How Valuable Are Your Customers?: 4 Ways to Calculate LTV

‍How valuable are your customers? Not in the abstract way - we know customers are at the very core of each business, and in that sense, they’re invaluable. We’re talking about the overall revenue you’ll earn from them over the course of their lifetime with your company. 

Of course, you want to ensure you’re reeling in those high-paying customers. You also want to make certain that your customer acquisition efforts are paying off. 

That’s why top-performing SaaS businesses calculate LTV. Shorthand for Customer Lifetime Value, LTV is the amount of revenue the average customer generates across the course of their relationship with your business (A.K.A. their “customer lifetime”).

❓ Why is it important to calculate LTV? 

There are numerous reasons why businesses calculate LTV. Here’s a short list:

1. You need to know your LTV (as well as how it compares to your CAC) to determine how much to spend on customer acquisition. Your LTV:CAC ratio is how you estimate the efficiency of your acquisition efforts - more on that later! 
   

2. Knowing how much revenue is generated by the average customer helps predict overall revenue in the future from existing customers. 
   

3. Since LTV is directly related to retention, it’s crucial when determining retention investment amounts. If your LTV:CAC is lower than you’d like, it’s a sign that your retention efforts need some adjustment. 
   

🤷 Which factors can influence LTV? 

First, there is a direct relationship between customer retention and LTV. Customers that stay longer spend more over the course of their lifetimes, so the higher your retention rate, the higher your LTV will be. 

This means that for B2B SaaS companies dealing primarily with SMBs, LTV will be lower than for those serving enterprise customers. This is because of the relatively high rate of business failure for SMBs. If a customer closes their business, they will churn, ultimately lowering your overall LTV.

The other key factor is upsells. The more internal revenue growth you have, the higher your existing customers’ value. More upsells equal higher LTV. 

🧮 How do I calculate LTV?

There are several different methods for calculating LTV. Which one you use depends on three factors: 

1. The amount of fluctuation in your business’ churn rates
   

2. Whether or not you choose to factor in gross margin, and
   

3. Whether or not your business model includes upsells/expansions.
   

☝️ Method 1: The Basic Approach

This method is the most basic, and it’s appropriate for businesses that have linear (very consistent) churn rates. Here’s the formula: 

ARPA is the Average Revenue Per Account for a given period.

Let’s complete an example calculation. Suppose an annual Customer Churn Rate of 12.5%, and ARPA of $25K.

Note that both ARPA and Churn Rate need to be calculated for the same period. For instance, if the period you used for ARPA was a year, you need to use the annual churn rate for that same year.

This formula assumes a linear churn rate for the life of the contract - ie, the odds of a customer churning in the first year is the same that they’ll churn in the future. However, that may not be true for you - in fact, it’s likely that if a customer has retained the first year, their retention will be higher in subsequent years.

Also note that the formula accounts for recurring revenue, but not one-time revenue. While that’s a bit conservative, we recommend taking this approach as recurring revenue is the most relevant for subscription businesses. However, if there’s usage-based revenue, we also advise you to include that.

✌️ Method 2: Including a Discount Rate

This method uses the same formula as above, but adds in a few extra steps to accommodate fast-growing businesses with annual contracts.

For these businesses, month-by-month churn rate doesn’t reflect the true probability of a customer churning. That’s because  many of their recent customers can’t churn due to their annual contracts. As a result, the churn rate is understated, and the LTV is overstated. So here, we apply a discount rate to make the estimate more conservative. 

How does this help? You want to err on the side of caution - it’s much better to underestimate LTV than to overestimate and later find out you spent way too much on customer acquisition. 

A 0.25 percent discount rate is common.

Here’s the formula for discounted LTV:

LTV=(ARPA/Customer Churn)(1-Discount Rate)

If you used a .25 discount rate as recommended, you simply multiply your LTV calculation by .75.

Here’s another example with the numbers we used above.

Another way to handle churn rates is with a trailing twelve month number for customer churn. To do this, look at how many customers churned over the course of the preceding 12 months. This provides the most accurate picture of churn. 

This is only doable if your business had enough volume to give you a representative number from a year ago.

☝️✌️ Method 3: Calculating Gross Margin Laden LTV

The advantage to this method is that using your gross margin accounts for the cost of goods sold (COGS). The resulting figure will reflect the value of your customer after accounting for the cost of serving them. We recommend this method over Method 1, as it more accurately reflects the value of a customer.

