What is LTV?
Customer Lifetime Value (LTV) is the estimated revenue you’ll receive from an average subscriber over their lifetime, from signup through cancellation. LTV is a valuable metric for assessing the health of a subscription business and making informed decisions about customer acquisition.
However, it can be difficult to reliably estimate. In SaaS businesses, this is almost always a forward-looking estimation rather than a measurement of historical data.
Calculating LTV
LTV is the estimated revenue you’ll receive from an average subscriber over their lifetime, from activation through churn.
There are actually a number of different models to calculate customer lifetime value. We will cover a basic (and widely accepted) method and a more advanced one by David Skok. Whether using a basic or complex approach, understanding the methods for calculating LTV is crucial for making informed decisions for your business.
Simple LTV formula
This basic formula for LTV is commonly accepted as a useful starting point for estimating the LTV of SaaS customers:
ARPA: Average Revenue Per Account (the average MRR a single customer generates).
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 helpful starting point. However, it’s only a rough estimate and doesn’t properly account for MRR expansion, contraction or non-linear churn.
Limitations of the basic formula
The basic LTV formula produces an overly optimistic result. It assumes that churn happens linearly over the lifetime of a cohort. This is never really the case in most real-world scenarios. Most businesses see cohorts with churn at its highest in the first three months, before tapering off in later months:
In the example above, the blue “realistic” churn would lead to a far lower LTV than that of the linear model.
Additionally, the basic formula doesn’t account for expansion. If your customers usually upgrade plans over time, this greatly impacts LTV.
Let's look at an example.
Customer X is on a $100 monthly plan. We expect them to churn after 1 year. LTV = $1200.
Customer Y is also on $100 monthly plan, also expected to churn after 1 year. But Customer Y upgrades plans to a $150 monthly plan in month 4, and then again to a $180 plan in month 8. LTV = $1800. Pretty significant difference!
We are using a formula to predict the future, and the future, by its very definition is not predictable. The value in this analysis is to get enough accuracy to make useful business decisions, such as what factors to look at to improve profitability. David Skok, Partner, Matrix Partners
Advanced LTV formula
To address some of the shortcomings of the widely-used simple formula, David Skok, Partner at Matrix Partners presented a more sophisticated LTV formula:
This is much more complex — but don’t worry! Let’s dig into it a little.
The two concepts added to this new formula are:
“K”, the discount factor: Which takes care of value reduction on all fronts. This includes the usual customer churn rate, but also “Discount Rate”. Discount rate accounts for both risk and reduced value of money over time, mentioned above. It’s a predefined annual rate of your choosing. Skok suggests a Discount Rate of 20-25% for pre-scale businesses or 10% for scale-stage businesses. Using the discount rate and the churn rate, you can compute your discount factor as
“G”, the expansion rate: Annual Growth rate for customers who haven’t churned. Aka: the business expansion rate of your existing customers. Which turns your negative MRR churn into a positive figure in the formula.
Example
My fictional SaaS business has 1000 customers, with a total MRR of $300,000. That’s an ARPA of $300. Gross margin is 85% and my customer churn rate is 10% monthly.
I’ll apply a discount rate of 20%, because we’re pre-scale. The monthly growth rate of non-churned customers is 25%.
The simple LTV formula gives me $2,550.
Using the David Skok formula, my LTV is $1,496.17
Clearly, Skok’s formula results in a much more pessimistic projection of LTV, based on its discounting of value.
This advanced formula should result in a more realistic estimation of your business’s LTV. In the majority of cases it’s likely to be more pessimistic, except in the case of a really strong expansion rate.
The ChartMogul LTV formula
ChartMogul calculates Customer Lifetime Value as Average Revenue Per Account in each report interval divided by a six-month trailing average of Customer Churn Rate for that interval.
For example, with an ARPA of $100 and a 5% six-month trailing average of customer churn rate, LTV is $2,000.
Why is LTV important?
