model, cutomer churn happens because customers lack a value coach, take their eye of the ball, and fail to realize value.
Equally as bad, this model of problem-focus, reactive-fire fighting leads to an extraordinary level of CSM churn or turnover. You can only get yelled at for failing to deliver a no-hitter so many times before you are done. Burnt out, uninspired, CSMs resign.
Instead, best-in-class Success organizations need to find a way to inspire the CS team to see themselves (and to be seen by others) as value creators for customers -- champions and coaches to help each customer grow and thrive.??The CSMs that do this well understand their customer’s business, bring ideas and best practices to their customers, and help their customers set and stick to a course of success.??When the Success organization does this well and does this consistently, renewals and expansions stand as bold testimony to the business value delivered through Success.
LTV:??A Metric that Matters
As mentioned above, the second way to think of LTV is as a key management metric. Something executives should use both to measure and to manage their business. In this case, the conception of LTV is a bit narrower than as described when thought of as a strategic framework. Rather than include all revenue that might ever come from a given customer, the calculation is limited to the revenue from subscriptions already sold at that point in time.??This is called Net Retention. [See Figure 2 for the difference between Net Retention and Gross Retention]
Net Retention rate recognizes one immutable truth of the SaaS world --nothing lasts forever. No matter how successful a company is in serving its customer portfolio, revenue from those customers will erode over time:??some customers reduce spending year over year, some customers cancel, and some customers go out of business. There will be churn.?
To calculate the?Lifetime Value?of the current customer base, simply sum up all the future profits – or more specifically the gross margin contributions – a company will generate from the current subscription contracts with its?existingcustomers.?
Three metrics generate the calculation:
If you are not tracking and reporting on at least these three metrics, fire your CFO.??The LTV of the existing customer base (or a given customer) can be calculated by dividing the margin contribution from the customers by 1 minus the Net Retention rate.[vi]
Let’s take a relatively simple example:
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LTV??= Lifetime Value of Customers
??? ?????= [Annual Subscription Revenue x Gross Margin %] / [1 – Net Retention %]
????????= [$10 million x 80%] / [1 - 85%]
???? ????= $8 million / 0.15
????????= $53.3 million
In simple terms, given an 80% gross margin and net retention of 85%, the current $10 million in subscription contracts will generate a stream of margin contribution cash flows totaling $53.3 million.[vii]
Now with LTV in hand, a business can calculate a several important and very informative metrics.??The first and perhaps most powerful SaaS enterprise performance metric is?Lifetime Value of a Customers divided by the Cost to Acquire Customers?or “LTV to CAC.” Cost to Acquire Customers is the total amount spent on Sales and Marketing in a year to acquire new customers.
With “Customer” at its center, LTV to CAC focuses on two fundamental business motions:??building customer relationships and profiting from customer relationships.??If it costs more to acquire a customer than a company will ever make on that customer, that company is in trouble.??In contrast, if a company that can recover customer acquisition costs quickly that reduces business risk and fuels growth.
The power of this metric is in its simplicity. To put in a fishing metaphor:??LTV to CAC asks “how long can these fish feed my family and how hard (expensive) is it to catch more?” More broadly, for growing a customer portfolio, the question might be “If I want to feed more and more people, how expensive is it to get all those fish?”
LTV to CAC | What Does Good Look Like?
Now that we have the LTV:CAC ratio, what do we do with it? The first thing to remember is that this a rule of thumb metric similar to the Rule of 40[viii]?and other metrics. The focus should be on accuracy not precision and, above all, consistency and transparency of calculation. This will allow a business to compare itself with industry benchmarks and also to track its own progress and management actions over time.
Generally speaking, an LTV:CAC of 3 is seen as “solid” or “good” performance.??Below 3 signals a problem and below 1 literally means that the company is destroying value by acquiring customers.??
With a low or negative-trending LTV:CAC ratio, leadership should take action, including one or all of the following:
An LTV:CAC of 4 is very good and 5 is outstanding.??While in general higher is better for LTV:CAC, if the ratio reaches 6 or higher that may be a sign that the business is under-investing in Sales and Marketing and thus constraining overall growth.
In Conclusion
Maximizing the lifetime value of customers by focusing on the business value customers realize creates a tight alignment between a software provider and its customers.??As explored in the first edition of?The Truth about Customer Success, the subscription business model flipped the former risk imbalance between customer and solution provider. In the past, customers took the majority of the financial risk when committing to a new software solution. Now software vendors are investing heavily in the customer relationship and need to work hard to make that investment pay off. In the subscription world, value is the name of the game if solution providers want to create shareholder wealth.
Importantly, the focus on value – both customer value realized and enterprise value created – provides an important and hopefully inspiring role for the Success team. This will help companies retain one of their most valuable assets:??a successful Success team.
If you cut churn in half, you DOUBLE the LTV of your customers.
Please share your thoughts on lifetime value.??Is it the right goal???Is it a realistic, practical, and actionable goal???What has been your experience?
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Rob Foster is a mentor and advisor to executives across the high tech industry. He helps companies achieve unfair advantage by developing and executing innovative strategies which in turn dramatically increase enterprise valuations. He is the founder and CEO of R Foster & Associates, LLC and the Co-Founder and Chief Operating Officer of The Silicon Valley Laboratory.
[i]?I fully acknowledge that shareholder value is not the only objective of a business and, in fact, is not even the first objective.??In order to increase shareholder value, a business must first find a way to delight customers, reward employees, and deliver value.
[ii]?Novel Investor,?Benjamin Graham Quotes.??https://novelinvestor.com/quote-author/benjamin-graham/, November 21, 2022.?
[iii]?Buffet, Warren.??“The Chairman’s Letter to Shareholders.”??Berkshire Hathaway Inc. 1992 Annual Report,?https://www.berkshirehathaway.com/letters/1992.html
[iv]?In a future edition of?The Truth about Customer Success, I plan to dig a bit more deeply into the pros and cons and the implications of setting sales goals for your success team.
[v]?Assuming 85% renewals, at a sustained new ARR growth rate of 75% the ARR balance between renewal and new stays just under 50%/50% almost perpetually.
[vi]?“1 – Net Retention Rate” can sometimes be referred to as the rate of Churn but given the importance of using Net Retention, not Gross Retention, using the “1 – Net Retention Rate” it a bit more clear.
[vii]?Interestingly, by convention, when talking about LTV, and when using that figure in other metrics and calculations, analysts do NOT typically express LTV in present value (future cash flows discounted back to what they are worth today). If you would like to calculate LTV as the present value of the future cash flows, you can simply add the discount rate to the denominator of the calculation.??Therefore, Present Value LTV = [Annual ARR x GM%] / [1 + Discount Rate – Net Retention Rate]. In the example given the present value of the $53.3 mm LTV is $32 mm if you use a 10% discount rate.
[viii]?The Rule of 40 says that the sum of a company’s revenue growth rate and profit margin should should equal or exceed 40%. At 40% or higher, a SaaS company is believed to be generating sustainable profit.??Below 40%, the company may face cash flow or liquidity problems.