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What is LTV?
Customer Lifetime Value (LTV) represents the average revenue that a customer generates before they churn, offset by gross margin. LTV in SaaS is only ever used as a forward-looking estimate of the future, but calculating a reasonable estimate allows you to make smarter decisions for your business.
How is LTV useful?
Balancing customer acquisition spend
If I know my LTV is ‘X’, I can confidently spend ‘Y’ to acquire customers without much risk.
Determining payback period
How long does it take for a customer to “pay back” their acquisition cost? The longer this is, the more risk there is tied up in the business.
Many investors in SaaS want to see LTV as a part of their “health” assessment of a prospective investment.
The basic LTV formula
ARPA: Average Revenue Per Account (The average MRR across all of your active customers)
Gross Margin: The difference between revenue and COGS (Cost Of Goods Sold). This is typically extremely high in SaaS (>80%)
Customer Churn Rate: The rate at which your customers are cancelling their subscriptions.
This basic LTV formula is commonly accepted as a useful starting point. However, it’s only a rough estimate and doesn’t properly account for MRR expansion, contraction or non-linear churn.
The “David Skok” formula Advanced mode
G is an annual growth rate for customers who haven’t churned
K = (1 - Customer Churn Rate) x (1 - Discount Rate)
Discount Rate is a pre-defined annual rate of your choosing, accommodating risk and reduced value of future money. Skok suggests a value of 20-25% for pre-scale businesses. The calculator above uses a fixed discount rate of 20%.
SaaS VC and thought leader David Skok recently introduced a more advanced LTV formula, which produces a more ‘realistic’ estimate of the metric. The formula incorporates:
- Revenue expansion from customers upgrading plans
- Risk (resulting in a more pessimistic value)
- The reduced value of money over time