Of all the metrics you need to track as a SaaS company, lifetime value (LTV) may be the most mysterious. It feels difficult to calculate, and then once you have the calculation, you don’t really know what to do with it whether it’s good or bad.
Hopefully today we can demystify the metric and offer some insight to help you use that metric better within your company!
What is customer lifetime value?
Lifetime Value is the predicted amount a customer will spend on your product or service throughout the entire relationship, hence – “lifetime.”
This metric can help you move from transaction-based thinking to focusing on the long-term value of repeat business.
Say you charge $100/mo for your service and a customer stays with you for 12 months. Their LTV would be $100 × 12 = $1,200.
Why does LTV matter?
The primary reason LTV is so important for your SaaS business is that it drives what you can spend to acquire new customers. If your customer acquisition cost (CAC) is $100 and that same customer has an LTV of $500, you’re basically printing $400.
Can you say “money machine”?!?!?!
The higher your LTV and the lower your CAC, the faster you can grow your business.
Is it really that simple?
Sounds easy, right? Well, it mostly is. The kicker here is that taking the top-level view we’ve mentioned thus far isn’t a great longterm solution.
Why? Because all customers are not created equal.
You need to know what the LTV is of each major customer segment. For SaaS companies, that’s usually the various price points you offer.
Joe on your $30/mo plan will almost certainly have an LTV that is a fraction of what the LTV is of Sally on your $200/mo plan. And not just because $200 is more than $30.
LTV and Churn
The reason those LTVs will likely be so different is because of one nasty word: churn.
Generally speaking, users on your lowest-priced plans will also have the highest churn, making it your most dismal LTV compared to the other plans.
And remember what we said earlier? LTV drives what you can spend to acquire customers. If the average customer takes $200 to acquire, it makes no sense to spend that to get a customer with an LTV of $100.
Knowing what your LTV is for each customer segment is critical.
This is something Baremetrics (subscription analytics & insights) offers right out of the proverbial box, available as soon as you connect your account.
To measure LTV, we’ll need additional metrics
1. Churn rate: This is the number of subscribers that unsubscribed or stopped paying in a given period of time.
Example: If you had 100 subscribers last year and lost 5, your churn rate is 5%.
Example: If you have 100 accounts, and from 50 of them you made $50 per year, and from the other 50 you made $100 per year, then your ARPU is $75 yearly.
3. Average Margin Per User (AMPU*):* This is the average amount of profit you receive from each account. You should subtract cost of goods sold (COGS) and account management and customer service expenses from your ARPU.
Example: Let’s say you’ve calculated that your ARPU minus expenses equals average margin per customer (AMPU) of 80%.
How to calculate LTV for SaaS (LTV formula)
Earlier I mentioned a basic way to calculate churn for a single customer, but that obviously isn’t practical for running your business (since you hopefully have more than one customer).
Let’s take a look at the actual formula for calculating LTV.
LTV = ARPU (average monthly recurring revenue per user) × Customer Lifetime
This could also be calculated using churn (which is a number you likely have more readily available).
LTV = ARPU / User Churn
The higher your user churn, the lower your LTV will be. You can see why paying attention to both LTV and churn is so critical.
Other variables to consider: Churn variance and sample size
Quite often, churn can be messy. For example, if you think about any given cohort (a group of users that subscribed in a given period – i.e., all subscribers gained in July 2017), there’s often a “cliff,” right after the first month of that cohort’s start date.
To keep this churn variance accounted for, we can multiply our results by a discount rate. (Discount rate means “discounting” for cash flow losses that may occur in the future).
Use a discount rate of .75 to find a more conservative estimate:
((ARPU x Profit Per User)/Churn rate) x .75
$1200 x .75 = $900
Sample size is also important, and unfortunately, the scientific method often falls by the wayside in business. If you don’t have many users, or you’re counting too few users in your metric calculations, then your data may not be scientifically valid. Here are the scientific guidelines for sample size:
- Less than 100 users: 50% or more user data needs to be counted for valid data (100% is best)
- 1,000 to 10,000: 10% of user data needs to be counted for valid data, (i.e., if you’ve got 5,000 users then you need to include the data of at least 500 users in your calculations).
- More than 1 million: 1% of user data need to be counted for valid data, (i.e., if you’ve got 3,000,000 users then you need to include the data of at least 30,000 users in your calculations).
Put LTV to good use
Lifetime Value is an important metric, especially when matched with Customer Acquisition Costs (CAC).
If you know how much a customer’s value will be over the course of a lifetime, then you can make smarter decisions about what to spend to acquire a customer.
A good rule of thumb is that if LTV/CAC isn’t above 3, you’re spending too much on acquisition.