Software-as-a-Service (SaaS) companies the world over are seeking what all other companies seek: More revenue. But how can a SaaS company forecast revenue to plot their growth and invest their funds wisely? With Lifetime Value (LTV).
What Is LTV?
According to Keith Fix, CEO and co-founder of RetailAware. LTV, also known as Customer Lifetime Value (CLV), is “how much a customer is worth to you in total revenue over the lifespan of that customer’s subscription.”
It’s worth noting that LTV is how much a customer is worth, not necessarily how much they pay. “People forget that LTV includes the value of customer referrals and not just how much money a customer pays,” said Kris Rudeegraap, CEO of Sendoso.
Related Article: Keys to Building Customer Lifetime Value
How to Calculate LTV for a SaaS Company
“The easiest way to calculate LTV is to take average monthly subscriptions multiplied by the average subscription duration,” Fix explained. “For example, if you have a $9 a month subscription and customers subscribe on average for 3 years, your LTV would be $9 x 36 months = $324. It is important these assumptions are informed by your existing data, taking into account your average churn and subscription rate,” he continued.
And that is where the math gets more complicated, explained Shane Murphy-Reuter, SVP of marketing at Intercom. “Most businesses typically use a 1-, 3- or 5-year LTV calculation. If your company hasn’t been around that long, you can do some relatively simple modelling on subscription renewal rates (for a subscription-model business) or repurchase rates (for a more transactional business).”
On the other hand, if you’re looking for a simpler formula based on relatively easy-to-come-by metrics, here is the LTV formula used by Omnicalculator to calculate SaaS LTV:
LTV = [0.5 * 1 / churn * (2 * ARPA + ARPA_growth * (1 / churn - 1))] * margin
If math isn’t your forte, their free LTV calculator can do the heavy lifting for you. But even then, for an ambitious SaaS company, the math shouldn’t end there.
Related Article: Enterprise SaaS Churn Rates: What's Acceptable?
Why SaaS Companies Must Care About LTV (and CAC)
According to Rudeegraap, SaaS companies “live and die” by the CAC/LTV ratio. “A customer's lifetime value is necessary to understand if a business will succeed or fail. It is not the only important metric for a business to know. You also need to calculate the CAC. An ideal CAC/LTV ratio is one where the CAC is low while the CLV is high,” Rudeegraap explained. Asserting that large SaaS companies “owe it to their shareholders to know this crucial calculation. Similarly, small SaaS companies need to know this calculation so that they can get investors to fund their growth.”
Murphy-Reuter mentioned that LTV helps SaaS brands answer the most important question — will the customers that are being acquired contribute more revenue than they cost you? “Understanding LTV helps marketers determine the best ways to spend their money to ensure they are spending on the right ad placements and other marketing materials that will add value to their business and, ultimately, generate more revenue. In turn, LTV helps marketers unlock additional budget for their programs,” Murphy-Reuter explained.
LTV is vital for three key reasons:
Adjusting Your Customer Acquisition Cost (CAC)
Knowing your LTV allows you to correctly balance the amount of money your SaaS company spends on obtaining customers, also known as your CAC. After all, if your CAC is higher than your LTV, urgent action needs to be taken.
Knowing Your Customer 'Payback' Date
Once you ascertain your LTV and CAC, you can work out how long it takes for a customer to “pay you back” for the money you spent on acquiring them in the first place.
Raising Funds and/or Exiting Your SaaS
Any investor will want to see your LTV and CAC rate in order to judge the health of your SaaS business. The software may be groundbreaking, but if the numbers are weak or uncalculated, you’ll struggle to raise funds or exit your SaaS company.
CAC and LTV May Change Over Time
“It's also paramount to know that CAC and LTV can change over time. Your first 100 customers might be way more expensive to acquire than your next 100. The key is to learn from your experiences to optimize for both CAC and LTV,” Rudeegraap said.