The metric that matters - Customer Lifetime Value
Kevin Suitor
Founder & Managing Partner @ NetGnoSys | Talent Acquisition, Growth Strategy Alignment
“The business that is willing and able to outspend the competition to acquire a new customer won't always win as some people say, Unless they are continually reducing their lead costs, while raising the customer lifetime value at the same time.
This is the essence of what Customer Value Optimization Is.
If you don't reduce lead costs and increase customer lifetime value, you'll just willing outspend your competition and go out of business faster.”
― Jeremy Coates
Customer Lifetime Value
The final key metric for a subscription-based business is the Lifetime Value (LTV) or Customer Lifetime Value (CLTV). In a nutshell, LTV means the total expected value generated over the lifetime of a customer.
This matters to investors since they want to know the value of newly acquired customers over the long term.
Let’s break this concept down further:
- LTV is an expectation, which means that it is averaged or statistically inferred.
- LTV measures value, the value metric that a SaaS business typically cares about is revenue, it could also calculate margin for example.
- LTV is measured over a customer lifetime.
Customer lifetime value (CLTV, or LTV for “lifetime value”) helps you predict future revenue and measure long-term business success. CLTV tells you how much profit your company can expect from a typical client over the course of the relationship. More to the point, LTV helps you estimate how much you should invest in order to retain a customer.
There isn’t a ‘right’ target for LTV. It needs to be evaluated relative to your CAC. We demonstrated how to calculate CAC in a section above. At a minimum, you want your LTV to be greater than your CAC. If you are spending more to acquire the average customer than you gain from them, your business is destined to fail.
The LTV/CAC ratio is the total average value you expect to receive from a new customer compared to the average cost to acquire a new customer. Using the LTV: CAC ratio provides you with a single metric to evaluate the long term viability of your Go To Market efforts.
Ultimately, what you’re trying to answer is: On average, do we earn more revenue per customer than the cost to acquire new customers?
Ideally, you should aim for an LTV: CAC ratio of at least 3:1 for sustainable success.
Mathematically, customer LTV can be expressed as:
Where v_i stands for the value and s_i retention or survival rate for the billing cycle i.
The billing cycle can be a week, month, quarter or a year depending on the business model.
The Total Number of Cycles N stands for the duration of the customer relationship. For a yearly subscription model, N=100 is a good reference number. Looking at the math you can see why LTV is a great metric. It measures both profitability and loyalty simultaneously and generates a single metric.
It can also be more simply calculated as:
Lifetime Value = (Avg. Revenue / Account * Gross Margin %) / % Monthly Recognized Churn Rate
Calculating CLTV
So we have a couple of new calculations - Average Revenue Per Account (ARPA) and Gross margin that we will need to work through before getting to an LTV value.
Let’s address ARPA first. Average Revenue per Account (sometimes known as Average Revenue per User or per Unit), usually abbreviated to ARPA, is a measure of the revenue generated per account, typically per year or month. This can be calculated using either your MRR or your ARR. In our example, we will look at this using both methods.
It is also good practice to drill down on this metric to look at ARPA for both Existing Accounts and Net New Accounts along with the amalgamated view.
This allows you to understand how your new customers look when compared to your existing base.
So you are really doing the calculation three times with three clusters of accounts and MRR/ARR.
So, Gross Margin. It’s a hairy old accounting term. How is it used in SaaS? What do you include? Your CFO or accountant can help you here but our recommended approach includes Support, Services, Customer Success, and your Cost of Operations - hosting, R&D amortization, resold product expenses (you know those 3rd party licenses you’ve bundled into your offer). There could be other stuff included but this covers the big items you should consider.
There’s often an argument for throwing Customer Success into Operating Expenses. Does your team do upsell and cross-sell? If so, throw them below the line, if they don’t and they are retention focused they are a cost of sale.
So, to get your Recurring Revenue Margins you take your Recurring Revenue for the period (MRR / ARR) minus the cost of the departments that directly support that revenue - Service, Support, CSM and Operations.
Recurring Revenue
- Service
- Support
- Operations
= Recurring Gross Margin
You’ll likely want to calculate your gross margin with and without R&D amortization so you and investors can assess your numbers correctly.
You should measure both your Recurring Margins and margins for your other revenue streams such as service, professional services, third party sales etc. In that way, you don’t have non-recurring items masking your true recurring revenue performance.
Okay, we are in the home stretch in this document and this set of calculations. Let’s figure out what SaaSly’s LTV is and then their LTV/CAC Ratio.
CLTV Example
Going back to our CLTV formula:
Lifetime Value = (Avg. Revenue / Account * Gross Margin %) / % Monthly Recognized Churn Rate
Let’s get SaaSly’s input data for March 2020.
Revenue March 2020
Entry 600 @ $49 $29,400
Pro 100 @ $499 $49,900
Enterprise 25 @ $999 $24,975
Total Revenue 725 Customers $104,275
So, we have $104,275 in revenue from 725 accounts. This provides us with an ARPA figure of $143.83 for March 2020
Let’s get a handle on Gross Margin for March
Recurring Revenue $104,275
Service $ 5,000
Technical Support $ 6,250
Customer Success $ 40,000
Operations $ 10,000
Recurring Gross Margin $ 43,025 | 70% (!!!)
Well, we finally have a red flag. Best in class SaaS companies typically have recurring gross margins north of 80%, IPO track companies typically in the 85% range. This is something to look at, are freemium and Entry customers chewing up too many support hours and possibly hosting time? Something for SaaSly’s team to look into further.
From our earlier calculations, we know that in March 2020 SaaSly had a Net Negative MRR Churn Rate of -35% which is excellent.
Let’s now plug in the numbers and look at the LTV
Lifetime Value
Avg. Revenue / Account $143.83
Gross Margin % 70%
% Monthly Recognized Churn Rate 0.385%
Customer Lifetime Value 26,150.90
Well, I guess that they can handle their low gross margins.
Finally, how does the LTV:CAC ratio look for SaaSly.
The rule of thumb is your LTV: CAC should be 3x or better.
SaaSly has hit a home run with a figure north of 100.
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