This is the formula:

Assuming an 80% gross margin, here’s what that calculation would look like:

✌️✌️ Method 4: What about expansions and upsells?

If your business model includes significant upsells after the initial sale (land and expand), other LTV calculations won’t fully capture how much your customers are worth. 

There are many proposed solutions to this problem floating on the internet. However, in our experience these are overly convoluted. 

These complicated formulas also often bake in unrealistic assumptions. Primarily, they assume that year 1 upsell rate will be repeated forever. That isn’t how the land and expand approach works on a practical level, since the expansion is capped by the size of the customer.

With that in mind, here’s how we recommend thinking about high upsells:

1. At a minimum, using ARPA as the numerator captures how many of your customers have already upsold. This might be sufficient if the majority of your customers have been with you for a while. It’s not the best if your customers are brand new.
   

2. You might just use an ARPA value that includes customers who have had the opportunity to expand already. For example, iyou might include customers who are 1 or 2 years old (if there’s enough representative data in that cut, that is.)
   

3. Another approach is to use cohorts.This way you can see net revenue retention  1 or 2 years after signing. Then, you can apply that to more recent customers to produce a blended ARPA.
   

Let’s say you decide to use option 2 above, and find that the ARPA is $35,000 instead of $25,000. The calculation for these numbers is as follows: 

🙋‍♀️ Can I use Revenue Churn Rate instead of Customer Churn Rate?

It’s possible to use Gross Revenue Retention, but we don’t recommend it as it isn’t standard nor is it particularly accurate. Calculating with Revenue Churn Rate usually results in overestimations of LTV.

🔢 How much does the method change the result?

These methods can each produce wildly different numbers. We’ll show you how our calculations compare to one another, but first, let’s review the different methods.

• Method 1: The basic approach, which Includes no expansions, upsells or discount rate.
• Method 2: The basic approach plus a discount rate.
• Method 3: The basic approach, with the addition of gross margin.
• Method 4: Accounts for expansions and upsells.
  

Here’s how the values compare to one another:

The numbers speak for themselves - the method matters!

👍 I’ve Calculated My Business’s LTV. Is it good?

If you want to know the answer, your work’s not done yet! It’s impossible to determine the strength of your LTV unless you compare it with another figure. 

Specifically, you need to compare LTV with customer acquisition costs (CAC). These two figures can then be evaluated in a ratio, LTV:CAC. This ratio states how many dollars of revenue are generated for each dollar spent on customer acquisition.

As a rule of thumb, an LTV:CAC ratio of 3:1 is strong. This means that every $1 spent on customer acquisition should result in at least $3 of revenue. 

If it’s lower (like 2:1) you’re spending too much on customer acquisition in comparison to the amount of money you’re making. If it’s higher (like 5:1) it means you can spend more on customer acquisition, and increase your revenue even further!

It’s worth noting that as your business moves out of the startup phase, it’s normal for LTV:CAC to increase well above the 3:1 ratio. In the early days businesses typically have less of an idea of which sales and marketing activities and motions work best - but as they get better at it, the efficiency of sales and marketing dollars improves. This means lower CAC and therefore, higher LTV:CAC.  

😩 My LTV:CAC is too low. What should I do?

First and foremost, focus on increasing retention. The counterpart of increased retention is low churn, and lower churn leads to higher LTV. 

Your next course of action is to re-engage existing customers and push upsells. We don’t need to explain to you that upsells increase revenue, but they don’t just do that. Higher revenue means higher LTV. 

Lowering CAC is another avenue you can take to increase your LTV:CAC. Do you actually need to spend as much as you do on acquiring new customers? Could you optimize expenses in that area? If it’s feasible, cut customer acquisition costs. 

🚫 Are there any limitations to calculating LTV?

While knowing your LTV is important, there are some limitations.

For starters, calculating LTV can be difficult when you have a small number of customers. The smaller your sample size, the harder it is to extrapolate trends. You can’t really say much about the behavior of your “average” customer unless you have enough data to generalize. 

As well as the sample size limitations, some businesses are too young to see how churn will actually play out over time. Maybe you’ve been around for ten months with minimal churn, but when the year mark rolls around, many customers will drop with the end of their contract. 

Both of these factors mean that newer businesses probably won’t have enough data to complete a meaningful analysis.

👋 Some Parting Thoughts

That’s a lot of numbers to manage! If you’re feeling lost, Subscript can help. LTV calculations and beyond, we put all your data in one place for quick, convenient access to all the metrics you need.