The real secret sauce to understanding your customer is being able to understand your Average Revenue Per User (ARPU). This metric allows you to identify trends and implement change that can shift the trajectory of your business towards that large pool of SaaS profits we all dream of.Read More
Guide to Customer LTV: Calculation, Formula & SaaS Business Strategies
Kelly Duncan Mar 11 2015
When you’re considering the direction your company is taking, the Lifetime Value (LTV) of a user is one of the most important metrics to understand. Different LTV models can inform decisions like how much you can pay to acquire a user, the effects of losing users, and how changes to a product affect the sum-total revenue you can expect to bring in from a user.
It’s also an easy metric to look at to see the overall health of a product in terms of both revenue and customer retention. A growing customer LTV means a company is doing well—customers are happy and will be giving you more money over the life of your relationship. On the other hand, a declining customer LTV means that a company is getting less money from each customer and needs to fix something fast.
The lifetime value of a customer is an especially important metric because it shows you a more complete picture than other figures. For example, ARPU (average revenue per user) only shows what you are charging, on average, for a customer in a given month. What it doesn’t show is whether or not your customers are going to keep paying that amount for a long or short time period, or if they are likely to upgrade and pay your company more money in the future.
Similarly, retention figures don’t tell the whole story. While customer retention shows if your customers are sticking with you, it won’t show if customers are paying more or less each month. And while revenue retention will show if your customers are upgrading or downgrading—and thus giving you more or less money—it won’t show you whether your number of customers is fluctuating.
This is why customer LTV is so important to understand—it fills in the blank spaces between ARPU and retention, giving you a more robust picture of where you stand and the revenue you can expect over the course of a customer lifespan with your company.
1. What is customer LTV (lifetime value)?
2. Why customer LTV is so important
3. How customer LTV influences CAC
4. How to calculate LTV?
5. Our secret LTV model
6. How do discounts affect customer lifetime value?
7. Customer lifetime value & other SaaS metrics
8. Three ways you can extend customer LTV
9. Customer LTV FAQs
What is customer LTV (lifetime value)?
Customer LTV (CLTV, or CLV) is the total dollar amount you’re likely to receive from an individual customer over their subscription with your product. Since the metric hinges on looking at your existing customers in aggregate or at least by customer segment, Lifetime Value (LTV) allows you to account for and accurately predict your business’s revenue and profit.
Why is customer LTV important
Whether you're a startup or an established company, you need to care about customer 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 customer 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 takes all" type of market.
How customer LTV influences customer acquisition costs (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 customer 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 tracking success (channels, marketing campaigns, sales reps, etc.)
Since customer 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 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 customer LTV, allowing you to knowledgeably build out your product, marketing, sales, etc. to maximize the likelihood of keeping and acquiring these customers.
Test if features, add-ons, and retention efforts are successful
LTV reflects customer satisfaction and ultimately encompasses how effective your retention is. 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 on maximizing value through the product.
SaaS financial planning and growth projections
If knowledge is power, customer 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.
How to calculate LTV
While there are multiple LTV calculation methods, they all involve determining how long each customer is expected to stay with your company and how much revenue they will contribute over their subscription.
One of the simplest ways to calculate customer lifetime value is to multiply the average revenue a customer generates over a given period of time (month or quarter) by the average length of the contract.
The LTV formula for this multiplication method looks like this:
Another simple formula for LTV calculation is based on ARPU and the company’s churn rate over a certain period of time:
One of the simplest and most frequently used models of LTV for subscription companies is based on ARPU and the company’s churn rate over a certain period of time. Due to the fact that most SaaS companies charge monthly, we’ll be using the month as our period. Then, the LTV for any given month is the amount that each current customer is expected to pay during the remainder of their lifetime with the company.
One of the biggest drawbacks of these traditional customer LTV calculations is that there needs to be a large enough sample size (number of customers) in order for the LTV calculation to be meaningful. Suppose a company has a large number of both customers and revenue.
Then there should be low variation in month-to-month changes, unless the company is either doing something very right (in which case, we’d expect these numbers to increase drastically) or very wrong (decrease drastically). The problem with having a low number of revenue (or customers) is that it reduces the statistical power of the model, meaning that the model’s expectations are less reliable. Also, with fewer customers, each customer has a greater impact on the LTV calculation for that month.
If a company with a small number of customers loses 1 or 2 customers or a few hundred dollars it will cause the LTV to spike for that month, giving a chart for LTV that looks like Figure 1.
Figure 1. An example of a traditional LTV calculation for a company with a small number of loyal customers.
