The Retainable Guide To: Customer Lifetime Value
If you acquire a new customer, how much is that customer worth to you? How much can you spend to acquire that customer, while maintaining profitable unit economics?
It is a critical to know and understand how much a customer is worth to your business, and can allow you to make important strategic decisions on acquiring and servicing different customer profiles. Calculating your Customer Lifetime Value can shed light on these questions and provide the framework for smart strategic decisions.
Let’s dig in to learn more about Customer Lifetime Value!
What Is Customer Lifetime Value?
Customer Lifetime Value, referred to as LTV or CLTV or CLV, is a measure of the revenue generated from a customer over an unlimited span of time, or a lifetime ;-).
Customer Lifetime Value is a critical metric for companies to understand, as it places a dollar value on each customer, and can inform how to much money can be spent to profitably acquire and service customers.
For example, if your SaaS product is $10 per month, and the average customer stays for 4 months, the LTV calculation is $10 x 4 = $40
Simply put, the LTV is important for companies to understand how much a customer is worth. This insight can help answer the following questions:
- How much can you spend to profitably acquire a customer
- Which marketing channels are most effective — for acquiring customers? For acquiring the most valuable customers?
- How long will it take to earn back the acquisition cost? Ideally this is a relatively short pay back period.
How Do You Calculate Customer Lifetime Value?
There are various ways to calculate lifetime value, depending on the assumptions and desired output.
The simplest calculation is:
Gross LTV = [Average Revenue Per User] x [Customer Lifetime]
For example, if you run a project management tool, and have an average revenue per user of $30 (per month), and the average customer stays for 4 months, your LTV = $30 x 4 months = $120. This is your Gross LTV, not taking into account any expenses…..we’ll get into that later.
The lifetime of your customer is just another way of arriving at the customer churn rate. So you can also use the following equation:
LTV = ARPU / Customer Churn Rate
The numbers above are counting only top line revenue. But to really understand the unit economics of a business, it is important to know the inherent expenses, and what that means in terms of profit.
For the example above, let’s assume that the profit margin per customer is 50%.
We determined that our Gross LTV for the customer is $120. To find your Net LTV, use the following formula:
Net LTV = [Average Revenue Per User] x [Customer Lifetime] * [Gross Profit Margin]
Net LTV = [$30 ARPU] * [4 months] * [50% profit margin]
This post will focus mainly on LTV from the perspective of B2B SaaS companies.
The nuances of estimating LTV for ecommerce or B2C apps are different than B2B.
For example, a company that sells coolers and mugs like Yeti may see a returning customer after 9 months, which may constitute a repeat purchase. While a free social media app may consider a user churned if they do not log in within 3 weeks of sign up.
B2B SaaS companies can clearly understand when a customer has churned: have they renewed their subscription, or cancelled their subscription?
Why Is LTV So Important?
Customer Lifetime Value is the benchmark that guides much of your business decisions: how much can you spend on sales and marketing, how much can you spend on customer support, product development and more.
In a vacuum, LTV doesn’t mean a whole lot. Whether a customer is worth $200 or $10,000, the LTV is most important when put in the context of how much it cost to acquire that customer. Thus, getting a firm grasp of customer lifetime value and how it relates to customer acquisition costs is critical to understanding the unit economics of your business.
Here are some of the reasons that Customer Lifetime Value is so important to understand:
- Set Goals for Acquisition Costs: The general rule of thumb for SaaS companies is to follow a 3:1 ratio, LTV: CAC. This accounts for the cost to get a new customer, the associated costs to provide customer support and future product development, and of course a percentage for profit. If the ratio is higher than 3:1, there could be room to run more aggressive campaigns and pay more money to acquire more customers. On the flip side, if it is lower than a 3:1 LTV: CAC ratio, then profit margins may be too low, and acquisition costs should be re-evaluated.
- Create Helpful Customer Segments: Using Lifetime Value for an entire customer base can be misleading, as not all customers are worth the same amount. Therefore, if you are able to identify what the Lifetime Value is for customers on different plan types, or geographies, or who came from different acquisition channels, you can create powerful customer segments that can guide you to efficient future growth.