Balance customer acquisition spend
Customer Lifetime Value is useful when considering how much to spend on customer acquisition. If I know my LTV is ‘X’, I can confidently spend ‘Y’ to acquire customers without much risk. As a general rule of thumb, LTV should be at least 3x higher than your customer acquisition costs (CAC).
For example, if you spend $50 on average to acquire a new customer, your goal should be to generate at least $150 in revenue over the customer’s lifetime.
Determine payback period
How long does it take for a customer to “pay back” their acquisition cost? A higher LTV relative to CAC indicates a shorter payback period, allowing companies to invest more in growth.
Investor reports
Investors are interested in LTV because it is a key indicator of the long-term profitability and sustainability of a SaaS business. A high LTV suggests that customers are likely to stick around and generate consistent revenue, making the business more stable and attractive for investment.
It also helps investors gauge the efficiency of customer acquisition strategies by comparing LTV to Customer Acquisition Cost (CAC). If the LTV significantly exceeds CAC, it shows that the company can profitably scale and achieve long-term growth, which is crucial for investors seeking returns on their investments.
In short, many investors in SaaS want to see LTV as a part of their “health” assessment of a prospective investment.
Cohort analysis with LTV
LTV is also useful when comparing cohorts (groups) of customers to see which cohort generates the highest ROI on customer acquisition spend.
Cohorts are typically segmented based on characteristics like the time of acquisition, geographic location, industry, or behavior patterns. By analyzing the LTV of each cohort, SaaS companies can identify which group is most profitable and which marketing or sales strategies are driving those high-value customers.
For example, if one cohort has a significantly higher LTV than others, this could indicate that a specific acquisition channel, product offering, or pricing model resonates better with that group. This insight helps optimize marketing spend, tailor product development, and adjust sales strategies to focus on acquiring customers that will yield the highest ROI. Tracking LTV by cohort also uncovers trends such as seasonality, product-market fit in different regions, or changing customer preferences over time.
Inform marketing strategies
LTV also plays a crucial role in aligning sales, marketing, and product management processes. By tailoring acquisition strategies based on an understanding of different customer segments, SaaS companies can improve their marketing efforts and enhance customer acquisition to acquire customers.
A comprehensive understanding of LTV drives sustainable growth in SaaS.
LTV to CAC ratio
The LTV/CAC ratio is a vital metric for assessing the financial health and growth potential of a SaaS business. To ensure long-term viability, SaaS businesses should aim for an LTV that is at least three times their CAC. A higher customer lifetime value suggests a healthier financial outlook, enabling better decisions on customer acquisition investments.
Investors often look at LTV/CAC to gauge a company’s financial stability and growth potential, making it a critical metric for attracting funding. An effective LTV/CAC ratio indicates that a SaaS company is generating more profit from its customers than it spends on acquiring them. Companies with a strong LTV/CAC ratio often experience easier access to capital and better growth opportunities.
Tools and Resources for Calculating LTV
ChartMogul is a subscription analytics platform that helps SaaS businesses track and analyze key metrics like LTV.
It allows you to segment customers into cohorts based on various criteria like acquisition date, location, or plan type. You can compare LTV across these cohorts to see which groups are the most valuable. You can spot patterns, analyze growth opportunities, and adjust customer acquisition strategies based on accurate data.
By using ChartMogul, SaaS businesses gain a clearer picture of how LTV is evolving and what actions they can take to maximize customer value and improve ROI on acquisition.
Summary
Understanding Customer Lifetime Value (LTV) can raise several questions. A good LTV indicates a strong financial outlook and effective customer retention strategies. LTV is crucial for SaaS companies as it helps in assessing the long-term value of customers and making informed business decisions.
Whether using simple or advanced calculations, the insights derived from LTV help in making informed decisions about customer acquisition, retention, and overall business strategy.
Improving LTV involves enhancing customer retention, increasing order values and frequency, and reducing churn. By leveraging tools and resources for calculating LTV and performing cohort analysis, businesses can optimize their marketing strategies and drive growth. Ultimately, a strong focus on LTV ensures that companies can make the most of their customer relationships and achieve long-term success.