Another potential problem is that if a company is awesome enough to have 100% retention in a given month, the calculation becomes mathematically impossible because you can’t divide by zero.
Our secret LTV calculation model
Here at ProfitWell, we love to geek out on data and metrics. A lot. Probably more than we’d normally admit in public. After a lot of pondering and discussion, we feel like we've figured out a better way to deal with low customer numbers and retention by developing a unique algorithm (the technical term being “secret sauce”). This algorithm lets us better regulate small changes, as it looks at how customer LTV is trending instead. It does this by comparing this month’s LTV to last month’s to remove the spikiness caused by small samples sizes, giving an overall more accurate LTV.
Also, by looking at trends instead of using other methods to deal with highly variable data like lifetime capping—saying that an average customer lifespan is a certain number of months or years (a number that will be different for each company)—we can also better predict an LTV for all types of companies, regardless of their size, retention numbers, or growth rates. Using trends also helps deal with problems like having months with 100% or greater retention—instead of having huge unrealistic spikes, we can show a reasonable uptick in customer LTV, shown in Figure 2.
Figure 2. LTV calculated with the ProfitWell secret sauce (in green).
It’s much easier to see the trends and growth in the LTV for the company with our algorithm, as it smoothes out some of the spikiness found in the raw data. At the same time, the up and down fluctuations are maintained. A simple trend line won’t show these peaks and valleys, which can be important for making decisions.
Overall, our model of LTV provides more actionable data, while still ensuring that the information is presented in a reasonable and accessible way, leaving you with actionable insight, not fussing over peaks and valleys. That’s why we’re calculating LTV as we do, and it’s our driving goal with everything we do with ProfitWell. Who needs more charts without a clear purpose?
How do discounts affect customer lifetime value?
Discounts can have the opposite effect that you want on customer LTV. Data shows SaaS discounting lowers SaaS LTV by over 30%.
Why would it lower your LTV?
A discount rate can offer short-term gain. However, it can damage your long-term gain and plan for success.
There are three reasons why discounts can hurt your company's prosperity. Customers that are attracted to discounts tend to be users with:
- A higher price sensitivity, therefore a lower willingness to pay full price for a service
- A higher rate of churn than your core user group would have at full price
- A dramatically lower LTV than your core user group
- A higher price sensitivity, therefore a lower willingness to pay full price for a service
The table below shows a discount comparison group. One has had minimal discounts, while the other has had aggressive discount pricing.
You can see that the 3-month churn rate is significantly higher for the larger discounted group and shows a decrease in LTV, while the minimal discount had no negative effect on LTV.
Read more about how discounts affect LTV here.
Customer lifetime value & other SaaS metrics
Calculating your customer LTV will help you calculate the Customer Acquisition Cost, or CAC. The CAC reflects the cost of bringing in a new customer. Combine these two metrics to create a ratio of revenue per customer to the cost per customer.
This is known as the LTV:CAC ratio. As long as the LTV:CAC is at least 3:1, then you can count on a profitable and viable business model. If you are averaging a 3:4 ratio, then you are looking at a losing bottom line. Simply put, you are paying more to acquire a customer than that customer is paying you to keep the lights on.
It's important to keep your LTV:CAC ratio at the forefront when developing your pricing strategy because maximizing LTV through pricing will help your LTV:CAC ratio remain high.
Three strategies to extend customer 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 customer LTV.
Here are some actionable ways to extend the life of your customer and get LTV higher.
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 your retention rate. 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 increase purchase frequency and incentivize repeat business. You already have them in the door, so make sure you capitalize on that customer relationship by 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 shouldbe created to scale either up or down capturing the smallest/cheapest customers, up to the largest, most valuable customers 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.
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Customer LTV FAQs
What does customer LTV mean?
Customer LTV refers to customer lifetime value, which is the overall revenue driven by a customer over the course of the entire customer lifecycle.
How do you calculate customer LTV?
There are multiple ways to calculate customer LTV. To find LTV for a single customer, you just need to add up the total revenue per month and multiply it by the number of months they’ve been a customer. To find your business’ average customer LTV, you need to divide the average revenue per user by your company’s churn rate. To automate your customer lifetime value calculation, try this LTV calculator.
Why is customer LTV important?
Customer LTV reflects how successful your company’s retention efforts are and how much revenue bring relative to the cost of acquiring customers (CAC). This ratio, LTV:CAC, is one of the best reflections of the profitability of your business, and the lower your customer LTV, the more unfavorable it will be.
By Kelly Duncan
Kelly is a data scientist at Price Intelligently. She was born in Washington, D.C. but grew up in Massachusetts. She has a corgi named Toby.