Getting new customers is good.
Keeping a customer and getting them to continue paying is better. Regardless of what you sell, whether you're an e-commerce business, a SaaS company, or a brick-and-mortar shop, you'll need to know how much the average customer is spending on your products and their purchase frequency.
To optimize this though you need to understand and improve how much a new customer will spend on your product during their lifetime - also known as tracking your customer's lifetime value or LTV. Further though, calculating LTV by segment can help you understand who your profitable customers, channels, and even sales reps are to your company. This makes LTV crucial to the health of your overall business and the best SaaS companies obsess over lowering their acquisition for new customers (CAC) relative to maximizing their Customer Lifetime Value (LTV) (also known as maximizing their LTV/CAC ratio, which is a common SaaS "compass metric").
To help you better maximize your LTV, let's walk through the importance of understanding LTV, how to calculate it, and ways you can make your LTV grow to make your SaaS company more profitable.
What is customer LTV (lifetime value)?
LTV is the total dollar amount you’re likely to receive from an individual customer over the life of their account with your product. Since the metric hinges on looking at your customers in aggregate or at least by segment, Lifetime Value allows you to account for and accurately predict your business’s revenue and profit.
"Want your SaaS to last? LTV is a fountain of youth, the key to your SaaS company's longevity"
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Why customer LTV is so important
You need to care about LTV, because a successful business model requires that your customer spends more than the cost it took to acquire them. In other words, your LTV must be higher than your CAC (see image above). If your LTV is lower than CAC, you are losing money with each new customer. If that’s the case, it’s worth dropping everything else you’re doing to reduce your CAC (easier) or improve your LTV (more difficult). (Click here to learn more about how to calculate and optimize your CAC.)
An important note here is that your LTV can be lower than your CAC in certain instances, but all of those hinge on you eventually making up the deficit through new products, features, revenue sharing, etc. Additionally, some venture backed companies forgo LTV for extremely high CAC to run a "scorched earth" strategy of acquiring logos. This is risky, but an effective strategy if you're in a "winner take all" type market.
LTV dictates acceptable CAC
While understanding your LTV relative to your CAC is seemingly obviously important on the surface - LTV tells you what you can afford to spend to acquire a new customer - the metric's importance goes much deeper. Specifically, tracking LTV allows you to:
Optimize your LTV/CAC ratio to 3 or higher: Every quarter you should be managing your LTV/CAC ratio. As a benchmark, you want this number to net out to at least 3, meaning for every dollar you put in your SaaS machine you're getting 3 out. Depending on tradeoffs (alluded to above), this number may be justifiably lower or hopefully much higher in the aggregate or on a per segment basis.
Determining and and tracking success (channels, marketing campaigns, sales reps, etc.): Since LTV is a measure that combines how well you're monetizing (MRR) with how well you're retaining your customers (MRR Churn), LTV can be used to benchmark success across different aspects of customer acquisition. Comparing LTV across channels, sales reps, marketing efforts, etc. will give you insight into which aspects you need to eliminate in your process and which you need to put accelerate with more fuel.
Determine your best customer personas: One of the major goals in SaaS is to clone your customers. SaaS as a giant math formula allows you to break down which attributes lead to high LTV customers, allowing you to knowledgably build out your product, marketing, sales, etc. to maximize the liklihood of keeping and acquiring these customers.
Test if features, add-ons, and retention efforts are successful: Because LTV encompasses how effective you are in your retention, the metric can be used to track the impact of different retention efforts, allowing you to advance your product org down a path that focuses in on maximizing value through product.
SaaS financial planning and growth projections: If knowledge is power, LTV gives you the ability to reasonably project your cash flows and growth as you acquire additional customers. This can be incredibly important to your cash flow, allowing you to financially plan your team growth, marketing spend, etc.
What should you include in LTV
In most basic form, there are two major components that go into an LTV calculation:
Component 1 ARPA: Otherwise known as average revenue per account (or "user" as APRU), ARPA is the number that tells you the average revenue per month you will receive from an active customer.
Component 2 - Customer Churn: Signifies the “end” of a customer's life cycle. If you calculate your ARPA monthly, you should calculate your customer churn rate monthly as well for comparison.
What you should not include in LTV
LTV is one of the more hotly debated SaaS metrics, mainly because different businesses have different inputs that go into the revenue of a customer. For instance, some businesses have consistent one time revenue that they can reasonably predict a customer will spend in addition to a subscription. Other debates center around which customers actually make it into LTV - should it only be new customers, already existing customers, or somewhere in-between?
At ProfitWell, we’ve worked with hundreds of SaaS companies and found that most are actually using the most basic calculation that we go through below. That being said, this data is at best directional and worst hiding something if you don't segment LTV down by plan, channel, customer segments, etc. Additionally, you need to do what's best for you when it comes to this calculation, meaning if you need to make things more complicated, go for it. Just make sure you're consistent and working to improve the metric.
Ok, so how do I calculate LTV?
Once you have an understanding of how your SaaS company is defining the components that go into LTV (ARPA, Active users, Customer churn), you can calculate it easily. This is the lifetime value calculation we've been using to find our most loyal customers! Note in the below, we're reffering to active customers strictly when we say "Total # of Customers", because these are the folks who presumably will stick around.
LTV Formula: Here you take the average revenue per account for a month’s period and divide that by the number of churned customers for a monthly period. This essentially expands out how much revenue that particular group of customers is going to bring in on average. It also gives you two main points of optimization - the average revenue a customer brings in and how long they stick around.
Three Ways you can Extend LTV
Lifetime value is a testament to the success of your SaaS business. The higher your customer lifetime value is, the longer you can turn profits and grow. Remember that LTV is a balancing act that goes hand in hand with your CAC. A viable business model will always yield a higher LTV.
Here are some actionable ways you extend the life of your customer and get LTV higher.
Cross sell/upsell: Grow your customers’ LTV by building add-on revenue into your product, particularly through your overarching pricing strategy. Be sure to find add-ons that supplement both LTV through increased revenue, but also retention. As a rule of thumb, you should be looking for products that satisfy at least 30% of your customer base, since you should reasonably be able to monetize that group. A great example of this strategy is Appfolio.
Product line expansion: Give your customers not only add-ons, but entirely new products to purchase and retain into. You already have them in the door, so make sure you capitalize on that relationship through adding pieces of product to their workflow. Overall, these solutions should be at least related to your core product to promote synergy amongst your product and customer success teams, but this isn't an absolute requirement.
Scalable pricing through the use of a value metric: Scalable pricing is vital to success in any SaaS business. The pricing structure should be created to scale either up or down capturing the smallest/cheapest customers, up to the largest customers that are willing to pay more. The best way to do this is through what's known as a value metric (number of users, number of visits, depth of usage, etc.). Read more about value metrics and choosing the right one here.