How to Calculate the Lifetime Value of a Customer (LTV)

Not all customers are equal and the best customer have a high customer lifetime value (LTV). Being able to calculate your LTV helps you to ensure your business model is sustainable.

2 years ago   •   4 min read

By Leo Moore

Not all customers are equal, in fact, there are some customers that are not worth it. It's not always about money, some customers pay well but are never satisfied or just drag you down and sap your energy and possibly your will to live ;-)

On the other hand some customers are just a joy to deal with, they appreciate that all relationships are based on compromise.

What is Customer Lifetime Value?

The lifetime value of a customer is an estimated of the total subscription revenue that you expect to get from a customer over the period of the relationship. LTV is very useful as it gives the business a way to estimate the potential value of new business. This is turn, allows SaaS businesses to make decisions related to customer acquisition, product development and customer success.

Customer Acquisition

The Customer LTV determines the success of failure of a marketing channels. In the excellent book Traction from Gabriel Weinberg (who is also the founder behind the Duckduckgo search engine), Gabriel identifies 19 traction channels ranging from SEO and Paid Advertisements to Trade Shows. Each of these channels has a unique cost structure. Knowing your LTV helps to determine what marketing channels are appropriate for your business.

Product Development

By identifying customers with a higher LTV than the average it can lead to insights on particular features which are used by these customers. This in turn can be used to segment the customers and to identity new features which can improve the Customer LTV. Also, product changes like removing unused features or simplifying the product which improve the customer experience will improve the LTV.

Customer Success

One of the best ways to improve LTV is to improve the customer satisfaction. It is much more expensive to acquire a new customer than to keep and existing one. There is nothing more frustrating for a customer than to have a problem and not know how to fix it. Customer success can be improved not only by promptly providing assistance to the customer, but it can also be improved by improving documentation, improving the product and creating a space for customers to learn from each other. This could be using online tools like Slack or offline through user meetups.

How to Calculate the Simple Customer LTV

There are a number of ways to calculate the LTV. At the most simple it is:

$$Simple\ LTV = {(ARPC * Gross\ Margin\%)\over Customer\ Churn\ Rate}$$

ARPC - Average Revenue per Customer (The average MRR for active customers). Sometimes referred to as the Average Revenue per Account (ARPA)

Gross Margin % - The percentage of revenue left after the cost of goods sold (COGS)  are removed. Most SaaS business have a high gross margin, often more than 80%.

Customer Churn Rate - The percentage chance that a customer will cancel their subscription a a given month.

So, for example if the customer is paying €50 a month and your gross margin is 80% and your Customer Churn Rate is 5% then this give a Customer Lifetime Value of €800.

MRR €50
Gross Margin % 80%
Churn Rate 5%
Customer LTV €800

This simple value is sufficient for most people especially as it is just an estimate that can vary based on future events (e.g. reducing the customer rate, increasing the MRR etc).

How to Calculate the Complex Customer LTV

There are more complex ways to calculate the LTV. A more accurate way is to take into account potential future customer subscription growth and the present value of the revenue. This gives us the more complex customer LTV:

$$Complex\ LTV = {(ARPC * Gross\ Margin\%) * {1\over (1-k)} + {Growth\ Rate*K\over (1-K)^2}}$$

Growth Rate - The annual growth rate for active customers

K = (1 - Customer Churn Rate) * (1 - Discount Rate)

The discount rate is used to work out the current value of future money at the current time. One of the best and funniest examples of this is action is when in the Austin Powers movie when Dr. Evil decides to hold the world to ransom for 1 million dollars. It was a lot of money in the 60's but not these days. So, the value of an amount of money in the future is not the same as it is today and the discount rate is what you use to determine the current value of that future revenue. The discount rate is custom defined annual rate which you can choose. There is no correct value but it should incorporate the cost of capital, interest rates and risk premium. Examples if this include using the Weighted Average Cost of Capital. For early stage companies a rate in the region of 20-25% is suggested.

What has LTV ever done for us?

The Customer Lifetime Value is a fundamental metric used to establish the viability of a SaaS business model. Churn is a natural occurrence in business. Customers change, their requirements change, they get bought out, they go out of business so a SaaS business has to constantly find new customers. The aim of course is to grow the business and to do this you need to acquire new customers. This costs money.

Typically businesses expect to spend around 10% of LTV on acquisition costs. In this example above that would imply around €80 available for acquisition. The efficiency of the business model is determined by the relationship between the LTV and the Customer Acquisition Cost.

For more details check out What is Customer Acquisition Costs and why does it matter?

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