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Customer life time value
And this summer's hottest remix - LTV to CAC
Customer Lifetime Value (LTV) estimates the total dollars you’ll earn from a customer before they churn. It effectively tells you,
“If I add up all the deals I do with a customer, on average I’ll squeeze a total of [$x] out of them before they bounce”
Let’s look at each component:
Average Annual Revenue per Account: Pretty self explanatory. Note that this is easiest to estimate for subscription based businesses, since they’ll pay you a consistent amount each period. You can still calculate LTV for non subscription businesses (like Starbucks in the tweet above); it’s just harder to estimate the average annual revenue for a series of less predictable, one-time sales.
Average Account Churn Rate: This is the inverse of your average account renewal rate. Note that it’s measured on an account, not dollar denominated, basis. This is important because you may have a much better dollar denominated churn (or renewal) rate, as the larger customers subsidize the smaller customers. This is also easier to predict for subscription businesses because churn is pretty black and white - you know when they leave.
Cost of Goods Sold (COGS): This includes hosting costs, customer support, and customer success. It’s basically all the ongoing costs you incur to keep that customer around. The fish aren’t completely free once they’re in the boat. Also, I just made up that analogy and it’s not very good.
Generally all of these figures are best measured on a trailing twelve month basis to smooth for seasonality. If you have one bad renewal quarter it may cause your LTV to drop precipitously (shout out spell check).
What’s “good” look like?
Well, it all depends on how much you’re spending to acquire that customer. Ideally you want your Life Time Value (LTV) to be 3x to 5x your Customer Acquisition Cost (CAC). We call this LTV to CAC. If it’s not, it means you’re basically burning money, or destroying value.
If you want a refresher on CAC, check out this brilliant piece here.
Can LTV to CAC Be too High?
This might be controversial, but yes. “TOO MUCH VALUE?!” you say! Bear with me!
It could indicate you’re actually leaving growth on the table by not investing more in your sales and marketing machine to go out and acquire more customers. Since valuation is often tied to growth, you could be restraining shareholder value. And from a competitive standpoint, you might be making life too easy for your competitors by not more aggressively chasing net new customers.
Are there differences in LTV by Industry?
Absolutely. Most people only think of software, due to it’s contractually recurring nature, but other businesses can estimate LTV as well (like Starbucks. Take my money.)
You can even calculate LTV for heating and cooling (HVAC) companies. Most HVAC companies have an LTV of $47K, with customers starting off with smaller jobs and ramping up as shit breaks over their average two to three year lifetime. It’s also a lumpy one to calculate due to seasonality (people’s AC’s go out in the summer and heat breaks in the winter). You can find a couple of other funky examples here.
Anything else to watch out for?
You’ll want to look at both LTV and LTV to CAC by segment, or sales engine. Enterprise customers usually have a higher cost to acquire than SMB customers, but larger life time values driven by larger deal sizes and lower churn.
However, you may also discover cases where some customers are less valuable up front, but they expand over time and cost little to nothing to maintain. In other words, you need to slice and dice it based on who you’re selling to in order to get the full story.
And much like CAC, there’s a nearly 100% chance that whatever LTV a company self-reports understates churn as well as cost. Churn is often understated by excluding accounts tied to “sunsetted” products. On the cost side, expenses may not be fully burdened for overhead (rent, office expenses, IT) and share based comp (often a massive non-cash charge for startups) within Sales, Marketing and Customer Support. Beware of that Hollywood Accounting!