- Evaluate Marketing Channels by LTV: Related to the point about segmentation above, when you assess the LTV of customers based on marketing channel, you can measure and prioritize your sales and marketing efforts. For example, if you are able to acquire boatloads of new customers from paid social channels, that’s awesome! But what if they have an LTV that is even lower than what it costs to acquire them? Not so awesome. But if customers acquired from webinars have an LTV that is 5x the customer acquisition costs, then it only makes sense to focus on webinars over paid social.
- Focus on Keeping Your Most Valuable Customers Happy: LTV can be a helpful guide in how you onboard, engage, and support your customers. If you are able to identify which customers have the highest LTV, and therefore are most valuable to you, then you can prioritize your efforts to engage and retain those customers.
- Guide Product And Business Decisions: Let’s assume that you have used the LTV calculations above, and segmented out your customer base to discover that your customers in your lowest tier have a lifetime value of $75. Those on your highest plan have a LTV of $1500. Moreover, you realize that the $75 customers require the most customer support and are only 5% of your customer base. What would be your strategy to manage this situation? The answer is up to you, but using Lifetime Value data and nuanced customer segmentation, you are able to arrive at a much more thorough analysis.
Challenges With Calculating LTV
Because the Lifetime Value metric is so important, and can guide critical decisions like sales and marketing spend, it is important to be mindful of the challenges and shortcomings of LTV calculations.
Here are a few:
- The Assumptions that you make: The Lifetime Value calculation relies on the quality of assumptions that are used as inputs: how much do customers pay you every month? How long will customers stay with you before churning? It often requires a lot of time, and data, in order to arrive at accurate answers. With a limited sample size, there would be lots of fluctuations and variance in LTV.
- LTV Calculations Don’t Account For Expansion/Contraction: The LTV formulas above do not account for any changes to a user’s subscription plan over the course of their lifetime. Customers will upgrade or downgrade their plans, which will impact the lifetime value. However, in the simple formula above, it assumes a constant ARPU.
- Customer Lifetime Values Are Always Changing: The lifetime value of a customer is not a constant, but instead is changing all of the time. This could be due to a variety of factors, from customer behavior, to market changes, competitive landscape, pricing, and much more. Therefore, the lifetime value that you calculate this month could be different from what you calculated a year ago.
How Do You Increase Customer Lifetime Value?
At a high level, there are two levers to increasing lifetime value:
- Keep customers longer (ie improve retention)
- Earn more revenue per customer (ie improve monetization)
Here are a few high level areas of focus to increase customer lifetime value. We will cover these topics in much greater depth in future posts:
- Customer Engagement and Onboarding: The most critical juncture to establishing customer satisfaction and success is in the early stages, from the time of sign up to completing the onboarding. The customer has already identified potential value with your product, which compelled the sign up in the first place….the question now is can your product deliver on that value proposition? A successful onboarding campaign, where the user understands and gets value from critical features, can go a very long way in retaining the customer. Better retention and longer customer lifetime will directly impact positive lifetime value.
- Understand Customer Churn: Your customers are always offering hints as to if and when they are going to churn–it’s all in the data! While many companies have robust tracking and analytics, it is far less common to see companies pull actionable insights from the data. One of the biggest gaps is understanding in app user behavior to know which customers are headed towards churning, and why. If you are able to understand these inflection points and get in front of customers before they hit the cancel button, then you have just made an immediate impact on reducing churn, and increasing your customer lifetime value.
- Increase Pricing: SaaS pricing is a nuanced and challenging topic. In many instances, there may not be a “right” answer to how to price, but there is often a better way to drive more revenue per user. Regardless of what the unique pricing strategy that works for your business, speaking with your most engaged users to understand what drives the value for them can be hugely insightful in creating strategies to increase revenue.
Understanding Lifetime Value underscores the importance of a few key growth levers for SaaS businesses: how long can you keep a customer (retention rate) and how much can you earn from them (average revenue per user).
Ultimately, as with any successful business, the secret is to add value to your customers at a price that is agreeable to customers while being profitable for you.